DUNCAN THERON DECEMBER 2016 www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB) QUATRE 2016 Q4 MARKET COMMENTARY INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING MARKET OVERVIEW 2016 was a year where Black Swan events were not just risks limited to the world of investments, but we experienced such surprising events in polics. When they occur the impact on investment markets are material. The year ahead will probably be no different. The All Share Index produced a dismal return of 2.63% over the 12 months ending December 2016. It was another disappoinng year if one considers that the local equity market only yielded 5.13% in 2015. So, it’s been a tough two years. Over the 12-month period, Financial and Industrial shares lost ground yielding -3.09% and -6.55% whereas Resources shares were the star performers with a 34.24% result and a significant turnaround from the -36.99% performance in 2015. The MSCI World Index, which reflects the developed world’s largest listed shares, also had a negave year in Rand terms yielding -4.81% on the back of the Rand strengthening by 11.46% against the US Dollar (USD). Local listed property and Government bonds yielded strong returns of 10.20% and 15.45% respecvely and even Cash which returned 7.39% outperformed local inflaon of 6.61%. Many investors were very negave on our bond market post Nenegate, but it was the place to be on a risk-adjusted basis. Most investors have also missed the strong performance in Listed property aſter a very average year in 2015 where it yielded 8%. All offshore asset classes returned negave returns due to the Rand strength. Offshore Listed property yielded -6.77%, Global bonds – 9.61% and US Cash -11% in Rand terms. A year ago most investors wanted to simply take money offshore. We argued that if they wanted to, they should hedge it. The Rand at the me was trading at R15.60 / USD. The Rand has now strengthened to below R14 and could strengthen further. CHIEF EXECUTIVE OFFICER “Knowledge has become the key resource of the world economy.” - Peter Drucker QUATRE A french ballet term meaning, four of something. GraySwan gives their perspecve on each of the four financial quarters.
Transcript
DUNCAN THERON DECEMBER 2016
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
QUATRE
2016 Q4 MARKET COMMENTARY
INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
MARKET OVERVIEW
2016 was a year where Black Swan events were not just risks limited to the world of investments, but we experienced such surprising events in politics. When they occur the impact on investment markets are material. The year ahead will probably be no different.
The All Share Index produced a dismal return of 2.63% over the 12 months ending December 2016. It was another disappointing year if one considers that the local equity market only yielded 5.13% in 2015. So, it’s been a tough two years. Over the 12-month period, Financial and Industrial shares lost ground yielding -3.09% and -6.55% whereas Resources shares were the star performers with a 34.24% result and a significant turnaround from the -36.99% performance in 2015. The MSCI World Index, which reflects the developed world’s largest listed shares, also had a negative year in Rand terms yielding -4.81% on the back of the Rand strengthening by 11.46% against the US Dollar (USD).
Local listed property and Government bonds yielded strong returns of 10.20% and 15.45% respectively and even Cash which returned 7.39% outperformed local inflation of 6.61%. Many investors were very negative on our bond market post Nenegate, but it was the place to be on a risk-adjusted basis. Most investors have also missed the strong performance in Listed property after a very average year in 2015 where it yielded 8%.
All offshore asset classes returned negative returns due to the Rand strength. Offshore Listed property yielded -6.77%, Global bonds – 9.61% and US Cash -11% in Rand terms.
A year ago most investors wanted to simply take money offshore. We argued that if they wanted to, they should hedge it. The Rand at the time was trading at R15.60 / USD. The Rand has now strengthened to below R14 and could strengthen further.
CHIEF EXECUTIVE OFFICER
“Knowledge has become the key resource of the world economy.”
- Peter Drucker
QUATRE
A french ballet term meaning, four of something. GraySwan gives their perspective on each of the four financial quarters.
QUATRE 2016 Q4 MARKET COMMENTARY
INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
“Challenges are what make life interesting. Overcoming them is what makes life meaningful.”
