CIARAN RYAN: Over the past year we’ve seen unprecedented levels of fiscal and monetary support globally. A combination of US President Joe Biden’s $1.9 trillion stimulus aid, the US Federal Reserve’s determination to suppress interest rates for longer, and a possible post-Covid-19 consumer spending boom give market participants enough reason to believe that a spike in inflation is imminent.
Today we speak to the chief investment officer of PSG Wealth, Adriaan Pask, about investment risks in the current environment. Hi, Adriaan. Just picking up on that subject, what are the current risks to investors in the current environment?
ADRIAAN PASK: Hi, Ciaran, and thanks for the opportunity. There are quite a few risks around. In investing in markets there are never no risks, but I think what we are definitely experiencing in the current environment is innovative levels of risk – not just referring to what we saw last year, but also looking ahead. What we saw last year was very much risk induced by volatility. Typically, why that’s so detrimental is that from a very practical perspective it tends to shorten investment horizons quite a bit. So everybody has a plan until the markets get too volatile to stomach, and then plans change.
From a wealth manager’s perspective that’s obviously quite detrimental to wealth creation. So, if you look at what happened in the industry, for example last year at the peak of the currency weakness, a lot of money was still going offshore and simultaneously money [was] going into either cash products or very conservative fixed-income products. That just speaks to the fears that were in the minds of investors at that point in time.
The problem there is that if you look at inflation, for example, and the levels of cash that are being rolled up into the economies, if you’re investing too conservatively you obviously run the risk of not beating inflation, especially with interest rates at 50-year lows. The other thing is, obviously, many of these investors who disinvested at the bottom of the market missed the recovery – essentially just crystallising the losses. So that volatility is always detrimental.
The volatility in itself is not a problem. Volatility creates investor behaviour that becomes self-destructive.
The other thing is that historically we’ve always seen, as capital starts to enter economies and markets, things tend to get a little bit more on the adventurous side. So we would have seen IPOs, for example. But this time around we are seeing a whole new thing. Bitcoin’s been around for a while, but what we are seeing is other types of speculative behaviour, and Archegos Capital was one to think of. The other would be the Robinhood/GameStop saga – and the list goes on. So, these speculative-type investments, I think, are catching investors at the moment because obviously, with interest rates low, investors are quite open to taking on other types of risk in an effort to get some more yield or return out of their investments.
But I think for us, first and foremost, the biggest risk looking forward would be the risk of inflation, or maybe more accurately the interest-rate hikes that will follow any inflation lower.
CIARAN RYAN: Let’s just pick up on that emotional investing for a moment, because every time there’s been a shock to the market, as we saw last year with the Covid crash, people make very rash knee-jerk decisions – and these do seem to be emotionally driven. What do you think of emotional decision-making? Is it a big risk in the investment markets at the moment?
ADRIAAN PASK: Yes, I think for us [it is], but volatility will ensure that risk will be there. From another perspective you can say that it also creates opportunities for other investors, so ultimately you get the investors who make mistakes and other investors profit from it.
It’s very important to understand what’s going to determine that you end up in the right camp. So typically, if you’ve got a plan and it sounds easy but [you are] sticking to it, even if there’s a lot of uncertainty like last year – and people are quite unsure of whether there will be global economic recoveries and what the world is going to look like three months down the line, and even three years down the line – for you to still hold on to your equities that are there to generate long-term growth takes a bit of courage.
But I think there are always things that you can look back on and remind yourself of. We’ve seen multiple crises over many, many years – and they will happen again. For some inexplicable reason we will see the same mistakes being made once again, and those that typically tend to profit are the ones that see the bigger picture and are willing to stick to the plan, regardless of how hard it gets.
It’s always much easier to keep that investor behaviour in check if you know firstly what to expect, and secondly how you need to react when that event takes place. That for me is really the essence of good wealth planning.
Someone should sit with you and coach you and talk you through it, and just calibrate the thinking, focus you on the long-term plan, no matter how difficult the short-term pains can be.
CIARAN RYAN: All right. Let’s pick up on another point you raised there about the threat of rising inflation. A lot of people are concerned about this, particularly given the size of these stimulus packages that we’re seeing around the world at the moment. Should we be concerned about inflation, and why?
ADRIAAN PASK: Well, like I mentioned, I think inflation in itself is not really a problem. It depends on how drastic it is. You can always have an all-time Germany-type inflation, which is obviously very detrimental on neighbouring countries. There’s a good practical example of how inflation can be quite detrimental. What we are talking about here is still reasonably moderate hikes relative to that. So maybe a more plausible – although still quite extreme – situation is what you saw in the US in the early eighties, where [Paul] Volcker just stepped in as Fed chair. Inflation was around 11% when he came in and a lot of that had been stoked by Vietnam war expenses. Typically, through war periods you’ve got supply-side shortages around food and those kinds of things, which create inflation. At the same time the oil price was accelerating, and that created inflation.
In the first six months of Volker’s tenure inflation actually rallied further higher, up to 14%. At that point he decided to pull the trigger and increase interest rates, which quite astonishingly hit 20% six months later. You can imagine what happens to the economy if you sit with interest rates at 20% – you will find that unemployment will pick up, you’ll see bankruptcies pick up because people can’t afford debt anymore. Obviously, you’re going to choke the economy in terms of GDP growth. Markets won’t love it. Fixed-income markets hate interest-rate hikes to that extent. So, there are a lot of negative consequences from that.
