CIARAN RYAN: A shift is taking place in financial markets. A low-interest-rate and high-growth environment has been the general experience for most investors over the past decade. Now the environment looks decidedly unsettled, with the risks of higher inflation and interest rate pressure adding to the uncertainties of the war in Ukraine and threats to oil and wheat supplies. With inflation surpassing all-time highs throughout the world, the main concern now is how market players will keep their portfolios balanced.
Joining us to unpack this is Adriaan Pask, chief investment officer at PSG Wealth. Hi, Adriaan – good to have you back on again. Having noted some of the major shifts that investors should be wary of, what risks do you see in the offshore space in the coming months?
ADRIAAN PASK: Hi Ciaran, and hello to the listeners. I think in the offshore space things are certainly reaching some type of inflection point. If you look at the offshore bond space, for example, which has historically been the area that’s done quite well in times of equity market turbulence, correlations have sort of moved to one, in sync. So, as equity markets sold off offshore bonds [they] provided little protection – in fact they are now at similar levels to the S&P 500. So it’s marginally less, but still [there were] significant losses in that space.
So the conventional diversification properties have – at least for the time being – disappeared. But I think it has something to do with the fact that we’ve been in a very good space in offshore bond markets in the US for quite some time. So it’s really been a 40-year bull market – and we’ve spoken about this before. Where we are now is [that] they were essentially at a point where they [couldn’t] go any lower and interest rates are set to move higher, and that’s really prompted some turnaround in that space.
On the equity side of things, I think valuations have started to become a little bit more noticed than previously. So in a low-interest-rate environment I think investors are quite comfortable for multiples to expand, for PE [price-earnings] ratios to move higher just on the basis that volumes are continuing to grow, [and] profit margins are continuing to grow.
But what we are seeing now is the reversal of that trend. So interest rates are going to move up and we’ll see input costs go up and we’ll see volume growth decelerate. That’s going to have a knock-on effect on sentiment towards ‘glamour’ stocks as well, but the broader market in general.
I think more worrying is that, if you look at what consensus analyst forecasts are expecting, they still remain extremely optimistic [in] our view. So if that’s going to unwind at some point, which we think is going to happen, then we can expect more market turbulence for sure.
CIARAN RYAN: Okay. You mentioned [that] the sentiment towards glamour stocks is turning. Maybe just explain what do you mean by ‘glamour stocks’ – and are they turning for the better or for the worse?
ADRIAAN PASK: These glamour stocks are stocks that typically enjoy plenty of limelight and are usually quite popular. That popularity is propelled by a narrative of sorts that generally excites people. Things like Bitcoin could be an example, but I think there’s a bigger narrative out there that’s been in the limelight under technology – and technology shares have benefited from that as well. It’s actually not the first time that tech stocks have fallen into the trap, where there is this continuous narrative around profit-margin expansion; volume growth taking over the world kind of thing.
But in previous cycles we’ve seen other areas. You would remember the commodity supercycle narrative, where the narrative at the time was that Chinese growth was going to accelerate into perpetuity and that commodity supplies are way too short for the demand that’s in the pipeline. Right now I think, though, we are in that tech narrative unwinding a little bit. So as rates increase reality is sinking in, recession fears are starting to come into play and investors are starting to question the sustainability of volume growth and in particular margin growth.
CIARAN RYAN: One of the things you’ve observed yourself in the past is that this environment of rising interest rates is likely to impact negatively most offshore asset classes. Would you say that domestic assets have a better chance of outperforming the offshore equivalents over the coming months or year?
ADRIAAN PASK: Yes. I think we’ve already seen domestic assets starting to outperform offshore counterparts for a short while. Looking back longer term, South Africa has been through a very tough period. But for where I think we are right now, I think local assets are likely to offer better prospects than global ones amid the rising inflation and interest-rate cycle that’s taking place globally.
Our data shows that real yields on SA bonds remain attractive – and that’s in spite of significant improvements on the fiscal side. It wasn’t too long ago that we saw some forecasts indicating debt-to-GDP ratios exploding over 100%. They’ve actually moved lower, largely on the back of support from higher commodity prices, but they are now under 70%, which is actually even under the OECD [Organisation for Economic Co-operation and Development] country average. So we are actually in decent shape, yet our bond yields seem to indicate that there’s significant default risk there.
