By: Bryn Hatty, Chief Investment Officer at Stonehage Fleming South Africa
Lessons learned in allocating capital in a fragile environment
As capital markets grapple with profound shifts in the macro-economic and geo-political landscapes, for investors, 2022 is turning into a year we’d rather forget.
Following relative calm over the South African winter, volatility in bond, equity, and currency markets recently returned with a vengeance. Global equities have declined by 25.3%[1] so far this year, while global fixed income markets are down 12.1% and the trade-weighted US Dollar is up by 17.2%. Persistent inflation in the US has been of particular concern, motivating the Federal Reserve to accelerate its rate hiking plan in line in an attempt to bring inflation under control. This has accentuated the trend in US Dollar strength – a common market dynamic when macro uncertainties are elevated.[2]
To say that we are living and investing in interesting times is a huge understatement. However, there are a few lessons learned in 2022 thus far, that may help investors be better prepared to withstand future market shocks as we continue our bumpy ride toward the end of the year.
Careful capital rotation vs aggressive market timing
Long-term investors who have shown tolerance for short-term volatility by sticking to a disciplined approach should find themselves in an advantageous position. In particular, our experience shows that a portfolio management approach focusing on careful capital rotation – i.e. leaning away from assets at the centre of market fragility (such as European and Emerging Market assets) and towards areas of greater resilience (such as US Dollar denominated assets) – is superior to an aggressive policy of timing the market.
A multi-faceted defensive equity strategy
In our view, a well-constructed equity strategy should contain aspects of defensiveness that will provide some protection in a rapidly evolving landscape. This could include allocations to US equities over more cyclical economies like Europe and Japan, and within global industries that stress lower earnings cyclicality such as Pharmaceuticals, Insurance and Software over Autos, Banks and Semiconductors. Smaller companies, whose valuations have declined aggressively this year, represent compelling long-term value going forward.
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Despite the economic challenges of emerging markets, we believe they should remain as a component of an investor’s long-term equity strategy. Currently, valuations are low, and earnings expectations are also modest, which for active managers possessing a long-standing specialism in this area, presents opportunities for strong performance over time.
Considering the local equity market more specifically, the MSCI SA index one-year forward PE ratio (8.0 times) is trading at a 27% discount to the MSCI EM index, which gives an earnings yield on the index of over 11[3]%. Furthermore, the nation finds itself insulated against global headwinds to a certain extent as strong commodity prices and a vigilant Monetary Policy Committee have protected the trade weighted Rand, resulting in lower inflation than many developed economies are experiencing. The potential for delivery of domestic reforms, such as the Eskom unbundling, major capex and additional financial reforms could provide further benefits to the economy in the medium to longer term.
Overweight in cash
A tactically higher weighting in cash carries the benefit of cushioning portfolios from further volatility, providing liquidity to capture attractive opportunities, and generating a reasonable income stream with interest rates now at more compelling levels.
Investment Grade Credit Bias
Within the credit markets, investors seeking a balance between long-term capital growth and stable income streams, with prudent diversification, will have retained a bias to investment grade credit in fixed income allocations, investing with specialist active managers. Increased allocations to short duration US Treasury Bonds are looking more attractive, as yields have risen sharply since the start of the year.
Into 2023 and beyond
While 2022 may not end up as envisaged, our view at Stonehage Fleming Investment Management remains consistent: a long-term minded investment in a blend of financial assets, with quality, value and diversification as key allocation principles, will continue to offer investors solid prospects. Instead of allowing the stress of market volatility to drive investing decisions, investors would do well to continue with a prudent and objective long-term approach that will hold them in good stead for 2023 and beyond.