The global macroeconomic environment is treacherous at the moment. The shift to populism and the resultant risks have brought politics front and centre. This is inherently unpredictable. At the same time, extreme monetary policy action has de-emphasised the standard cycle. In this world, it is prudent to focus more on valuation (price) and to hold macro views lightly, while focusing on building portfolios that are well diversified.
Themes suffer in the wake of uncertainty – a heavier weighting on price
As part of our investment process, we develop a set of evolving themes that take the macroeconomic environment into consideration. The theme that influenced our latest portfolio construction is that the US will underperform and, as such, our portfolios are underweight US equities. This is based off very high profits, high valuations and a strong US dollar, making it difficult for things to improve. Globally, we expect a low return world, which will force money to search for yield in an environment of ultra-low global interest rates. This has the potential to support SA assets, which are offering better value.
SA expected to fare better
In terms of SA, we maintain our ‘winds of change’ theme. This theme recognises that things are by no means easy, but at the margin we expect improvement – with lower interest rates and faster economic growth. The risk to this is that Government does not act decisively on the parastatals, particularly Eskom. There is no time to waste. If Government does not take swift corrective action, we will be downgraded to junk status and the resultant loss in confidence will mean us navigating through a path where even the welcomed winds of change turns into a storm.
Local assets to yield a better return
Our expected returns across SA assets have generally been revised up, while global bonds have once again deteriorated and are now expensive. On a relative basis, the investment case is pushing harder towards SA and away from global assets. SA assets have de-rated; in other words, they’ve become cheaper and are now offering better value. To this end, we have increased our longer-term expected returns for SA equity and property and have maintained our outlook for SA bonds, which are particularly attractive in a global context.
An important change to our outlook is that SA cash will fall. Cash has offered tremendous ‘competition’ for investments and that’s because we’ve had very high real rates in SA. Now with the first rate cut, with more expected to come, those real returns are starting to drop. Therefore, on a relative basis, SA assets are now more attractive than global assets and SA yield assets (property and bonds) are more attractive relative to cash. We see this trend of global assets becoming a little more expensive and local assets getting cheaper as an ongoing theme. SA markets are starting to show decent value for the first time since 2011. If we sum this all up into a Balanced Fund, our expected real return is 4.6% a year over the next five years – only slightly higher than six months ago at 4.5%, but much better than the low point of 3.5% in 2015 when markets were expensive and our theme was that of a low return world.
Unpacking asset class expectations
We have increased our expected real (after inflation) returns for SA equity by 50 basis points (bps) to 6% a year over the next five years, up from 5.5% in January and 5% this time last year. This is driven off a 4.3% forward dividend yield and a relatively depressed earnings base, which provides a good platform for better growth into the future. However, this improved outlook will require a turnaround in the local economy.
Our expected real return has increased by 50 bps to a mouth-watering 7% a year, up from 6.5% six months ago. This is backed by a very high dividend yield, despite a negative expectation on growth. We remain pessimistic about the trading outlook for these companies, but with such high yields we cannot ignore the value.
Local bonds continue to offer high real returns and are very attractive in a global context. While, over the long term, we expect SA to be downgraded to junk status, we are comfortable investing in the bonds because they have been priced for this. Our five-year real return outlook for local bonds remains 4% a year.
A big change in our asset class outlook is that interest rates in SA are now falling and we expect cash to deliver a real return of just 1.5% a year going forward. With the economy on its knees and no underlying inflation, we think further interest rate cuts from the South African Reserve Bank (SARB) are appropriate. With cash yields falling, it forces investors to look at other assets.
The global equity market is schizophrenic, with the US equity market and growth shares expensive, while the rest of the world and value stocks are cheap. Longer term, there is no alternative to equity, but we are concerned about profits as we expect them to fall. As a result, we are cautiously positioned on global equity and have revised our five-year real return outlook down to 5%.
Following a stellar six-month period, global bonds are once again priced to give negative real returns. In fact, the whole of the German bond curve now offers negative yields! Our five-year outlook on global bonds has further deteriorated to -1% a year.
We also expect global cash to deliver negative returns going forward. To combat the trade war induced global slow down, central banks have swung to easier monetary policy. We hope they are successful, but monetary policy is starting to run into its limits.
Peter Brooke is the head of MacroSolutions at Old Mutual Investment Group.