- Joshua J. Marine
Fortunately our institutional retirement fund clients have hedged against Rand strength as from levels as high as R18 / USD in 2015 and such has been a very valuable risk management strategy. We identified that, the Rand was oversold and presented a GraySwan risk. It was simply how we would manage the risk and our hedges paid off handsomely for our clients. Our clients are top performers and “Sleep Well At Night” (SWAN).
We have now started unwinding these hedges below R14 to take some profits. Now is the time to start moving monies offshore but in a controlled and gradual approach. As Benjamin Graham once said “The essence of investment management is the management of risks, not the management of returns.”
BLACK SWANS AND GRAY SWANS
Black Swan events are random and unexpected events. They are the unpredictable unknowns such as Brexit and Trump. “GraySwans”, as we coined the term and named our business, however, are risks that can be identified and which may have unintended consequences for investors and therefore should be managed to ensure adequate compensation thereof or should be avoided.
Reflecting back over the past year, expert pollsters considered U.K. citizens 70% likely to vote to remain a member of the European Union (EU). In the end, Brexit won the race. In terms of the US elections, Clinton was as an 8-to-1 favorite in August 2016. On election day, most expert pollsters put her chances of winning at higher than 80%. However, Trump won!
Populism has clearly challenged globalism last year. Globalisation was supposed to make life better for everyone. It helped some but many experienced very little if any benefit. As Trump noted “People talk about how we’re living in a globalised world, but the relationships people value most are local – family, city, state, and country. Local, folks, local.”
Events such as these, while analyzable to some level, are difficult to predict. As with the markets, it’s just very hard to predict things in the short term. Seeing beyond the day-to-day noise is what matters most in investments.
Now that Donald Trump has been elected as President of the United States, it has potential consequences (both risks and opportunities) on the investment outlook for 2017. What will a de-globalising world look like? We don’t yet know how it will unfold, but it will probably continue across the world. We just have to monitor it very closely and constantly check whether our client’s portfolios are suitably positioned from a risk return perspective.
Trump will be a very pro-business president and his planned corporate tax cuts and decreases in regulation could be positive for investment markets especially in the short term as the market typically overshoots. Don’t be surprised if the US stock market and the USD produces a 2 standard deviation event on the upside. Too much stimulus could however lead to rates being raised faster than what the market anticipates which could be negative.
The concern right now is that the US market seems fully priced to expensive on a valuation basis. The US equity market has climbed by more than 6% since the Trump victory and the trend remains up, making 2016 the fourth year of positive performance over the last 5 years. Can the US market continue to perform if the USD remains so strong?
SEEING BEYOND THE DAY TO DAY NOISE IS WHAT MATTERS MOST IN INVESTMENTS.““
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INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
2016 Q4 MARKET COMMENTARY
According to research from BCA Research, the S&P 500 has rallied along with the USD in the last three major USD bull markets: 1978 – 1985, 1994 – 2002 and 2011 to today. Albeit at elevated levels, the US equity markets may continue to do well if there is an orderly increase in inflation and rates in the US.
But Trump has not actually done anything yet. Details of his economic plans are still scarce. Perhaps, the market is simply cheering because after 8 years and 100,000 pages of new regulations during the Obama administration are they ready for change.
The USD will also most probably remain strong against vulnerable currencies such as the EURO and some Emerging Market currencies and may reach new highs in 2017.
There is significant uncertainty about what Trump holds. What we do know is that inflation pressures are rising in the US as the economy continues to expand and such will put pressure on the FED to continue to raise rates. Rates will therefore rise in 2017, the path is however uncertain and will remain very data dependent. Most probably we will see at least two increases in the next 12 months.
A BIRD’S EYE VIEW
For example, with 5% annual growth (it’s a high number) it will take just 14 years to double a country’s GDP; with 3% growth it will take 24 years. If we don’t grow at a minimum of 3%, our children and grandchildren might be worse off than us.
The risk of rising populism in Europe will need to be watched closely. The upcoming national elections in the Netherlands (March), France (April / May) and Germany (September / October) are all events that could cause increased market volatility. Will there be further fractures in the European Union? A FREXIT (France exciting the European Union) in April / May could have a major impact on world markets. These upcoming elections in 2017 will be strong indicators of how vulnerable the political will is to uphold the EU.
