I find the end of every year strange. It is as if everything gets tallied up on December 31 and irrespective of what happened during the year, January 1 is a new beginning. Out with the old, in with the new….out with the bad, in with the good…. Then during January reality sets in and we realise (as if we didn’t know it), nothing has changed, and we still must deal with the challenges and demons of the previous year. This applies across all aspects of life, business, politics, pandemics, and investments.
During 2021 an astonishing USD 17 trillion was added to global wealth by the world’s equity markets. Even more astonishing is that USD 14 trillion was added by the US equity market on its own! Over the past two years, it really has been a case of not Deutschland, but “America über als!” This has led to the following scenario in the US:
- US stock markets are at an all-time high – that includes the S&P 500 as well as Nasdaq.
- Home prices are at an all-time high.
- The crypto market cap is at an all-time high.
- Wages are at an all-time high.
- Job openings are at an all-time high.
- Inflation is the highest it’s been in 30 years.
Clint Eastwood alias Dirty Harry comes to mind when he famously asked, “Do you feel lucky, punk?… Well, do you?” (With no reference to any of the readers!). When investors reach a point of exuberance after above average, and often ridiculous returns as we have experienced from certain sectors of the US market and crypto investments, it becomes a challenge to tone down the expectations of such investors. Greed (as opposed to fear in turbulent markets) sets in and often investors opt to pour more money into these fantastic investments.
So, investors do you feel lucky? The graph below indicates the relationship between the SPX Index (S&P 500 options index) and the US 10-year Treasury Bills Index. Periods to take note of are the 1999 SPX Index indicating the tech bubble selloff, 2007 onset of the GFC (Global Financial Crisis) and 2020 when we encountered the Covid-19 pandemic.
The trend of treasuries providing returns well below inflation and the steepness of the SPX Index line at more than 60 degrees since after the GFC is unsustainable. Something has to adjust, and it is likely to be both… The two lines indicated above need to move much closer together.
As mentioned before, interest rates are a function of inflation. If inflation rises or is expected to rise, then interest rates are adjusted upward. Interest rates and long-term bonds in the US and Europe are still providing negative real returns and that is unsustainable. Either the Fed will adjust interest rates upward or the equity market will adjust the interest rates. However, interest rates may remain low for quite some time purely to force economic recovery.
My question should actually be: “How lucky do you feel considering a five-year+ investment horizon?”. We know that the best long term inflation-beating asset class is equities. We also know that price matters and equities that are bought at the lowest intrinsic value are the ones most likely to provide the best long-term returns. This was at least the case until the onset of Cocid-19 when many investment theories flew out the window.
From the beginning of Covid up to now, the stars of performance were the tech stocks and outliers like Tesla and cryptocurrencies. From a valuation perspective not much made sense. Tech companies’ stratospheric returns can still be understood with the explosion of online transactions and the rate of development within the sector. Tesla and crypto boggle my mind. Tesla has yet to make a decent profit and there are companies like BMW that are innovative in electric cars as Tesla with sustainable profits at a much better price. Tesla is priced that all vehicles in the world will be electric by 2030 and all of them will be Teslas. Credit to Elon Musk, he is a master of innovation and a grandmaster at marketing and manipulating crypto markets and the Tesla share price.
What is clear from the latest data is that there is a new type of investor that we must consider. One who ignores investment principles and prices. One who believes in the story of tomorrow and that tech, whether that be systems or currencies, will overshadow everything in the future. However exciting this may sound, the inherent dangers of this outlook can cause severe losses if extreme trading continues. This will also have a severe impact on how indices will be represented and on the volatility of global tech-rich indices.
By the end of 2021, it is predicted that there will be more than 10 000 cryptocurrencies in existence. At the same time, there are more than 1 000 cryptocurrencies that have failed and many of the 10 000 current ones will follow suit. The crypto market has a low barrier to entry. Anyone with an idea on coding and has a plan can create their own cryptocurrency.
Many investors have made spectacular returns from crypto. As many have lost fortunes. Crypto is not a currency yet. As a traditional investor, I have difficulty understanding the price of an asset that you can’t touch, that doesn’t provide an income, that can’t be used to manufacture something, that is not linked to an economy or something of value and the creator of the largest coin has never been seen….
Having said that, I also dabbled in Ethereum some five years ago and I made more than a 1 000% profit when I sold my holdings a couple of months back. What a return! However, I consider that as speculation and gambling and I have no intention of allocating large sums of money to crypto.
My apologies, I have digressed somewhat. Getting back to my comments about the market and looking forward…
I made comments about the US market and the tech sector in particular. I also want to state that there are sectors within the US market that offer good value, not all assets are pricey and there are most certainly pockets of value that will benefit from consumer spending thanks to the US government that enriched many citizens.
Where I do see deep entrenched value is within emerging markets. Why do I say this? Currently:
- Emerging markets debt is less than that of the developed markets.
- Emerging market inflation is lower than in developed markets.
- Emerging market growth is higher than developed markets and they already produce almost 70% of the world’s GDP.
- Emerging markets are trading at an almost 30% discount to developed markets.
Leading the EM is China but it has its own set of problems:
- Ongoing regulatory announcements.
- The default of China’s second-largest property developer, Evergrande (China’s Lehman moment?).
- Electricity shortages (It’s not just SA that has this problem…).
Irrespective of the challenges and risks (that we cannot ignore), China can be the country that will lead market returns over the next five to 10 years. If we can look beyond the regulatory changes that China enforced aggressively virtually overnight, then there is an opportunity set that cannot be ignored. The drive to enhance consumerism in China is aggressive and purposeful…
In the same basket as China nestles good old SA…
Our economy is broken and without power, not much can be done to restore it. Unemployment, corruption, corporate governance, and low productivity with cumbersome labour laws make it difficult to attract new investors.
However, SA assets suddenly seem very cheap, and we recently saw real capital flowing into SA with transactions where Pioneer, Afrox, Imperial, Distell, AVI and Omnia were all bought by foreign companies.
Ratings look cheap across the board with low multiples and high dividend yields. But:
- there are unknown fiscal risks;
- unemployment and social grants are here to stay;
- require policy reform;
- power outages are here to remain for some years to come;
- interest rates are on the rise; and
- commodity price sustainability?
Irrespective of the above we must remember that more than 60% of the JSE listed companies are not SA focused. With assets trading at 2011 prices, there is a high upside potential over the next four years.
In summary, my take on global markets over the next five years is as follows:
- Developed markets are fully priced with pockets of value in certain sectors. Europe and Japan over the US.
- Emerging markets in particular China promise decent upside. Be mindful of risks.
- South Africa shows decent value with deep discount in certain sectors like financials. Sustainability of resource prices is questionable but resource companies are financially much better structured than in the past.
The challenges over the next five years:
- Higher worldwide inflation. Transitory inflation theories are changing to more long-term inflation trends.
- Rising global interest rates.
- Rising global bond yields (which implies capital losses in global bonds over the short to medium term).
- World debt is high across the board. Developed world countries and China can print money to deal with internal debt. That is more of a challenge to smaller EM countries where printing money will lead to currency depreciation.
- Rand exchange rate. Your guess is as good as mine … It all depends on the view of the world and if they agree with my theory that EM is the place to invest. If that happens the rand can remain range-bound at an around fair value between R14.50 and R16.50. If Covid-19 persists and the world goes into “safe mode” and ignore EM then the rand will slide and R18 can be in the range…
The bottom line is if you are a long-term investor, none of the above really matters. If you are a stock picker, good luck. If you invest via funds or trackers, then remain invested. Trust your fund manager and enjoy the festive season.