So I think there’s opportunity there. The risk-adjusted yields are quite attractive and the real yields, even if you compare [them] to other emerging markets, look quite attractive. We should also remember the key fear at this point in time is really about inflation and which companies are able to protect their margins and pass on input costs and inflationary pressures to consumers. But South Africa has a very commodity-centric market, and there’s an inherent hedge against that from higher commodity prices that are driven into the inflation number. So I think we are well poised there.
The other area that tends to benefit is, typically, banks. As rates tend to move higher, banks become more profitable, because they can actually afford to borrow on the short end and then earn better income on the long end of the curve. So that could be beneficial. I think the one thing just to keep in mind is what’s going to happen to volumes for the banks in terms of credit.
But I think the biggest driver across sectors is probably keeping in mind volumes and profit margins. I’ve mentioned it quite a few times already, but I really do think it’s something that’s critical in the assessment of where things are going and the prospects for various asset classes globally. In the South African case volumes and margins are quite weak by historical standards, and you see that in the valuations.
In the US ratings – and when I say ‘ratings’ I specifically mean PE multiples for valuation ratings – seem to suggest robust growth off a very high base already, with volumes that will remain unchallenged and margins that will remain at record levels. We just don’t think that’s realistic.
So, from a valuation perspective, the South African valuations have a lot of margin of safety already built in, and [reflect] reality, really, where in the US case we don’t see that at the moment. And that’s where the risk starts to come into play.
CIARAN RYAN: It’s quite interesting that South African inflation rates have been surpassed by global inflation rates in Europe and the United States, which is almost history in the making there. But given this environment that you’ve laid out there – where South Africa looks quite attractive from a domestic point of view – are there certain pitfalls that people should be aware of?
ADRIAAN PASK: Yes. I think some of the biggest mistakes that we currently see out there – as you can expect when things are quite volatile – there’s a level of over-optimism, and that comes to my earlier point around the volumes and margins in US markets in particular. So it just seems that things are being assessed very generously in terms of what the volume growth and sustainable margins would be over the long term.
But then I think there’s also a mistake of over-pessimism at the other end. That comes to my point around the SA bond market. I think our bonds are not accurately reflecting the fundamentals.
Yes, we acknowledge that we are under pressure, I mean we are seeing the pressure of Eskom and load shedding again. These aren’t unfamiliar things to South Africans, and yet our bond yields are accelerating but our debt is actually retreating, and we are actually doing a lot of improvement. At the same time the rating agencies have been coming out with better outlooks for the country – and yet the bond market is just ignoring that flat.
Some of the other things that come to mind in terms of what investors could watch out for is ignoring known risks – [such as] the US bond market, the impact of inflation rates and debt. We don’t think the US bond market is accurately reflecting the risks in that environment. So US debt-to-GDP has only grown, I think it’s grown probably by a multiple of four times since GFC [the global financial crisis], and yet we’ve only seen yields go lower and lower. That would suggest that the debt situation is actually improving, but it hasn’t. It has deteriorated quite significantly.
And then something that we use to our advantage – but we think many investors get wrong – is ignoring the lessons from history and, in particular, the cyclicality of things. Nothing moves in a straight line in our environment with investments, especially long-term ones, and it seems like people continue to ignore the things that have underperformed, and continue to invest in things that are quite popular. Something that comes to mind is, for example, the growth-versus-value debate, which I think has been well publicised. But that’s largely to be expected to revert again; that’s just normal market behaviour and we don’t think investors pay sufficient attention to those kinds of things.
And then, maybe lastly, [investors] not taking valuations into account. We’ve seen a lot of this over the last five years in particular: investors buying into glamour stocks and continuing to prop valuations up. I think what we see now is some unwinding of that.
So those would be the more common pitfalls at this point in time.
CIARAN RYAN: You’ve mentioned some of the market mismatches or pricing mismatches in both overseas and local bond markets, but what are realistic expectations for offshore assets, in your opinion?
ADRIAAN PASK: I think it’s a really good question because investors need to prepare themselves for returns that are far more muted than what we’ve experienced, for example, since the GFC and the recovery out of that space.
