18 February 2022 Off to a bumpy start - By Dr. Francois Stofberg, Managing Director: Efficient Private Clients
The perfect storm besieged global equity markets at the start of 2022. The impact is even more pronounced when global investments are measured in ZAR, as the rand has strengthened since the beginning of the year, further exacerbating the negative performance of global equities for South African based investors. The rand appreciation can be attributed to a variety of factors, mostly to do constructive outlook for emerging markets as well as a positive trade balance due to a robust performance by commodities. While the dollar has strengthened against most currencies recently, we expect the dollar to be range-bound to slightly weaker going forward, as the greenback typically peaks before the rate hiking cycle begins. Longer term though, we do expect the rand to weaken against the dollar due to the economic and political reasons we are all familiar with.
While the rand has strengthened, most global indices, and especially the tech heavy NASDAQ, came under pressure as the trio of geopolitical, growth, and inflationary concerns grappled markets. This served as a stark reminder to investors that both the rand and global markets can work against investors, especially in the short term.
In geopolitics, Russian military forces amassed on the Ukraine boarder. President Putin wants to ensure that the Eastern European country, with a population of more than 40 million people, do not join NATO. The risk of potential conflict caused energy prices to soar, and brent crude surpassed 90 dollars a barrel for the first time in years.
The increase in energy prices added to inflationary pressures already evident in the global economy. The symptoms of trillions of dollars of stimulus pumped into the world over the preceding two years such as excessive savings, supply chain disruptions and labour shortages, all contributed to the inflationary environment we find ourselves in today.
Side note: While governments and central banks might have kept the stimulus tap open for too long, the net effect is that near term global economic growth will be higher than if we never experienced the pandemic in the first place. This is what economists mean when they say that trend growth will be higher post the pandemic.
Back to the inflation story: For most of the previous year the narrative in markets was essentially that these inflationary pressures will be transitory, and work itself through the system, as the global economy reopens. The transitory nature of inflation meant that a limited monetary response will be required and central banks where quite happy to let the economy run hot. While we still believe that many aspects of inflation currently experienced will be transitory, and that inflation will likely peak in the next month or so, clearly a portion of inflation, particularly the wage and shelter component, will be less transitory than expected. In light of the fact that current inflation is above seven percent in the US, and investors are faced with a Federal Reserve governor that appears somewhat behind the curve when it comes to interest rate hikes, for us the risk has pivoted to a possible over reaction by the Fed, which could hurt growth.
That is not to say that we are bearish, but more that we expect volatility to continue. We have conducted copious amounts of research, analysing numerous interest rate hiking cycles, and in most cases equities outperform. That makes intuitive sense. Rising interest rates increase a business’ debt burden which, all else being equal, is negative for profit margins. However, the reason that we are experiencing higher inflation, above trend economic growth, is good for equities. As long as revenue, propelled by economic growth, grows faster than total costs, many of which are fixed, profit margins smile.
While inflation and interest rate concerns created the lion’s share of recent market volatility, for us it is becoming less of a concern. We are far more interested in monitoring the vitals of the global economy, as it impacts growth and growth expectations. Coincidentally, we now have four economists in our team to ensure we do not miss a beat!
Many investors experience one of two emotions in times of volatility. Some unapologetically stick their heads in the sand, somewhat akin to an Oudtshoorn ostrich. This is undoubtedly a less than ideal strategy, since volatility presents active investors with opportunity. Then there is the second emotion: Sell everything and hide in cash until it’s all over, planning to re-enter the markets when things calm down. Off course, by then markets have recovered and a plethora of attractive valuations are clearly visible in the rear-view mirror. Neither of these are prudent strategies if long term wealth creation is the goal, and we, therefore, propose a third approach.
While many of the businesses we invest in have structural growth drivers independent of the macro environment, the concerns mentioned here have made us hesitant to be fully invested. Therefore, we raised our cash position within our global portfolios. The aim of this was twofold. Firstly, we wanted to reduce the overall volatility of the portfolio relative to the market. Secondly, and more importantly, we wanted some dry powder for the eventual opportunities market volatility creates.
In portfolio management, you can only control two variables, what you buy and how much you pay for it.
In terms of “what”, there are quite a few excellent businesses that meet our investment criteria and that we believe can outperform over the coming years, which we want to add to the portfolio. Should growth look like it will disappoint, we have identified a few high-quality defensive businesses to include in our portfolios. Should rates look like they will increase more than expected, we will add some interest rate sensitive names that have not yet rerated. Should growth look acceptable but longer-term yields stall, we will increase our growth exposure. The most likely scenario is that we will add a combination of the above mentioned companies, based on macro-economic and company specific reasons.
In the current environment the “how much” is also important. A key consideration for investors should always be “at what price is this quality company also a good investment?”. As always, we conduct extensive analyses of expected returns on potential investments, and we continue to monitor the valuations of potential investments. Given the rising rate environment, we are hesitant to invest in opportunities where outperformance hinges on a higher valuation. Rather, we focus on counters where a progressive earnings profile is misunderstood or underappreciated by the market.
We have tilted our global portfolio to more traditional sectors to ensure that we benefit from the current macro environment. Late last year we invested in Royal Dutch Shell, as we hold a constructive view on energy prices and the oil major has a few company specific characteristics, such as a leading position in LNG, activist pressure, an attractive cash return profile, and a large discount to its break-up value on our numbers, which rendered it attractive. Earlier this year we also added a regional US bank to our portfolio. Citizen Financial is one of the largest regional banks in the US and its valuation is more attractive than some of its larger peers.
Going forward, we have cash to deploy at the ready, and we will continue to invest in quality global businesses and take advantage of potential opportunities. Investing in equity is a longer-term strategy with a five year plus outlook, a term over which the asset class has proven to outperform most other asset classes. As Charlie Munger once said: "The big money is not in the buying and selling … but in the waiting.”
We believe that if we continue to apply this strategy consistently, over a multitude of market cycles, we will generate substantial returns for our clients. Please let us know if you or any of your clients want to speak to our economists or portfolio managers in these volatile times.