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By Alwyn van der Merwe, 11 February 2013
Investor sentiment appears to have shifted markedly from the mood at the beginning of 2012. Local equities had returned only 2% in 2011 and economists had reduced their growth expectations for both local and global economic activity. Investors were discounting a lot of bad news and we thought the scene was set for some pleasant surprises. And indeed, despite mediocre economic growth in 2012, financial markets were exceptionally strong, with local equities recording a total return of 26.7% for the year. Our clients were the beneficiaries of this strong performance.
It is this upward trend in risk asset prices that creates expectations for continued positive performance. There is a sense of optimism as investors use the common argument – which we argued again a year ago – that low cash yields and the actions of central bankers in keeping interest rates low will ultimately direct the flow of money to risky assets, which, ultimately, give investors a growing income stream.
Although this is a valid argument, which may have supported the recent appreciation in share prices, it is simply not good enough to base one’s expectations on one factor. Globally, the USA will struggle with a restrictive fiscal situation and navigation of the so-called debt ceiling, and Europe will continue to battle with the problem of its very inflexible exchange rate. Economic growth in China, however, appears to be stabilising and might well have some pleasant surprises in store in terms of activity levels.
Despite this outlook, our starting point for explaining the future outcome for investment returns is current valuations. Valuations of local and, to a lesser extent, global equities are no longer in cheap territory. Hence, we have downscaled our return expectations for the local asset class. Against a background of deteriorating economic growth, it is very hard to imagine positive earnings growth for companies that generate the bulk of their profits from local business activities. Even exporters might struggle, but support from a shaky rand is not unlikely. A wider global equity universe and subdued earnings expectations might well produce another good year of global equity performance for SA investors.
Despite the variables that we can’t control, we can control what assets we buy and understand the price we pay for these assets. We can still find quality assets locally at a fair price that is likely to produce cash-beating returns over the medium term. Following a year of very low turnover in our portfolios, market conditions might well provide good opportunities to take profits on shares that have performed well and replace them with unpopular and undervalued counters.
Globally, bonds are expensive and might remain expensive for a while. Our off-shore equity colleagues have, arguably, an easier job than we have, as value is more compelling. It is still possible to find companies that can grow their net asset values and, with potentially positive macro surprises, sentiment might just provide another year in which global equity returns will exceed expectations.