China’s change from an investment led to a consumption led economy will most likely continue to slow their economy over the near term as the country manages the transition. There is probably less concern this year regarding China’s growth as it has shown signs of stability and remains at a decent level compared to other large economies. Its growth is unlikely to disappoint their five year plan of 6.5%. It should however be noted that any major disruption in trade between the US and China could have a negative impact on the Chinese markets.
The global economy is transitioning from an era of deflation to reflation. The European Central Bank’s (ECB) decision to extend asset purchases to the end of 2017, even though it is a slower pace than before, should keep real GDP growth positive for 2017. Normalizing of inflation is a positive sign as it points to an improving world economy. We need a growing world economy to accommodate the growing population.
“When it is obvious that the goals cannot be reached, don’t adjust the goals, adjust the action steps. ”
- Confucius
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INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
2016 Q4 MARKET COMMENTARY
On the commodity front, in general, such prices seems to have bottomed in 2016. But it’s not clear whether we’ll see another rebound in 2017. Rather expect sideways commodity prices and hopefully less volatility.
In terms of Global Emerging Markets, a Trump election has clearly been seen as negative as Emerging Market growth is vulnerable to increased trade protectionism. A stronger USD has and will most likely also cause more downside to over-leveraged Emerging Market borrowers given that 80% of Emerging Market foreign currency debt is dominated in USD.
Emerging Market valuations are now more attractive again so we’d recommend to be at least at a more neutral level right now. The MSCI Emerging Markets Index currently trades at 12.1 times the projected earnings of its members, 26% lower than the price-earnings ratio for the MSCI World Developed Market Index. Some of the worlds leading IT companies are also based in the Emerging Market universe and such now represents 25% of the MSCI Emerging Markets Index. It should however be noted that the world’s worst performers are also among the Emerging Markets. Investors therefore need to pick with care. Importantly, Emerging Market currencies can certainly get cheaper before they revert to historical norms but they could also move back quickly to fair value. The real challenge for Emerging Markets is whether they can truly decouple from Developed Markets. If not, it may lose its fundamental appeal and the diversification benefit from investing in Emerging Markets will fade leading to capital outflows.
We believe investors can obtain decent returns from select Emerging Markets so should be considering increasing such where they are underweight. The initial conditions supporting Emerging Markets as per 2016 remain in place. Such include the continued demand for high yielding assets, an uplift in growth, improved currency reserves and supportive valuations. Further, even if the US economy and the USD strengthens further, specific Emerging Market companies are well-placed to profit from such as there will be a greater demand for their goods and products. Barring extreme policies from Trump, Emerging Market assets should provide excess returns above Developed Markets over the longer term thanks to a superior growth profile and more attractive valuation levels. There will undoubtedly be short term noise which will lead to some volatility but Emerging Markets is a long term play.
On the local front, our local equity market remains fully priced and political developments will continue to be a potential source of market volatility. The case for an improvement in the South African economy is however a reasonable expectation. The key issue to monitor is the upcoming credit ratings of South Africa – will we drop to below investment grade? The possibility is there in June 2017 but it may already be priced into our market. Further, any negative developments in US – China trade relations and its effect on commodities can be negative for our markets. An improving inflation and interest rate outlook should however point to decent returns from local equities. Further, local bonds remain attractive and we’re more positive on listed property post the recent pullback in prices.
Our positioning remains to be slightly underweight local equities and overweight nominal bonds, with a neutral weight to cash. We’re looking for opportunities to buy into local listed property in the dips.
IN BROAD TERMS, WE THINK GLOBAL EQUITIES SHOULD OUTPERFORM GLOBAL FIXED INCOME ASSET CLASSES. AS A RESULT WE HAVE A STRONG PREFERENCE FOR
GLOBAL EQUITIES RATHER THAN OTHER GLOBAL ASSET CLASSES.
