This article was written for Investment Solutions and appears on their website (http://blog.investmentsolutions.co.za/strategic-investment-opportunities-as-low-returns-persist/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A%20InvestmentSolutionsUpdates%20%28Investment%20Solutions%29) but the graphs aren’t as clear as I would like so I’m re-posting them here.
If we pull back the lens from the day-to-day noise reported in the financial media, we see that returns on traditional financial markets meandered lower again in 2016. The All Share Index (Alsi) returned 2.6% in 2016, which is less than the 6.7% CPI inflation reported by Statistics South Africa in December. Local equity returns have recovered slightly in 2017 but real CPI-adjusted returns on the Alsi have remained in negative territory over the past year. Negative real returns is in stark contrast to the double-digit gains for most of the post-2008 period.
On global markets the MSCI world returned a more encouraging 8.2%, but if one factors in 2016’s 11% appreciation of the rand versus the US dollar, investors actually took home less in local currency. These outcomes should come as no surprise. Low returns have been an ongoing theme. In these conditions, prudent investment management decisions are required. Investors cannot merely sit on their hands and expect to meet their retirement goals by passively holding overvalued indices.
In this article we detail a few of the reasons for the low return outlook, articulate why a balanced approach to investment decisions is required in these overvalued conditions and offer a few alternative return sources that are being investigated.
Examples of overvaluation in traditional asset classes
Many traditional financial assets have become ‘over-invested’ and expensive. Equity markets are a good example of this. Investors in both the US and South Africa have continued to buy, despite expensive prices, in the hope of the double-digit returns they experienced in the past.
There are many ways to depict overvalued markets. We’ve outlined three examples below, which should make the relationship easier to digest:
- The amount of capital invested in the equity market (market capitalisation) relative to the size of the economy (measured by GDP) has been at extreme levels. In the US and South Africa we find a similar relationship, where significant capital has been invested into the equity market, relative to the size of the economy, which usually precedes weak equity market returns in the years thereafter.
- Another way to depict the valuation disparity is the price of equities relative to the earnings derived from the investment, the traditional price earnings (P/E) ratio. We’ve used the US in this example due to the longer data history. Prices are currently high relative to actual earnings, which implies that investors have been willing to pay higher prices to receive scarce earnings and it speaks to the dearth of earnings growth in the traditional economy due to weak economic activity. Similar to the previous example, we find that subsequent returns from these high valuations are weak in both the US and South Africa.
- Coming closer to households, we assess US house prices, which are elevated relative to incomes. The average Joe has to work 20% longer or harder to afford one family home. This highlights the extent of the overvaluation of another traditional asset class, where prices have been inflated by unorthodox monetary policies. This example also provides insight into the growing level discontent between the haves and the have-nots in certain developed countries where poorer and younger generations have trouble acquiring financial assets, which are unaffordable relative to incomes.
Roadmap to the changing investment climate
It is clearly a tough time to be investing. However, there a number of pragmatic steps that can mitigate the risks in overvalued traditional asset classes
Cautious of index-hugging strategies
The graph below shows the relationship between the S&P price earnings ratio, which we spoke of above, and subsequent returns over the following five years. On average, we would expect 4.8% nominal returns each year over the next five years from current valuations. Is this enough to compensate for the risk? And after inflation? Whatever the answers to these questions, it is less clear than if valuations were below 15, for example.
A similar relationship is found in South African equity markets: expensive valuations lead to poor long-term return potential in the index. The point of this explanation is not to exhaustively list the extent of overvaluation for each market, but rather to highlight the broader risks attached to traditional asset classes when purely looking at index investing strategies. Investing into these indices at current prices will likely reap poor subsequent returns. Similarly, there is a low probability of finding the smaller gems that might exist below the surface of the index.
Active management gives investors the chance to seek out the opportunities within overvalued market conditions, to sit on cash when required and to deploy those funds quickly when new opportunities arise. In-house research confirms as much: the percentage of active managers that outperform their benchmark index is higher when returns on that benchmark are weaker. In other words, when equities aren’t performing well, active managers perform better.
The trend towards passive investing in an attempt to simplify investments and lower fees is an understandable development. However, we must recognise that this trend – prevalent since the financial crisis – might have been a reaction to financial conditions and that those conditions might be changing. Equities, bonds, property and other traditional asset classes all flooded higher in a tide of strong performance due to unprecedented support from major central banks. Of course index strategies performed well during this period – everything performed well! Conditions are much tougher now, because the US Federal Reserve is no longer backstopping financial markets with quantitative easing and global discount rates have edged higher. Purely passive strategies with no cognisance for potential risks is rash in current conditions. This is not to say passive has no place in portfolios, but a balanced approach is required – the risks should be understood and managed accordingly.
Investors need non-traditional asset classes that provide an alternative source of return and which are uncorrelated with current holdings to generate greater diversification benefits. Finding these investments is no easy task, but notable work is being done in the real economy space where managers seek out long-term infrastructure projects. Other exciting opportunities present themselves in the technology space where artificial intelligence, robots and cryptocurrencies have the potential to change the way we do business. Finally, we must show growing appreciation for the work done in the impact investing space. Prospects for better social outcomes and the technologies mentioned above create the opportunity to uncover areas of the economy with significant potential that were previously maligned by a single-minded focus on traditional investments.
A head in the sand approach won’t work
Financial markets have clearly entered tough conditions with weak returns expected from many traditional asset classes. Sitting with our heads in the sand – purely invested in indices and asset classes where the long-term returns might struggle to compensate for the risk – is imprudent. Opportunities present themselves below the surface. Active investment decisions are required within a sensible investment framework to take advantage of the shifting conditions taking place below the surface.