CIARAN RYAN: A shift is taking place in markets. A low interest-rate, high-growth environment has been the general experience for most investors over the past decade. As with all things in life, markets also go through cycles. PSG Wealth has been warning of this shift for some time now, and that shift is now clear for most to see.
But there are other material shifts we can expect over the next decade, shifts that investors need to be prepared for. To discuss this, we are joined by Adriaan Pask, who is chief investment officer at PSG Wealth. Hi, Adriaan. There are a few signals pointing to a shift in markets. Over the last decade investors have experienced some specific market behaviours. Explain what the market looked like in the past decade.
ADRIAAN PASK: Thank you, Ciaran. I appreciate the opportunity. Yes, the past 10 years or so have been somewhat unique and quite different from what we saw in the first 10 years of this century. We think it’s going to be materially different for the next 10 years as well. Why that second 10-year period – from the 2010s on to 2020 – was so unique is that the cost of capital was quite low. Interest rates on aggregate were below 1%. So, there was a lot of stimulus around. If you look at those first 10 years of the century, we had cost of capital above 3%. So, it sounds like small changes, but the impact downstream is actually quite significant.
Where you would see this impact investments, and equities in particular, is on profit-margin growth. So, if you look at the S&P 500, for the first 10 years it was roughly around that 7% level, whereas over the last 10 years we’ve seen it at 10% on average, and it’s currently around the peak levels of around 13%.
At the same time we saw projected growth rates for US stocks increase significantly on the back of that. The cost of capital is obviously also a proxy for the discount rate, so essentially how you value stocks. With that in mind, higher multiples were perfectly justifiable. So you saw that the top 10 of the S&P 500, for example, in the first 10 years were trading at around an 11 PE [price-earnings ratio]. I don’t think many people can recall those days when offshore stocks were trading at low double digits – 11 seems incredibly low. We would be incredibly fortunate to have such levels now.
But where we stand now is closer to that 27 times, so significantly more expensive as sentiment towards US equities, particularly over the last 10 years, has been very, very good. That’s exactly the component that we think is going to change. What we see now is multiple expansions, so PE ratios moving from 11 times to 27 times, as I’ve said. And the larger companies in the index have done quite well. So, for a long period of time our audience will know we refer to these as ‘Fangs’ – Meta [Facebook], Amazon, Netflix, and Alphabet [Google] – stocks, all the stocks that experienced lots of growth. Tech-type companies were really in quite a bit of favour.
The concentration levels on the S&P 500 typically make for a good proxy for how much risk there is in the index. In 2010, those top 10 stocks really constituted 18% of the index weighting. Where we stand now is closer to 30%. So significant changes there. But that is all still justifiable if you can look at the earnings and say, well, are the earnings there, or have the prices run ahead of earnings?
Now, if we go back to 2010, I mentioned that the top 10 stocks constituted 18%. But if you look at the earnings contribution, that was around 17% – so quite closely aligned. Where we are now in terms of earnings contributions is around 20% versus the 30% index weight. What this implies is that prices have moved fundamentally and significantly above the earnings contributions that are coming out of those firms.
So there’s this dislocation between earnings and valuation, and that means risk has significantly increased.
The last 10 years have been fantastic on the back of that; as these multiples expanded and stocks got more expensive, obviously investors benefitted from higher share prices.
So that is what we have seen in the last 10 years that we think [has been] quite unique.
CIARAN RYAN: Okay. So there is this dislocation between earnings and valuations, and yet a lot of investors seem to believe this same pattern will continue indefinitely. Now you believe there is a material shift or several shifts that are taking place. What are the top three shifts you believe investors should be aware of?
ADRIAAN PASK: Well, I think essentially there’s only one key change, but the consequences of that creates a domino effect.
The key change that I’m referring to is higher interest rates. We’ve seen what the Fed [US Federal Reserve] has done, we’ve seen inflation rates around the world escalate, we’ve seen monetary policymakers start to escalate interest rates. Even in South Africa we’ve seen the MPC [SA Reserve Bank Monetary Policy Committee] also announce that they’re making changes – and there are more expected.