If we think of the S&P 500, for example, in 2009, it’s almost unbelievable to think that the PE multiple for the S&P 500 was in the single digits. So obviously return prospects from that environment look a whole lot better than when you are at a PE multiple of 25 times. So if we work off a PE multiple of 25 times, that really means that there’s an earnings cash flow coming through of 4%, so the inverse of the PE. At the same time there’s a dividend yield of maybe 1.5% – that’s sort of the US long term.
So you’re looking at mid-single digits, probably, for the US from these levels, which is significantly lower than investors would’ve experienced out of that 2009 period. But there was a very good reason why those returns were so high: because the valuations were incredibly low – as I mentioned, a single-digit PE, and at the same time profit margins were zero. So they were completely flat. And then they expanded from zero to the levels where we saw them at the beginning of the year, closer to 14, at record levels. That has significant implications for equity; significant tailwinds. But if you go from 25 or lower, and from 14% profit margins to something that’s more sustainable on the lower end, we think 7% or 8%, the impact of that on equity evaluations is quite material.
So I guess the prospects aren’t as great as they were going back to that period of time, but I don’t want to come across as bashing offshore investments in general. I think they still have an important role to play in a diversified portfolio. But the important thing is [that] where investors have overallocated to offshore assets, thinking that South Africa’s going to go to the dogs and the US is a one-way bet, I think those types of scenarios need to be re-evaluated. Just make sure that you’ve looked at all the facts and valuations and make sure the portfolio is positioned properly.
And then, lastly, maybe just on the bond side of things, and why we don’t like that space from a valuation perspective is [that] since the early 1980s the US bond market has been in that bull phase and yields have moved lower and lower and lower, to a point where they couldn’t really turn around or continue to go lower – and we’ve seen that reversal now just from 1.5% to 3% and how painful that has been for bond markets. Through our engagements with some of our offshore investment partners the sense is that maybe it has been a little overdone over the short term, but the long-term thinking is yields are still relatively low in a historical context, so [there’s] probably more pressure on that environment. And if you sit on a 3% or 4% potential bond yield and inflation rates are continuously stubborn, that doesn’t really make for attractive yields, whereas in the South African case we are back at 10% bond yields. So [that] looks attractive.
Making a long story short, we have more muted expectations going forward on offshore assets.
CIARAN RYAN: Given some of these tailwinds that you’ve been talking about here, there are some very serious risks out there. What’s your general advice to investors? How do they position themselves and their portfolios going forward?
ADRIAAN PASK: Yes, I think things have been very volatile, and that would suggest levels of uncertainty are quite high.
In a time of uncertainty we always go back to first principles: doing the things that we know will be beneficial, as opposed to doing the things that we might feel are the best but are not a hundred percent certain [about]. Those first principles become really important.
So if we think of it from a retail investor’s perspective, what do we know for sure? We know saving more is better than saving less. So continue with your contributions. Don’t deviate from your plan.
What we do often see is that investors climb into their shells. They don’t want to make investments. They really need to, to get to their retirement goals, but they climb into their shells and then that lasts for two or three years – and that pause in savings can be far more detrimental than a temporary setback in markets. That’s one thing.
I think thinking long term has a much better success rate than thinking shorter term, so don’t shorten your investment horizon on the back of this volatility – which also often happens. An investor should acknowledge that typically when you do that, mistakes become more probable. Anything can happen over the short term, [so] if you start to run your portfolio thinking too short term and positioning it in line of sentiment, you can very easily find yourself in a tough spot.
But if you think long term around the prospects for asset classes, and you look at valuations, that’s a far more sound way of trying to approach the complexity of markets. I think it reminds us that the retirement plan was designed and underpinned by factual data. Most financial planners out there designed these plans taking [into] account multiple recessions over your 40-, 50- even 60-year investment horizon. So, if that was done properly, don’t make sweeping changes to your portfolio and think you’ve got to acknowledge that. Once you start doing that, you start to challenge the factual data that underpin that plan, and [then] you’re starting to actually position the odds against yourself – which is obviously not what you would want to do.
I think those are the things that are often overlooked. Investors do these things not understanding what the long-term consequences are. So just a reminder out there to investors that those things remain critically important.
CIARAN RYAN: All right. Adriaan Pask, chief investment officer at PSG Wealth, we are going to leave it there. Thank you very much, Adriaan.
ADRIAAN PASK: Thank you very much. And thank you to the listeners.
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