By Clyde Rossouw, Co-Head of Quality
Markets are caught in a crossfire, and it is not the time to take a side. The investment environment calls for identifying best-in-class businesses rather than proactively positioning global equity portfolios for one specific market outcome. Now, more than ever, it is important to ensure that any investment in a business is purely on the basis of strong fundamentals, and not an attempt to lock in potential benefits of specific macro regimes that appear to be firing across markets.
Tightening liquidity key driver of markets
Understanding and making sense of the factors influencing global financial markets, and the resultant behaviour of different asset classes, is becoming a difficult task.
The withdrawal of liquidity has been a key driver of financial markets this year. Major central banks have been shrinking their assets, which have weighed on emerging markets. Rate hikes in the US and UK are exacerbating the liquidity drain.
Figure 1: Total assets of major central banks (US dollars)
Source: Bloomberg, data to 18.07.18. Central banks: United States, Europe, United Kingdom, China, Switzerland and Japan.
Figure 2: Rising US Fed Funds rate (%)
Source: Bloomberg, data to 18.07.18.
However, hanging your hat on tightening liquidity as the ultimate determinant of your opportunities and returns is not enough. There are also numerous crossfires impacting the way individual stocks and sectors are behaving. Investors need to understand what these are if they want to come out of 2018 and beyond with their capital and portfolios intact.
Tariffs and trade wars not to be viewed in isolation
Issues around tariffs and possible trade wars have been brewing for the last six to nine months, and if you believe there is growing momentum around countries policing cross-border trade movements, it will definitely produce winners and losers on the investment front.
At the same time, it has been well documented that governments around the world are experiencing populist pressure against globalisation, because of growing global inequalities. The policies that are put in place by governments to resolve the inequalities will either cause further distortions or impact the way that capital is allocated, in the form of higher deficits and/or less private sector investment. These impacts should be seen against the existing trend of liquidity leaving the financial system. It then becomes clearer that the economic cycle is starting to show some signs of a downturn.
Declining commodity prices is yet another stray bullet flying through the air. Commodity prices have had a setback and with liquidity tightening, there has been a lot of money going into yield-bearing strategies. Investment-grade credit, for example, has attracted significant institutional pension fund dollars. Funding costs are rising and capital is no longer as freely available, which is a very clear sign of financial markets tightening.
However, the outlook is not all negative. The positive disinflation disruptions coming from technology are not showing any signs of abating, with significant wealth accruing to large-cap technology businesses. We have seen some very strong earnings numbers from businesses like Google this year as it garners more and more at the margin from advertising dollars. You have to be very aware of how businesses like Google and other technology businesses will impact traditional business models. When you aggregate their effect across the board, they represent a very strong disinflationary force that is acting in the opposite direction to tariffs and populist policies, which are inflationary.
Case for offshore remains strong
The rand has lost ground against major currencies this year and there is some concern that emerging markets in general, and South Africa in particular, are not very well positioned given the current environment. If you look at the impact of less liquidity, tariff increases, populist policies on the increase, declining commodity prices, and widening credit spreads, it puts us in a very tough space given that South Africa is not very well endowed in terms of driving technological innovation either.
As a general rule, we continue to believe that the case for offshore investment is stronger than the case for investing within South Africa, particularly if you believe there is potentially further rand weakness to come. However, it is not all about owning global technology shares in high-growth jurisdictions as part of your offshore allocation. Because if you look, for example, at Tencent, it has been a poor performer so far this year, particularly from May onwards.
In simple terms, we think the case for offshore is strong, particularly when investing in businesses that are able to minimise the risks on tariffs, trade wars, and declining commodity prices. The offshore investment environment is complex; we have simplified our offshore investment strategy by investing in a handful of businesses that make fundamental sense and have the ability to compound because their inherent growth rate is strong. They tend to be masters of their own destiny and are less economically sensitive.
Investors have to be very sensible and strategic as to how they go about investing offshore. While markets were awash with liquidity a few years ago, so far this year we have seen a 10-15% decline in market liquidity. This is an important development. When liquidity dries up, there is no longer excess money available to chase any and all investment opportunities, resulting in downward pressure on asset prices across the world. Weak companies are feeling the pinch. If a company has too much debt and it is not winning market share against its peers, it is likely to come under pressure.
While there are still enough investment opportunities, we are at that stage of the cycle where the risks are rising. Investors have to be extremely selective and identify best-in-class businesses, because the aggregate conditions are not conducive to investing across the board.
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Issued by Investec Asset Management, August 2018.