Asset Manager Review
Some are saying that we have entered an era of low growth and low investment returns – although the link between economic growth and investment market returns is often disputed. What are your views on this? Patrice Rassou, head of equities at SANLAM INVESTMENTS says President Trump’s vision to “make American Great Again” has been compared to that of Franklin D Roosevelt who boldly said that “the reward for a day's work will have to be greater, on average, than it has been, and the reward to capital, especially capital which is speculative, will have to be less”.
However we are currently a million miles away from the mid2000s, when Chairman Ben Bernanke observed that we are in an era of great moderation, lauding new found economic flexibility and resilience, while praising central bankers’ steering the world economic around major economic shocks.
While President Trump may not be the next FDR, the future is likely to be very different from what we have experienced since the naughties during which financial returns were boosted by record low interest rates.
Maybe to echo the words of the FDR, we are about to enter an era where other factors of production – especially labour – will demand their fair share and inflation may rear its head again.
This would equate to lower returns on capital and greater economic uncertainty – both of which would lead to lower investment returns. Samantha Hartard & Chris Freund, portfolio managers at INVESTEC ASSET MANAGEMENT say the combination of lower real economic growth rates and low inflation is consequently having the effect of lowering nominal investment returns across the globe.
However, there are definite cyclical opportunities that periodically present themselves to greatly enhance returns.
We consider that such an opportunity currently exists; in the last six months global economic growth has seen a clear cyclical acceleration at a time that the world’s central bankers have yet to meaningfully apply the brakes.
Over a short term period the correlation between corporate earnings and share prices diverge greatly as markets try to anticipate earnings growth.
Although there are these periods where equity markets lag or overreact, over the long run equity markets rise in line with corporate earnings growth, not GDP growth.
Companies are not immune to the environment, so it does indeed stand to reason that (excluding periodic cyclical fireworks) we should prepare ourselves for continued lower nominal equity returns.
What worries us more are the current ultra-low global short and long term interest rates.
The result of being at the tail end of a 35 year bond bull market means that developed market fixed income cash and bond returns are very likely to disappoint in the future, as markets give back some of these returns that have been borrowed from the future. Jay Vomacka, senior portfolio manager at AEON INVESTMENT MANAGEMENT says over time, the company has noticed a trend that the forward-looking nature of the equity market has increased.
This has led to an increase in the dislocation between economic growth and investment market returns in a single cross sectional view.
Investment returns are linked to economic growth but only on a time horizontal forward looking basis and so it is getting harder to see the correlation at any specific time due to changing look-back periods.
Currently, growth is starting to pick up globally, albeit at a lacklustre pace but equity markets continue to see through the slow recovery.
Certain markets, like in the US and Eurozone, are making new highs before being confirmed by increasing earnings, stretching valuations.
This shows the intense forward-looking nature of markets. Andrew Vintcent, equity and balanced fund portfolio manager at CLUCASGRAY ASSET MANAGEMENT agrees with the assertion that investors are entering a period of low investment returns.
Current valuations on Equity Indices, coupled with multi-generational low global Bond yields lead us to be cautious on the ability of both major asset classes to generate decent nominal returns.
“We do, however, believe we are entering a period of improving global economic growth, coupled with moderately rising inflation.
“This is likely to be supportive of an improving corporate earnings profile, but given the high multiples, this growth is unlikely to be sufficient to generate high nominal returns from Equity markets,” says Vintcent.
“South African investors have become accustomed to an ever weakening currency to boost offshore returns – we caution against assuming a continuation of this trend.
“The Rand remains undervalued in real terms, and an environment of improving global growth has typically been supportive of commodity currencies.
“South African investors have the benefit of high nominal and real income yields from which to derive reasonable returns.
“The ClucasGray Equilibrium Fund (Reg 28 Balanced) has a large allocation to shorter duration income assets. Within Equities, we believe there are a number of sectors that have the prospect of delivering good returns for investors over the next few years.
“As a result, we believe that SA investors are not faced with the same low return environment as is the case globally.” Mark Appleton head of multi asset and strategy (SA) at ASHBURTON INVESTMENTS says economic activity results from a combination of people plus productivity.
Globally long term demographic growth has shown signs of slowing as have productivity gains.
“Faced with a lack of demand companies have lacked incentive to invest in capex and productivity has been suffering from a lack of this capex spend.
“Taken together, this has had a constraining effect on potential global GDP growth,” says Appleton.
“There is a natural long term link between economic growth and aggregate corporate profitability, although this will be influenced from time to time by the shifting shares of labour versus capital within the economy.
“Profitability will normally be positively influenced by accelerating economic growth because this creates greater demand, although at the individual corporate level greater competition could limit these gains somewhat.
