By Gregoire Theron, Chief Investment Officer at GraySwan
As central banks take action to combat inflation, the tailwind that has boosted equity returns for close to two years is potentially dying down. However, new opportunities present themselves as material structural shifts take hold in the global economy.
After a sharp but brief sell-off at the start of the Covid-19 pandemic in March 2020, global stocks made a strong run as monetary authorities flooded financial markets with liquidity and US tech giants ballooned in value thanks to faster digitisation.
But central banks have realised that inflation is potentially here to stay, and it is now clearer that interest rates will be raised faster than previously expected, while stimulus programmes will be scaled back sooner.
But despite tighter financial conditions and signs of an end to the strong bull market, GraySwan still expects that equities will continue to outperform bonds and other asset classes this year. This is partly because corporate earnings are being inflated by price increases.
As market dynamics shift, however, there is a need to approach equities differently. For a start, US indices are now dominated by tech majors following their stellar runs – and this poses concentration risk. We typically hedge our client’s exposures to the US market. Nobody knows when the market may take another 10%to 20% dip, so we rather pay away some insurance to be able to “Sleep Well At Night (SWAN)”.
Moreover, as investors start moving into other asset classes, we do expect a more volatile year for equities in general. 10% losses in equity markets are part of the journey and we won’t be surprised to see two or more such dips this year but therein lies opportunities. Volatility will furthermore be exacerbated by a continued surge in retail investing as cash-flush individuals speculate on low-cost or no cost offshore trading platforms.
News headlines will continue to influence the ebb and flows of investors’ risk appetites, with investors keeping a close eye on tensions between Russia and the West, Covid-19 variants, supply chain pressures, China’s corporate debt challenge, and regulatory crackdowns on big tech firms, especially in China.
In this environment, we are diversifying our clients’ portfolios and increasing our exposures to undervalued stocks – in the healthcare and other sectors – and to businesses with predictable earnings streams and robust balance sheets. As rates rise, we avoid companies with too much debt on their books. We also allocate to local long-short equity hedge funds which are nimble and able to manage such volatility. Our client’s hedge fund allocations have outperformed the markets over the past three years and such with much reduced volatility.
We are also targeting offshore disruptive technology segments of the market that are trading at more palatable levels and which remain primed for long-term growth, including blockchain, cybersecurity, and semiconductor-reliant industries such as the Internet of Things and electric vehicles. Whilst the core of our clients’ monies is invested in low cost developed market and emerging market tracker funds our satellite exposures are allocated to these fast-growing investment strategies. We’re investing in the future, today.
There are also opportunities in commodities and the resources sector, with gold acting as a hedge against inflation, and with the shift to a net-zero economy gaining steam. Demand for commodities needed for the energy transition – including lithium and copper – will likely remain elevated for the foreseeable future. Most passive investment funds remain heavily tilted towards oil and other fossil fuels. Investors should rather increase their allocations towards rare earth metals and other ‘green’ minerals and start reducing their exposure to “old school” commodities. Our unique and forward-looking commodities for change portfolios where we invest in a basked of low-cost exchange traded funds are focussed on those commodities that will drive change for the next decade.
With US equity valuations generally high, the commodities boom presents opportunities to add exposure to emerging markets. We allocate our clients’ monies to low-cost emerging market tracker funds that overlay environmental, social and governance considerations. Not only has such responsible investment principles provided our clients with superior performance than the market but also at significantly lower cost that active funds that have mostly struggled to keep track with the market.
Meanwhile, we will take a more hands-on and even more active approach to asset allocation this year, with greater emphasis on diversification and risk mitigation. Whilst most people insure their houses and their cars and their lives, we also insure our clients’ monies against unforeseen events which may have an adverse impact on their portfolios.
We have trimmed our exposure to equities in general, taking some profits, but we have not yet dipped into the offshore bond market, although entry points are starting to emerge. Offshore bonds are a very strong diversifier for a South African client, but only once offshore bond yields are higher. We have a strong overweight to local bonds especially as and where the 10-year bond is trading above 9.50%.
More excitingly, South Africa’s direct-lending market is starting to grow in stature and there are attractive yields on offer in this space. Private debt is the fastest growing asset class in the world, and we are seeing more opportunities here too. It is an asset class to which we have been allocating pro-actively over the past three years and our clients have outperformed money market rates handsomely.
Looking forward, we believe that many investors will need to temper their return expectations. ‘Fear of missing out,’ or FOMO, has found its way into financial markets, and overzealous investors risk being blindsided by the fundamental changes underway.
Many investment opportunities for those who are prepared to look, to test, to always count, to verify and then to allocate. It is challenging work. Every day we start again. But fortunately, we love what we do. We think in years, not quarters. We think about megatrends and how to invest for the next decade.