The search for inflation beating returns
There’s no denying that the world economy is recovering. Indicators in the USA are recovering, led by an improving housing market and employment creation. Core Europe is getting better too, along with the peripheral countries of Spain, Greece, Italy and Portugal. And in China, the government is fast-tracking infrastructure projects to support sluggish growth. So good news abounds! Does this imply that it is a good time to increase allocations to investments geared to growth? Well, not so fast.
As we know, the economic recovery has been fuelled by massive monetary stimulus. As the economic recovery matures and becomes self-sustaining, liquidity will be removed from markets and the effect on financial markets is unknown. Most asset classes have benefitted from the abundance of cheap money created by central banks. Valuations on equity markets are not cheap and demand growing earnings to justify current PE’s. Interest bearing yields, including government and corporate debt across developed and emerging markets, have fallen to multi decade low levels as investors searched for real yields, often selling long dated government debt short to buy higher yielding assets.
Tapering comments spark pessimism
In late June, markets reacted negatively to Fed chairman Ben Bernanke’s comments about moderating the monthly pace of purchases later this year as long as the economy grows as expected. For the time being, the Fed said that it would continue its “QE3” policy of buying assets at a pace of $85 billion a month, and expects to keep interest rates low as long as the unemployment rate remains above 6.5%. Markets are looking forward to the economic scenario the Fed anticipates, when the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains. The fear is that this tapering of monetary stimulus would commence in the next few months.
Markets have become addicted to this cocktail of stimulus and easy money, and any hint of withdrawal has been met pessimistically by market participants – despite the fact that US economic fundamentals are improving and that everyone knows stimulus must eventually end. As if to prove that bad news can also be good news, markets celebrated the disappointing downward revision of Q1 US GDP growth from 2.4% to a much lower 1.8% (annualised) by igniting a three-day rally as players bet that the Fed would maintain its stimulus just a little bit longer as a result. More recently, better economic data has been met with similar reaction by market participants, and the market has struggled to reach new highs despite the improved economic outlook.
How do we manage the Nedgroup Investments Stable Fund in a world where volatility is increasing between and within asset classes, and where the ease of producing future returns in excess of inflation plus 4% has reduced significantly, despite the nascent global economic recovery?
One of our core investment tenets is to avoid assets where there is a high probability of negative returns which will be permanent in nature. Global bond yields are likely to rise as the recovery matures. Market participants in the US have started to discount the probability that the Fed will start tapering asset purchases relatively soon. And unless the world enters a period of negative growth soon, recent lows are unlikely to be achieved in the next three to five years. Higher yields and positive inflation will erode the real value of investments in long dated bonds. The same holds true for South African government debt. And while growth in SA remains pedestrian, yields will be affected by the rise in global bond yields, a switch out of SA bonds by global investors, and a stubbornly high budget deficit. With inflation differentials somewhere between 3.0% and 5.5% over our forecast period, and a rising risk free rate, investors are left with very little room for error when investing in long dated bonds.
Opportunities for investors
Volatility is something to embrace. It creates opportunities to invest in assets that will allow our clients to participate in the next investment cycle. Good quality companies are often discarded for reasons other than changes in their ability to produce good growth in earnings and dividends through cycles. There are times in the cycle where investors become either too optimistic or too pessimistic about the potential for companies to continue to generate returns going forward. As long term investors, our aim is to focus on the long term earnings growth potential of companies, and to use volatility to adjust our clients’ portfolios where short term trading from speculators has created opportunities to either increase or impair a specific company’s probability in meeting our clients’ longer term objectives. Like Truworths in 2007 – and today.
Striving for balance
Balance is a theme that is often neglected in portfolios. Investment managers focus so much on the upside potential that they forget about the potential downside to their clients should unforeseen events occur, particularly in a world where future returns are expected to be lower than returns in the recent past. One tool that allows investment managers to cope with increasing uncertainty is differentiation, and, importantly, finding investments with uncorrelated return and earnings profiles.
Finally, investments with growing free cash flow profiles, returned to investors as either capital or increasing dividends, have a far greater probability of meeting inflation plus objectives. While cash does play an important role in portfolios as it provides both optionality and security of capital over short time periods, the real focus should be on finding assets where incomes grow. Inflation linked bonds, corporate debt with rising coupon profiles, and listed property investments all play an important role in this regard, particularly over the long term.
William Fraser is Investment Manager of the Nedgroup Investments Stable Fund.