“Equity investment returns will be influenced both by potential profit growth and by the cost of capital. Rising interest rates for example will increase the cost of capital and raise the rate at which future earnings are discounted back to present values.”
Going forward into 2017, Appleton says the global growth outlook appears to be brightening somewhat. Leading indicators and Purchasing Manager Index readings are showing definitive signs of improve- ment.
He contends that fiscal stimulus is an emerging theme which could unleash “animal spirits” with respect to corporate capex spend and this would be positive for risk assets in general.
“There are, however, signs that inflation may also be headed up and central banks could become somewhat less accommodating on the monetary policy front.
“While a rising interest rate environment in the developed world will not be positive for developed market sovereign bonds, it should not be too much of a constraining factor from an equity market perspective as long as the upward interest rate response is slow and measured and results from increased economic activity (and demand),” says Appleton. Nick Curtin, institutional investor relationship manager at FOORD says yields have fallen across the board over the last three decades, resulting in a steady rise in capital values across all major asset classes. Interest rates now appear to be entering a normalisation phase, led by the Fed.
“In a normal cycle, rising rates are not necessarily a bad thing – they usually follow a period of economic strength with rising em- ployment, wage levels, inflation etc. all of which are supportive of company earnings.
“However, in this instance, a long period of very low interest rates in many developed economies has resulted in some misallocation of capital through corporate activity funded by very cheap debt and investors chasing yield anywhere they can find it.
“In many instances this has led to overvaluation, which lowers the prospective future returns that investors can expect. We are in a period of low investment returns, focussed on capital preservation with high liquidity levels to exploit market volatility,” says Curtin. Liston Meintjes, head of investments at SASFIN WEALTH says: “In the first instance, I do not understand what is meant by ‘we’ as the US, as the world’s largest economy is set to grow at 2.5 percent this year and, if President Trump is successful in his aims, it could be higher; China, as the world’s second-largest economy (arguably far larger than the US in steel, cement) by official estimates is likely to grow at 6.5 percent; and India, currently only the eighth largest economy is growing at 7.3 percent”.
“Essentially what I am saying is that I can find no justification for a statement that ‘we’ have entered an era of low growth and low investment returns.
“What we have had is a totally unsustainable period of low interest rates, engendered by central banks and their policies in response to the GFC which was nearly ten years ago.
“It is doubtful that that period of ZIRP and NIRP will continue under President Trump, although officially he has no say in monetary policy and Janet Yellen’s term of office is until 2018.
“Already, inflation in the US is running at more than 2 percent, a level that the US Fed has persistently indicated as an item that would allow a shift in their policy.” David Crosoer, head of research and investments at PPS INVESTMENTS says it makes theoretical sense that growth in stock market earnings and economic growth should be linked; but clearly this does not mean there will necessarily be a direct relationship between economic growth and investment returns.
This is both because earnings growth is not the only driver of investment returns (the price investors are willing to pay for any future stream of expected earnings can often drive investment returns especially in the short-term) and also because the companies listed on the stock-market are not necessarily representative of the broader economy.
So my view is that studies that dispute this link probably don’t properly control for the noise that makes this relationship harder to discern - it’s hard to argue for instance that economic growth that broadly disappoints should be positive in aggregate for stock markets. Anet Ahern, chief executive officer at PSG ASSET MANAGEMENT believes that constructing a portfolio based on any economic forecast is fraught with failure.
“Where economic forecasts and expectations become very useful for bottom up investors, is when extreme or widely prevailing views (such as the one of low economic growth mentioned here) lead to investment behaviour which provides excellent opportunities.
“For instance, at present the gap between the valuations of so-called defensive companies versus companies more reliant on economic growth (cyclical companies), is as wide as it was at the height of the dot com bubble.
“This means that many companies of high quality, with good business models and excellent management track records, have become very cheap. In contrast, companies that provide more certainty of earnings have become very expensive.
“These cyclical companies are cheap despite the poor growth prospects, especially when viewed over the long term.
“For the thorough, patient bottom-up investor this is a time to be excited rather than concerned despite existing economic views, which may in isolation incite a much gloomier mood.” Pieter Hugo, MD of PRUDENTIAL UNIT TRUSTS says given that the JSE derives over 60 percent of company earnings from offshore, the link between SA equity returns and SA economic growth is not a clear one.
“Global economic growth is important, and in 2017 is expected to accelerate from low 2016 levels as the US and EU economies gather pace, while China remains stable.
“SA economic growth is also forecast to rise from very low levels – both of these trends should be generally favourable for company earnings.
“However, a great deal also depends on the direction of commodity prices and the rand, both very unpredictable factors,” says Hugo.