Market Solutions – July: All Good Things Must Come To An End.

By Alexander Forbes Investments on Jul 11, 2018 in Market and Economic Commentary The news

After a scintillating performance in 2017, investor returns have deteriorated in 2018. The South African equity market, the biggest weighting within most pension fund portfolios, lost 1.7% between December 2017 and June 2018 after returning 21% in 2017, as measured by the All Share index (ALSI). Performance for the Shareholder Weighted Index (SWIX) and the capped SWIX was even worse, losing 4.8% and 7.6% respectively from January to June 2018. The global equity market performance was similar – the All Country World Index (ACWI) lost 0.2% in US dollars over the same measurement period. After experiencing an increase of 12% in annualised returns on the ALSI between 2010 and 2017, and 9.1% annualised on the ACWI over this period, investors are unaccustomed to equity market weakness experienced in 2018 thus far.

Low return expectations is a long-standing theme

Poor performance wasn’t without warning. Lower investment returns is a theme we advocated throughout 2017 due to the expensive valuations on traditional financial assets. To summarise the reasons, global central banks such as the US Federal Reserve, the European Central Bank (ECB), Bank of Japan and Bank of England conducted unprecedented stimulus programmes following the 2008/2009 Global Financial Crisis (GFC). These financial authorities hoped to support economic activity and employment through lower interest rates, but the biggest beneficiaries were financial markets. Rather than find expression in real economic activity, low interest rates and quantitative easing (QE) caused capital to flood into the financial system. The dynamics are complex, but the outcome can easily be viewed through real-world valuation measures.

Traditional Asset Classes as “over-invested” relative to economy

The market capitalisation of the ALSI is close to its highest level relative to the size of the economy, as represented by gross domestic product (GDP). Market capitalisation represents the amount of capital invested into an equity market, so we are essentially viewing the amount of money invested into equity markets relative to the size of the economy. The elevated ratio indicates that equity is over-invested relative to the size of the economy. This is usually associated with weak subsequent long-term returns. By contrast, a low ratio would signal underinvestment in equity, which is usually associated with strong subsequent long-term returns. We’ve shown the South African data in this article to bring the analysis close to home but, remember, this is a global phenomenon. The ratio of the S&P500 to US GDP is similar. It shows that US equity is overinvested relative to the size of the economy and is associated with weaker subsequent long-term returns.

 

Central banks are no longer an investor’s friend

The US Federal Reserve has tightened monetary policy since December 2015. Initially this shift was welcomed by financial markets because it suggested the economy was strong enough to withstand the tighter policy. Over time, however, the tightening starts to take its toll. Borrowing costs increase and place pressure on debt-laden governments, corporates and households. Some US corporates and households have deleveraged since the GFC, but absolute debt levels remain much higher than at any time before 2005. US government debt levels have continued to rise unabated since the GFC. Substantial liquidity remains in financial markets and interest rates are still incredibly low but, at the margin, liquidity is becoming less accessible than it was and rates are higher than they were. Evidence for this monetary tightness is visible in global interbank funding markets. The ECB has announced its intention to follow the Fed’s lead and end its asset-purchase programme in December 2018. These policy changes confirm a critical shift in financial markets. As we wrote in the March Market Solutions: “central banks are no longer an investor’s friend.”

Trade war headlines disguise underlying conditions

Donald Trump’s trade negotiations with China have featured in financial market headlines and have been offered as the reason for the weakness in financial markets. There is no doubt that tariffs put a dampener on the euphoric growth expectations that emerged in 2017 and are impacting performance. However, conditions pointed towards weaker equity market performance even before the trade dispute kicked off. Expensive valuations, tightening central bank liquidity and rising interest rates are much tougher for financial markets to contend with than cheap valuations, flush liquidity and falling interest rates.  Often financial markets just need a trigger for the underlying conditions to express themselves, and perhaps the trade dispute is this trigger.

Risk management in accumulation stage portfolios

The exact timing for equity market weakness is difficult to predict, but the conditions have been relatively clear. As a result, changes have been made to major accumulation portfolios to mitigate against the risks. For example, hedge funds and private equity have been introduced into our major accumulation portfolios. Valuations within the unlisted private equity market are more reasonable than the listed equity market and the long-term nature of these investments implies they are less likely to be negatively impacted by the volatility in listed markets. Additionally, hedge funds can gain from the type of volatility that equity markets have experienced in 2018 thus far.

It is critical to note that these strategies are used within our portfolios to mitigate against risks in financial markets, but they won’t completely negate poor periods of equity performance. Low investment returns should be expected despite the portfolio changes. Clients need to take a pragmatic approach to their investment and return expectations. Current conditions imply that it is unwise to chase returns – this strategy would expose portfolios to much bigger drawdown risks. Instead we’re looking to manage risk and create a smoother journey towards retirement for our clients. As a result, expectations need to be adjusted to achieve holistic financial wellbeing.

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Alexander Forbes Investments

Alexander Forbes Investments

Alexander Forbes Investments was established in 1997. We are a forward-thinking and trusted global investment provider, with roots in Africa. In pursuit of certainty we set out to understand our retail and institutional clients’ circumstances and risk tolerance to set clear goals. Our adaptive investment approach, called Living*Investing allows us to maximise opportunity and minimise risk at every stage of the investment cycle.

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