Reflation: New thinking for a changed market

SA investors advised to think global.
Picture: Shutterstock

Since 2009, markets have been stuck in a post-crisis, stall-speed, liquidity-trap – an environment where asset classes were highly correlated amid excesses of supply and very weak demand.

But things are starting to change, says Agam Sharma, portfolio manager, Global Multi-Asset Funds, PineBridge Investments. “Global markets have exited the post-crisis, stall-speed period that held from 2009 until mid-2016,” he says. This shift represents a new market ‘environment’ that will prove beneficial for offshore markets, and will have profound implications for South African investors’ positioning. 

It may be stating the obvious, but South Africa is not following in step with these markets and investors need to adopt a global perspective across their investment portfolios. While inflation has moderated and growth is expected to improve in the next quarter, South Africa’s long-term growth prospects are not promising. Local manufacturing is contracting, a turn in the commodity cycle is unlikely given the challenges facing the mining industry and the consumer economy is under pressure.

The results of the ANC elective conference in December are also unlikely to impact the economy greatly. Facing rising populist pressure neither the Nkosazana Dlamini-Zuma camp nor the Cyril Ramaphosa camp are likely to introduce the structural and growth-centred reforms necessary for the economy to boom. 

Local companies are looking offshore for growth and returns.

“If you look around the world there are other countries with better prospects – for both economies and markets, says Urvesh Desai, global equity manager of Old Mutual Investment Group’s MacroSolutions division.

But before investors rush offshore they must factor in the price of the rand. “This is the biggest factor influencing returns of offshore assets for South African investors,” he says.

“The moves of the rand have the ability to spectacularly enhance or seriously detract from the returns of offshore investments. So it must be the key consideration in the decision to invest money offshore.”

That said, according to Sharma offshore markets are undergoing a turning point towards a market that can be characterised as ‘reflationary’. What this means is that a step up in growth, confidence and pricing power will help to rebalance markets and shake off depressed growth, in much the same way that the 1950s finally shook off the disinflation of the 30s and 40s.

A number of factors have put an end to the stall-speed market environment, and have led to the current opportunity set we see in offshore markets, Sharma says. First, starting in early 2016, China balanced supply-side management, withholding capital from inefficient state-owned enterprises, forcing production cuts and supply rationalisations. This removed China’s oversupply of goods onto the global market and so ended its exporting of deflation.

Second is, simply, the passing of time. Most post-financial-crisis market periods of private sector deleveraging take about 10 years to run the course; March 2017 marked year nine.  Private sector deleveraging in the developed economies “saucer-bottomed” in 2015, says Sharma, and began rising again in the middle of 2016.

Third, the election of US President Donald Trump raised the prospect of dismantling much of the overzealous post-crisis regulatory structure. Business confidence subsequently rose, with most companies now poised to begin investing to grow again.

However, it is not a case of a rising tide lifts all boats equally or smoothly. “Globally we are in a space where politics has had a surprisingly large impact on markets,” says Desai. “Usually politics create short-term noise in the markets while longer-term markets are guided by economic fundamentals. Now politics is impacting economics.” Examples include Trump’s election, Brexit, the efforts to repeal Obamacare, fiscal policy. “All of these examples have impacted markets more than one would have expected in the past.”

What is important though is that if a particular market environment persists, it shapes the economic and market landscape, thus favouring certain offshore asset classes and investment styles over others. So what does the offshore market environment look like now, and what are the implications for offshore investors?

“Our favoured asset class is global equity,” says Desai. This comes back to the reflation mentioned above by Sharma. “Earnings expectations are stable and improving and wage inflation is negligible. Also we are not seeing warning signs of an imminent recession from the corporate bond and credit markets, which tend to be good at indicating trouble ahead.”

For instance, for the first time since 2009 growth has been healthy enough to generate confidence across global markets. “We are seeing this trend in renewed appetite and animal spirits among offshore investors for risk assets, which will continue to support asset prices,” adds Sharma.

A change in correlation bodes well

Offshore asset class correlations have crashed to pre-crisis levels. Correlations between securities and asset classes have fallen significantly, reflecting the newfound optimism about sustainable growth and improvements in pricing power. In this environment active asset managers are likely to find their feet again, because they rely on differentiation between asset classes to add value, he says. In contrast, passive investment strategies which have flourished globally since 2009, and are becoming popular with South African investors, will now likely struggle.

The deferral of consumption from persistent de-leveraging is over. Growth stepped up in the middle of 2016, as did inflation – even in Europe. Reflation is positive for growth assets, mildly negative for capital conservation assets, and neutral for real assets, Sharma says.

 As a result of these changes, offshore investment behaviour will need to change markedly, with less emphasis on defense and drawdown management, and more willingness to embrace capital appreciation. “We expect growth assets to move back into the spotlight as confidence, growth, leverage and prices improve,” he says.

This will provide an attractive backdrop for investors in South Africa willing to look further afield. Among asset classes, Sharma says the firm favours equities, cash, and floating-rate credit instruments over fixed-rate, low-yield credit. However not all equities are well priced and within this class selected pockets of US stocks are attractive, including US financials, US small caps, and value.

Beyond the US, he favours Japan (a classic beneficiary of rising global growth) and select emerging markets that combine structural reform with a focus on domestic consumption. These include Indian equities.

MacroSolutions’ preferred asset class is also global equities, with a particular focus on Europe where growth is rebounding following years of fiscal consolidation. Within Europe interesting countries include Poland, which benefits from a buoyant German economy; and Spain, which is seeing ROEs of their banks improving. Further east Desai says countries to watch include the likes of Taiwan, where the semi-conductor industry benefits from smart phone demand.

Considering the high valuations of many markets currently and the improving economic environment, Desai says the preference is for value stocks over growth stocks. “Global growth is on a 19x forward PE multiple while value stocks are on a 14x multiple.”

In a reflation environment, where economies are improving and bond yields are likely to go up, value tends to perform better, he says. On the other hand, quality companies – those strong stable entities with low volatility in earnings, do less well. “They have performed very well over the last five to ten years and as a result are quite expensive, but by their nature are less geared to whether the economy is better or worse. Instead companies that were doing badly are now doing better.” These could include more cyclical sectors like financials and industrials. However, the outlook for resource or material companies is less positive as “China’s transformation to a consumer-driven economy will delay the onset of a commodities upswing.”

High valuations are not a good indication of a coming recession or market crash, and in the current environment positive earnings growth remains likely. But what these valuations do indicate is that long-term returns will be lower than average. “In the last 50 to 100 years, equities have delivered real returns of about 7%,” he says. “That number is likely to be closer to 5% meaning we will see lower real returns over coming years.” Nonetheless, this remains better than the very low and possibly negative real returns likely from global bonds or global cash.

The point being made is that change in the offshore market environment is under way. Those who fail to recognise this are in real danger of being passed by.

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