Saul Miller is a Portfolio Manager at Truffle Asset Management, the managers of the Nedgroup Investments Balanced Fund. Saul discusses the Fund’s performance, its positioning going forward and why US inflation matters.
Contributors to performance
Over the last year, the PGM sector continued to be a great contributor to Fund returns. We still like the sector and think there will be sustained deficits in palladium and rhodium due to supply constraints, so will maintain a reasonable position here. The shares are also very cheap. Diversified miners have also helped us, such as Glencore and African Rainbow Minerals. We have been pulling back our exposure though as we think that profitability levels are particularly stretched. Iron ore miners are now making record profits. Foreign equity also contributed to returns despite the very strong Rand over the last year. Dual listed, e.g. Naspers contributed handsomely as well. The ones that struggled included the insurers and healthcare sector. We maintain our positions as we still think these sectors look interesting and offer value and have even increased our exposure into some of their underperformance.
Positioned for growth and wealth preservation
The Fund is invested in a diversified range of sectors. Our net exposure to property and equity has reduced to 64% because global valuations have got quite expensive. We’ve been particularly worried about growth type sectors and offshore tech, which have really benefitted from very low interest rates and have reduced this exposure in favour of value type sectors, which benefit from rising rates, e.g. financials. We have taken some of our risk exposure off via derivatives on the S&P and All Share. We increased our exposure to domestically exposed companies about a year ago. We do think the environment in SA is better than it was both economically and politically and we seem to be moving in a positive direction. The SA markets aren’t particularly expensive compared to the rest of the world, which allowed us to increase our exposure to domestically exposed sectors. Property is another area where we think fundamentals are going to be tough over the next few years. There are select opportunities with some counters trading on very deep discounts to NAV, but they do have reasonable prospects going forward. Not every part of the property sector is under massive pressure.
Interest rates and inflation are a concern for market valuations
We’re worried about interest rates and inflation going up and having a negative impact on global equity valuations going forward. Some of the factors that influence equity valuations include the equity risk premium, i.e. the spread that equity holders want to earn over bonds given the extra risk they carry. Dividend/earnings growth are also very important for equity valuations. If we take a long-term view, there could be pressure on earnings and dividends because of taxation in the US, which is at very low levels and labour’s share of the economic pie has been low compared to companies. We’re concerned with competing asset class valuations and in particular bonds. When bonds get expensive, people will find other assets to buy and equities would be one of those. Low bond yields have essentially pushed up not just bond valuations, but also equity valuations. The losses suffered during Covid were a fraction of those during the Global Financial Crisis (GFC). Yet, the Covid fiscal response was more than four times that of the GFC both in the US and Euro area.
The US debt to GDP is reaching a record high. If the demand in an economy is going to be higher than the potential capacity of the economy, it can often lead to inflation. For most of the last 15 years, the US economy has been below potential GDP, which tends towards deflation. Forecasts for the US economy are above potential GDP and are higher now than what they would have been pre-Covid given the levels of stimulus. Mobility related goods and services that suffered during the pandemic, e.g. airline tickets have been negative or deflationary at -5/6%. As people get vaccinated, there will clearly be a demand for these goods and services and would expect that deflation to go back to inflation, which will put pressure on inflation going forward.
Falling unemployment will drive inflation
Unemployment is another important factor in terms of inflation. As the economy goes back to full capacity, you’d expect unemployment to fall, which will put pressure on wages and wage inflation, which drive inflation. There’s a very strong correlation between unemployment and the rental component of CPI. Rental is the highest component of the CPI basket at more than 33%. As unemployment falls, you can expect rentals to rise, which will drive inflation higher. Regulation around rental caps will also start to fall away as Covid goes away, putting further pressure on rental increases and consequently inflation.
Inflation expectations for the bond market
Over the short term, the bond market is expecting inflation to rise above the Fed target of 2%. Inflation expectations for bonds over 5-10 years are in line with where they’ve been over the last five years and close to the Fed target rate. There is a source of risk here if inflation ends up being more permanent. Bond yields can be broken up into inflation expectations and real yield. What’s driven bond yields down over the last 20 years has been falling real yields. Real yields are now negative. The concern is that even if inflation does come under control and we get economic growth without an inflation spike, bond holders are unlikely to be happy to receive a negative return relative to inflation. The real yield can also drive up bond yields and this would have a negative impact on equity valuations. There are several factors that make us worry about yields going up and hitting equity markets.
Value is hard to find
All sectors and regions of the equity market are expensive, in particular growth areas and the World MSCI Growth Index is 66% above where it was. There are, however, sectors and shares that are offering reasonable value. Financials are not particularly expensive globally and will benefit from rising interest rates. SA does not look particularly expensive either and is why we’ve increased our SA exposure.
We are overweight the resources sector (PGMs). We are finding value in some of the Rand hedge stocks. Many of the SA focused stocks have recovered and there are still opportunities, but this will depend on government action. We are cautious on the property sector, but there are some select stock opportunities. Globally, there are opportunities in the value sectors with growth and tech stocks still expensive.