Low return warnings - crying wolf?
Understanding the return prospects of the different asset classes
Over the last couple of years, investors have been warned not to expect a repeat of the fantastic returns that they have received. With the same message repeated year after year, it has begun to sound like a stuck record. However, despite the tepid global economic recovery since the global financial crisis, markets have continued their upward journey. It is understandable that investors may have treated the repeated warnings with some scepticism. Have we cried wolf so many times that investors have stopped heeding our warning? In this article, we reflect on the valuation of the different asset classes and discuss our positioning in each asset class. We argue that it will be very difficult to repeat the returns of the past. Investors should look at alternative sources to enhance returns.
Prospective real returns for local equities are low
As the South African equity market has reached new highs, valuations have become less attractive. Our valuation model calculates an expected real return for South African equities based on trend earnings and the current price earnings multiple (PE) of the market relative to its long-term average. The model has good predictive power over time, proved by the reasonably good relationship between the predicted return and the subsequent realised return (as shown in the chart below). The predicted real return has fallen significantly over the last year, and the model predicts lacklustre real returns going forward. At a stock-specific level, we are finding it increasingly difficult to find attractively valued opportunities. For this reason, we have become cautious about the level of equity exposure in the Nedgroup Investments Opportunity Fund. We have trimmed our equity exposure as the market has strengthened and put protective structures in place on particular stocks that have recently performed well.
Local bonds offer reasonable value
The South African 10-year bond traded at an all-time low yield of 6% in May 2013, before selling off sharply once the US Federal Reserve Chairman announced that the tapering of quantitative easing (QE) was imminent. The Nedgroup Investments Opportunity Fund had zero bond exposure leading into the May sell-off, but once yields rose, we extended the Fund’s duration. By using our assessment of the fair value of bonds, we were able to protect the Fund from a drawdown, while at the same time maximising yield. We now see reasonable value in bonds, with yields above 8.5%. We increased the Fund’s bond exposure in January and February after the sell-off.
Inflation-linked bonds are expensive
Inflation-linked bonds (ILBs) have traded at expensive levels, as the market is willing to pay a large premium for inflation protection. The yield on ILBs is too low given the current level of global real yields and South Africa’s country risk premium. In a rising inflation environment, ILBs can deliver good returns despite the low yield. Since yields are so low, holders of ILBs run the risk of capital losses should yields adjust to normalised levels. Since selling out of ILBs in the Fund, we have maintained a zero exposure to this asset class. We will wait until the yield is more attractive before investing again.
Look out for headwinds in the local property sector
Property yields have moved up from 5.5% to 7% over the last 12 months. We believe that property offers reasonable value at these levels, and we maintain an 8% allocation to property in the Nedgroup Investments Opportunity Fund. While the yield is attractive, the sector faces headwinds due to a poor economic outlook and rising costs. Many of the property funds also face rising debt costs in light of potential increases in interest rates over the next year. The Fund has taken positions in higher quality defensive property stocks with low levels of interest rate risk. We will consider increasing our property exposure if yields continue to rise.
Rand volatility offers opportunities
For rand-denominated investors, a weak rand can greatly enhance offshore asset returns. As a result, holding offshore assets protects investors against a deteriorating local economy.
Over the very long term, the rand has depreciated 5% per year on average against the US dollar, necessitated by the market enforcing purchasing power parity. Over short timeframes however, the rand is notoriously volatile and has periods of excessive over and under valuation (as shown in the chart below). This provides opportunities to boost returns by adjusting the portfolio exposure to foreign assets.
The rand currently looks cheap. However with exports devastated by labour unrest and ballooning government borrowing (also known as a ‘twin deficit’ trap), we believe that there is still the risk of continued rand weakness. Due to these issues, we do not anticipate an aggressive appreciation in the rand towards theoretical fair value in the near term. Instead, we expect the rand to be undervalued, which is why we have moderate exposure to offshore assets in the Nedgroup Investments Opportunity Fund. We do however think that the South African Reserve Bank will act prudently and avert a catastrophic rand depreciation, which gives us comfort.
The normalisation of monetary policy globally holds risks
International stock and bond valuations were inflated by the ultra-easy monetary conditions across the developed world. While conditions may remain easy for several years, the Fed has begun the process of unwinding QE. As a result, the level of support for asset prices will begin to diminish. Global bond yields remain close to historical lows and do not compensate investors for the risk that monetary policy may normalise in the coming years. The S&P 500 has moved to new all-time highs despite a relatively weak economic recovery. The Hussman PE, shown in the chart above, shows the valuation of the market relative to peak earnings. The current PE on peak earnings is 17.5 times. The current valuation is close to historical highs if we exclude the dotcom bubble. We are therefore cautious about our level of international equity exposure in the Nedgroup Investments Opportunity Fund. Instead, we prefer assets such as convertible bonds, as these bonds provide upside participation to rising prices, but with limited downside.
Consider the risk/return trade-off
When making asset allocation decisions in the Nedgroup Investments Opportunity Fund, we use our views about expected returns for the respective asset classes. We consider the risk of each asset class and then search for the optimal allocation to each of the asset classes at different levels of risk (quantified as the possibility of an x% drawdown). This way, we are able to generate outperformance through tactical asset allocation while controlling for risk.
When deciding on an appropriate asset allocation, we assess how well risk is being rewarded based on market valuations at any point in time. As an example, the chart below shows the expected returns at different levels of risk after the 2008 global financial crisis. The chart clearly shows that investors would have been handsomely rewarded for taking on additional risk, as they would expect. We have tracked the difference between an 8% and a 2% drawdown risk portfolio.
The evolution of this risk/return trade-off over time (between 8% and 2%) is shown in the chart above. It is clear that the incentive for taking on increased risk is much lower than five years ago. We therefore believe it is prudent to take a conservative approach to markets. In line with this, we have reduced the risk to which the Nedgroup Investments Opportunity Fund is exposed substantially over the last several months by actively selling expensive assets and by adding protective structures to the Fund.
We prefer a conservative, multi-asset approach
This year could be another year where investors evade the wolf and receive strong returns. However, our view is that the risk/return trade-off justifies a conservative portfolio positioning. Based on our views and theories in this article, the Nedgroup Investments Opportunity Fund has been able to generate performance through a combination of bottom-up stock picking, tactical asset allocation and risk control, and we will strive to continue providing investors with this level of performance.