But what that really means is: obviously a higher interest rate puts a damper on the economy, so you would expect to see lower sales volumes come through as consumers feel the squeeze; then also lower profit margins because the financing cost that these firms have to pay to acquire capital to grow is increasing in line with interest rates.
Obviously with that, you’ve got additional pressures from wages [and] taxes are likely to go up because we see the debt-to-GDP ratios totally explode out. Where the US is now, nearing 140% debt-to-GDP means there’s very little room for them to provide further tax relief. If anything, it’s going to go in the opposite direction, and all these things really impact profit margins. So less for profits in general. And I think that the second phase of that narrative is really a rolling off of good sentiment. So we’ll see poorer sentiments in the coming 10 years as the outlook softens quite a bit.
Then the most important thing I’ve mentioned a few times now are the ratings. I think that’s something that’s going to retreat as well.
So we’ll see in general lower multiples. When everything’s going well and there’s a lot of easy money in the economy, you can justify higher multiples – maybe not as high as the 27 that we’re currently seeing, but higher multiples than the 11 times that we experienced in the first 10 years.
So the question is really: where should that multiple be? If you sit in an environment where interest rates are moving up, there’s a lot of pressure on costs, and generally sentiment is receding, [and] from that obviously we see stock prices adjust. I think it is going to be largely driven by a derating impact through interest rates – which is the core component for everybody to see. I don’t even think that’s obviously big news for everybody. I think the real trick is to make an accurate assessment of what the consequences of that will be on profits and sentiment and multiples downstream.
CIARAN RYAN: That brings us back to the old saying – and you’ve repeated this several times – ‘quality businesses make for good investments’. Is that a myth or is there some reality to that?
ADRIAAN PASK: I think quality as an investment strategy has worked quite well. So, businesses that generate high volumes of cash, typically their return on capital is good, more than the cost of capital.
But what we see now is there is more pressure on these businesses to sustain higher cash flow, because the cost of capital is going up, and obviously the margin of error is significantly decreasing.
It always helps to try and illustrate this point by way of example. So, if you look at something like Microsoft, for example, it’s a fantastic company with a good long-term track record. But if we look at what the share price was in the mid-nineties, you could pick up Microsoft stocks for $5/share – unbelievable. Investors obviously recognise that this is a great business. It’s on the right side of where the future’s going in terms of using technology to become more efficient. There’s a lot of demand around. So it really feels like it’s a well-managed business with a great product, a lot of cash flow coming through.
But actually, what happened following the early 2000s, obviously was the tech crash. What we saw in the 12 months over that period is that the share price halved to $25 a stock.
But that isn’t the worst news. The problem is, if you go into shares at these elevated levels, you can wait a long time to make your money back. In Microsoft’s case it took 16 years to get back to $50/share. That happened only recently in 2016. It doesn’t feel like it, because these tech stocks have done so well in recent periods. But essentially, if you invested at that time under the narrative that there’s a fantastic quality business, it’ll continue to grow and make money – all those things were accurate. The problem is you overpaid. You paid $50/share and you had to wait 16 years for it to come back to that level. You only recently started to make money out of that.
So there’s a significant opportunity cost involved as soon as you start to overpay. It significantly pushes out the required investment horizon for that stock. It’s really important, I think, that the key here is that investors have become increasingly casual about what they pay for earnings, what’s been generated as profits out of these businesses.
It’s good if you can look into the future and say, well, there’s a lot of growth on the cost, but you have to ask yourself, how much growth is currently priced into these businesses, because [if] that growth is already priced in, then there isn’t really an opportunity there. You are a hundred percent correct in terms of the narrative that the company’s going to do well, but it’s common knowledge, and therefore the price is already reflecting that and doesn’t necessarily make it a good investment.
CIARAN RYAN: Okay. You mentioned that offshore bonds will not be able to offset an investor’s losses on offshore equities during market turbulence. Just elaborate what you mean by that.
ADRIAAN PASK: Yes. I think it’s a fundamental shift in the way that offshore portfolios have been managed. In offshore we always see these 60:40 multi-asset portfolios, where 60% of the assets are invested in equities and 40% in bonds. The first principle that was applied there in constructing that type of product was that, should your 60% in equity suffer pain, we should expect a flight to safety, a flight to bond investments – and therefore we should see the bond yields decline and you make money off your bonds, which will provide a buffer.