So, if we were to see inflation pick up and interest rates follow, it could be quite painful – and it needn’t be as extreme as the example I just gave you. It can even be just going towards what the Fed has penned – done – for itself as a long-term normalised inflation rate of 2.5%. If you need to go from where we are at the moment, from near-zero to 2.5%, the implication for asset prices is quite severe. If you stress the 30-year US bond, for example, typically it loses about 20% in value for each 1% increase in interest rates. So, just broadly speaking, a 2.5% increase would equal a 50% loss on the capital value of that bond.
And similarly for equities; typically, analysts discount the cash flows of the companies as the profits they make with the discount rate, which is typically the shorter end of that same curve. So again there, if that’s to accelerate, it would ultimately imply lower valuation for stocks, which means all these stocks that have rallied up to higher multiples, like the tech stocks, the ones pricing in cheap capital into perpetuity, those could very well end up suffering for quite a bit.
CIARAN RYAN: If you look at inflation in South Africa and in the US, it has been fairly subdued up until now. The expectation is that interest rates will start to rise, but we haven’t seen a pickup in inflation as yet. Why not?
ADRIAAN PASK: It’s a very good question. If you look at the various regions around the globe, inflation is a mixed bag. So, in the US it recently went up from 1.4% to 1.7% last month, but still the 1.7% level is where they were coming into the Covid crisis last year. It’s still around that, just below 2%. South Africa is actually coming down from 3.2% to 2.9%, and you’ll see similar things across most markets. I think too exotic just yet, but we think if you look at the amount of capital that’s being introduced in the global economy through trying to stimulate the economy, it should have led to some type of inflation or at least indications of inflation ticking upwards, even if it didn’t mean massive hikes just yet.
But currently there’s just no evidence of any additional capital that’s flowing around.
What we’ve seen is that although M2 Capital – which is the broad money supply in the economy – has completely exploded and ballooned out, so have the savings rates in the US. If we go back about six months or so, the savings rates were around 35% – and that’s just all these cheques that are being handed out and money being supplied as a relief measure. Ultimately the hope is that that goes into the economy to support the economy, but it has just not reached the economy.
So, what they typically say is there’s no velocity of money in the economy – which is to say that money isn’t circulating. People aren’t spending it; it’s not being collected and then being spent elsewhere. And so on goes the circular. Part of that’s obviously explained by the fact that we’ve had lockdowns, and some of it is back to the psychology element, that people aren’t comfortable spending cash on luxury items at the moment when you’ve just been through a period where you lost your job, or your business has had to close down. You hang on to whatever you can. There’s not an absolute necessity [to spend]. You rather hold back.
I think there’s a lot of that behaviour playing out.
But as consumer confidence tends to pick up again and the economy opens up again, and we’ll see that money start to flow into economies, there’s a lot of pent-up spending currently sitting in the savings pool.
CIARAN RYAN: All right. Given the risks that we’ve just been talking about, the emotional risk, the risk of inflation, the risk of rising interest rates, what should investors be doing now?
ADRIAAN PASK: It sort of leads back to some of the opening remarks around thinking long term, how volatility can compromise your behaviour as an investor and shorten your horizons. All of this plays quite neatly into a common theme around looking ahead, where we think it’s very important to think long term at the moment because we are sitting with interest rates that are very, very low. So, your probability of generating inflation-beating returns out of those is very low. And yet that’s where capital is going.
And the other one is that capital is going to offshore markets, and to look at what the impact could be on some of the more-preferred destinations of capital over the last few years, which have been tech stocks and bonds. Bonds have now been in a bull market for 40 years. That trend has to reverse. There’s a natural cyclicality to most investments that must be overlooked. So I think looking ahead we must try to find opportunities where you see valuations.
Think long term, don’t just follow the crowd, avoid all the speculative investments that are currently being associated with this phase of the market.
I think if you could just stick to those things, you’ll do yourself a good service. It’s about avoiding mistakes at this point.
CIARAN RYAN: And also, I guess, using multi-asset fund managers that allocate assets across the different asset class spectrum would help.
ADRIAAN PASK: Yes, for sure. I think it’s quite strange that you’ve seen through the industry that people are quite happy to take the asset-allocation component in their own hands and allocate to cash as they see fit, or allocate offshore as they see fit. If you look at the calibre of multi-asset fund managers in the country, managers that manage portfolios across the spectrum of asset classes and can allocate on your behalf, that feels to me like a much smarter move at this point in time. We’ve got very skilled guys, as I’ve said, and it’s a very fluid environment at the moment that requires a lot of discipline. I don’t think investors should be taking on that responsibility themselves.
We did see, prior to this cycle, money flowing offshore and into the money market.
There was a big uptick in multi-asset funds with exactly that thinking, people thinking fund managers are better equipped to deal with this on my behalf – and I think we’ll see a return of that trend come back.
CIARAN RYAN: We’re going to leave it there, thank you. That was the chief investment officer of PSG Wealth, Adriaan Pask.
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