The outlook, both globally and locally, appears somewhat bleak: low to no growth, low inflation, low interest rates with supportive central bank policy with limited room to manoeuvre and the ongoing geopolitical worries seem to be the order of the day. This does translate into lower return expectations.
Whilst we do not know what will happen next year, we are confident that many forecasts will be wrong.
A defensive strategy can certainly give investors peace of mind but ultimately the selection of asset classes and potential returns are a function of the price paid for these assets.
From a broad global perspective, in general, defensive assets such as bonds appear to be fully priced compared to equities when taking historical averages into account. At current low interest rate levels, bonds are also tending to be more volatile compared to their own history which diminishes their defensive diversification characteristics when applied in a multi asset solution.
Global equities are looking more interesting and pricing in general is more in line, or below, long-term averages but again return expectations are more moderate. While spreading the portfolio across many countries can improve the risk characteristics of a portfolio, we believe that superior returns will be achieved by the underlying stock selection.
A high global allocation is our preference for client portfolios as the diversification benefits are crucial in order to manage risk and reduce volatility of portfolios. This argument holds true in uncertain times too. Investing in different asset classes, countries and sectors, reduces risk.
Despite economic challenges, South African equities are looking attractive as valuations are compelling.
Equity stock selection strategies to consider during times of economic turmoil that have more defensive or uncorrelated market characteristics include:
A source of potential uncorrelated performance to the market we like to consider are companies actively going through some form of corporate or strategic change. These changes tend to be company specific and less sensitive to the economic and market volatility. This could include strategic restructuring, spinning off non-core assets to become more efficient and focussed, or a potential unlocking of value due to mergers or acquisitions. Unlocking of value from within.
During times of uncertainty, investors tend to become more risk averse. To be safe, the demand for interest bearing assets such as fixed interest funds increase as riskier assets such as share portfolios lose their appeal. As investors shift away from risky assets, the decline in share prices create investment opportunities. Share prices are cheaper when investors get scared.
In South Africa, good quality businesses with solid balance sheets that offer high dividend yields are now priced more attractively. During times of uncertainty, with a long-term investment horizon, investing in attractively priced high dividend companies with steady growth prospects can provide returns comfortably ahead of inflation. Better quality stocks are more resilient when markets are volatile.
As the prices for risky assets have lowered, the share prices of those banks offering interest bearing assets are more attractive. An interesting comparison is the deposit rate you can earn at local banks (around 7%) with the dividend yield of listed banks (close to 6%). Investing in bank shares instead of investing in the bank’s money market deposit with a similar yield is worth considering. Banking shares are priced at a similar yield, with the addition of potential share price appreciation over time. This is riskier than investing in the cash deposit but may be suitable for investors with a higher risk appetite.
A well-diversified portfolio with a combination of global and local assets remains the optimal approach to ensure solid returns over time. Our preference for equities ahead of bonds is based on valuation considerations. Careful stock selection will remain key.