But in the current environment – and we’ve actually seen this now in the first few months of this year already – if bond yields are already so low, investors shouldn’t expect them to go down further, because they simply can’t. What we have seen now in the first six months is, yes, there’s been pressure on the S&P and offshore stocks, but bonds haven’t helped.
In fact, bond yields have moved up, which means that bond yields have suffered at the same time that equities have suffered. That brings a very important question into play in terms of what you are going to do to manage risk in your offshore portfolio to offset losses on equities over the short term. That’s a really important question to be able to answer. Also how you assess the risks then, because the risk landscape has completely changed and the range of outcomes for portfolios has significantly widened, because you don’t have that narrowing of performance in one asset offsetting the other.
So I think in the offshore space investors have a significant challenge on their hands to try and build a well-diversified portfolio that will offset risk, especially if you’re sitting in an environment where asset losses are generally quite expensive.
South Africa has been out of favour for a while. We made a good recovery out of Covid, but there are still so many things that everybody is uncertain about. But quite similar to what I mentioned on quality and Microsoft, and how not everything that looks good performs well as an investment – the counter to that, if you look at it from the other perspective – is to say, well, not everything that looks poor makes for a poor investment as well.
I think South Africa is almost the antithesis of where we stand with the US, for example. Because we do have many issues but our asset prices are reflecting terrible news – both in bonds and in equities – and therein lies the opportunity if you’re willing to embrace the risk and uncertainty that comes with that.
CIARAN RYAN: Okay. There is quite a lot of confusion around the rand. A lot of people are saying it’s a one-way bet. What’s your view on that?
ADRIAAN PASK: Well, the rand should depreciate under normalised inflation conditions and when capital is fairly well spread globally. But currently US inflation is at a multi-decade highs and we are seeing this through other developed markets as well, and even in South Africa.
The thing is the inflation numbers are now also stickier than what was expected. So in that type of scenario, you can actually think that the dollar should depreciate, which means that [with] the relative strengths versus the rand, the rand could actually be quite stronger versus the dollar.
So it’s not necessarily a rand story as much as it is a US story. You can imagine, for example, if we had inflation numbers to the levels where the US is experiencing, where our interest rates would be. Then you start to think, well, let’s look at the debt-to-GDP numbers currently in the US as well, and those don’t look great either.
If South Africa was in that situation our currency would be significantly lower – our debt-to-GDP is now under 70% – and yet the assets are cheap, reflecting complete chaos.
So, to put a long story short, I’m somewhat of a lone voice, I think, on this one, but I think the dollar is set to disappoint and the rand (could) go through a period of strength.
These are currencies in the end, so only time will tell. But I do think if you look at the fundamentals of what’s happening in the economies, and how much positive sentiment there still remains in the US, in spite of all the volatility that we’ve seen over the short term, there are still very high levels of capital stuck between the US borders. We think if that capital starts to move out to other areas, the dollar could take some pain. And obviously the inflation and interest rate outlook further supports that theory.
CIARAN RYAN: Okay. So, I’m going to ask you to look into your crystal ball and say how we or investors should prepare for the next decade?
ADRIAAN PASK: I wish I had that crystal ball. But I can give you a sense of what we’ve been doing in our own business in terms of preparing for the next decade.
I think first and foremost, investors need to have more realistic expectations in terms of offshore investing. The last 10 years have been absolutely fantastic, but you will be making a massive mistake if you think that that will continue over the next 10 years. Things have fundamentally changed. The backdrop has changed a lot, so it’s highly unlikely that we’ll see anything close to that. That’s not to say that we shouldn’t be investing offshore, because investing offshore still brings a valuable diversification component. So we go back to events like Nenegate etc, where the rand blows up – or bigger global events, where we see some dollar strength. That remains quite important.
So we continue to maintain offshore exposure, but our expectations are a lot lower for this asset class. And we think investors need to embrace risk in the local markets. There is a lot of uncertainty, but within that lies a lot of opportunity.
So those would be the two key things from my perspective in terms of how you prepare for the next decade.
CIARAN RYAN: Adriaan Pask, chief investment officer at PSG Wealth. We’re going to leave it there. Thank you so much, Adriaan, for joining us this morning.
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