Preserving capital in an uncertain world
For many investors, investment returns for 2016 were disappointing, irrespective of the strategies they followed. Many - if not most - flexible asset allocation funds across low-, medium- or high-equity strategies delivered returns well below cash rates, income needs and critically, inflation.
For some time now, domestic shares have been trading on inflated valuations, at a time when the economic expansion has stalled, and indeed periodically contracted. Fiscal and monetary policies have tightened, leading to stalling employment gains, lower real wage growth and a rise in debt service cost. Business and consumer confidence remained depressed for much of the year, with domestic political uncertainty adding to the negative sentiment, while a potential non-investment grade status on SA government debt hung over the country’s head during the second half of the year, with potential negative consequences for the currency and funding rates.
Global market valuations have been more reasonable, but macro/political events from Brexit to Trump’s victory in the US presidential election have made life very difficult for stock pickers.
Inflation-beating returns were achieved from domestic cash and bonds last year. The Nedgroup Investments Stable Fund had a material allocation to these asset classes, more so to cash than bonds. These relatively solid returns were offset by the domestic share allocation within the portfolio, and the position in offshore assets. The rand strength had a negative translation effect on these asset classes. Local share selection is biased towards global businesses listed in SA, in the non-resource sector of the market.
Looking forward, it should be evident that many of the risks we identified and aimed to protect against, indeed still exist. The fact that they did not materialise in 2016 doesn’t mean they have dissipated or disappeared. Equally true, not all the risks we are guarding against will in fact play out, but that does not mean that we should not guard against them.
The overriding theme within the fund remains one of capital preservation. After three decades of falling yields across asset classes, with commensurate gains in capital values, it appears as though we have entered the starting phase of a normalisation in rates, led by policymakers in the US. Rising rates in isolation are not problematic. Indeed, in a ‘normal cycle’, rates initially rise following a period of strength within an economy, with the benefits of an increased labour market, wage growth, volume growth and inflation boosting earnings of businesses.
Unfortunately, we are entering a rates normalisation period after a period of sustained low to zero percent interest rates in many developed economies, which has led to some misallocation of capital by both management of businesses through share buybacks and M&A activity funded by cheap debt, as well as investors desperate to find income-generating assets to replace the low yields on cash. This misallocation of capital has led to overvalued multiples on many markets and sectors, which lowers the future returns investors should expect from these markets.
Late last year, following the Trump victory, equity markets in the US (and indeed other parts of the world) re-rated at the same time bond yields rose, indicating sentiment among investors for an improving outlook for corporate earnings on the back of lower tax rates and improvements in fiscal spending. Frustratingly for investors in the Foord global funds, not all global sectors benefitted from the 'Trump rally'. Healthcare and pharmaceutical stocks in particular - a material allocation within the global allocation of the fund - were negatively affected by political rhetoric and a focus on reducing drug prices (nearly 80% of the healthcare sector underperformed global equities by a meaningful margin).
As mentioned earlier, not all the risks we are guarding against will play out in the coming years. It is possible that none of the risks eventuates. But it doesn’t mean that these risks do not exist. This is important to understand when positioning the portfolio for the years ahead. It may be tempting for investors who share our concerns, and wish to protect their capital, to cash in their units and switch to cash. While the short-term 'benefit' may be obvious (cash yields on a gross basis currently beat inflation), the long-term consequences from such a move may cause immeasurable damage to their wealth, should some form of normalcy return to markets, and geopolitics. It is equally important to have some degree of balance in the portfolio, where a negative outcome in one particular view is offset by gains elsewhere - the allocation to offshore assets last year was offset by gains in domestic bonds for example.
The positioning of the Nedgroup Investments Stable Fund remains very similar to a year ago, as many of the risks we have guarded against still looms large. The fund remains conservatively positioned in SA, with a low allocation to domestic-focused shares. The selection remains mostly in non-resource rand hedge companies, and a meaningful position in domestic fixed-interest assets. There is a likelihood that short rates will fall towards the end of 2017, given the weak economic outlook and lower food price inflation towards the second half of the year. A material position of the short-term cash positioning is invested in assets linked to the three-month JIBAR, where a credit spread is paid by the bank or corporate, which offers some protection to investors relative to inflation. Listed property distribution growth, in particular those in the secondary retail sector and offices are at risk of stagnation, given the weak consumer and stalling economic activity, coupled with some oversupply in some office nodes. Quality property REITs remain expensive with a material risk of capital loss.
The offshore component of the portfolio remains focused on businesses where earnings growth is likely to outperform the broader market over the long term. The fund's largest overweight positions by sector remain consumer discretionary and healthcare. Within the consumer discretionary sector, we maintain meaningful positions in both the global cruise line industry (holdings in North America-based Royal Caribbean and Carnival Cruise Lines) as well as the Macau casino industry. Both industries continue to benefit from the recovering consumer in the US as well as growth of the Chinese middle class. It is our belief that as earnings exceed modest 2017 expectations, investors will reprice these undervalued securities.
Secondly, the fund is positioned to benefit from a recovery in the healthcare sector. Investors have become concerned that forthcoming regulations may both limit future price increases and lead to precipitous price declines. While we acknowledge that additional regulation is likely in the coming years, we believe both biologic and traditional pharmaceutical firms' valuations are more than discounting this risk. With valuations at near-historic trough levels (relative to global equities) we again believe these securities offer attractive value relative to the risk implied. We have learned over time that patience will be rewarded, but often not as soon as one expects.
Lastly, the rand remains at risk over the longer term. While positive sentiment towards emerging markets and a recovery in commodity prices have aided the recovery in the currency, the outlook remains negative. The current account deficit remains sizeable, despite some recovery in the terms of trade. Dividend and interest payments to foreign investors are sticky, and at around 3% of GDP poses a real long-term threat to SA’s ability to fund foreign liabilities.
A period of further consolidation in investor returns is expected, given the risks outlined, and a future of rising interest rates globally. Real capital preservation is best achieved by preserving what has been created in the past, and allocating capital to asset classes in future when downside risk has diminished meaningfully.