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“Patience, persistence and perspiration make an unbeatable combination for success. ”
- Napoleon Hill
QUATRE 2016 Q4 MARKET COMMENTARY
INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
PORTFOLIO CONSTRUCTION
In general, we are broadly supportive of risky assets but in a guarded way. We’re not overly optimistic. We expect global and local equity markets to be higher in 12 months than they are today. Whilst we are positive we are again expecting low returns from traditional asset classes such as cash, bonds, property and equities.
Even from global and local equities can we probably only expect high single digit or low double digit returns over the next 12 months. Our outlook is unlikely to change until we see a combination of higher short term rates and more favourable valuations across most investment markets. Therefore, achieving the performance targets of diversified multi asset class solutions of more than inflation + 4% will again be challenging. Investors will have to consider alternative strategies to attain their performance targets.
From a risk perspective, we always strive to ensure adequate diversification of portfolio and risk exposures on behalf of our clients. We know we have to expect unexpected outcomes in 2017, so we need to be nimble in our approach to these scenarios.
Albeit that equities are the best source of real returns over the long term, investors should be tolerant to yield negative returns from time to time. For example, since 1900 the US stock market has fallen 10% at least once a year. We have now seen more than 200 days without a 10% correction. Falls of 20% or more happens every 3.5 years. It has been more than 6 years since we have seen a 20% correction. The good news is that if the market falls 10% then 82% of the time an investor would have yielded more than 50% in USD terms over the subsequent 5 years had they remained in the markets.
The current low volatility in the offshore equity markets as measured by the VIX (Volatility Index) is a concern as it points to the expectation of a smooth Brexit and Trump delivering on expectations. The reality could be very different to what concensus believes and we believe the market is underpricing these political and investment risks. The VIX may also be at such low levels as investors are simply moving assets out of bonds into equities so the trend for equity flow and returns seem to be up. Most people insure their houses, their cars, their lives, but they don’t insure their investments. We constantly hedge or insure our clients’ portfolios where we can access such instruments and especially when the cost thereof is reasonable.
We believe that our conservative positioning across our client portfolios have been and continues to be appropriate to provide the required balance between risk and return. The potential for inflationary surprises and geopolitical stresses steers us to remain conservative in our approach. We continue to focus on reasonable real returns with capital protection as we believe the markers will remain volatile in the near term. Having dry powder as per cash allocations, should we be able to take advantage of opportunities post elevated volatility events.
In terms of investment manager selection, we continue to invest our clients’ money with quality and premium investment managers with world class investment professionals which have not only been remarkably stable, but have proven to be able to provide outperformance over longer periods. We prefer independent investment managers that focus on one core business and that is the management of assets. They have a tried and tested, disciplined investment philosophies and a robust investment process. Most importantly, in a concentrated market like SA one needs to invest in investment managers that have a ability to get their big calls right more often than not. We invest our clients with investment managers that ignore noise and rather make decisions based on their long-term views. Such investment managers helps us to ensure that our client solutions are focused on risk-adjusted real returns.
“Reflective thinking turns experience into insight. ”
- John Maxwell
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INVESTMENT CONSULTING I WEALTH MANAGEMENT I REPORTING
www.grayswan.co.za l 021 852 2092 (CT) l 011 431 0141 (JHB)
2016 Q4 MARKET COMMENTARY
As per research from MorningStar, last year saw $285 billion of outflows out of active funds globally compared to $428 billion of inflows into passive funds. This trend has been persisting over the past 10 years. Will this trend continue into 2017? Equity valuations may not advance broadly this year, thus upside will be harder to capture in passive funds.
We combine passive, quantitative and active investment strategies across our client portfolios. While equity valuations are high currently, dispersion within the market is also elevated. Potentially this may be a year where active managers outperform the markets again. Our client portfolios are tilted more towards active management at this time but retains a healthy allocation to passive mandates. We recognise that in a low return environment, low cost passive mandate strategies are a key component of any investment strategy.
RISK AND RETURN
The market is random. We don’t know anything specific for sure, so diversification but not overdiversification is important. As investment advisors we do not get distracted by short term macro economic and market events. We don’t try to predict the movement of the markets but we do assess the probabilities and then tilt our client portfolios accordingly.
We think the next three years of investing will even be tougher than the past three years which simply emphasises the importance of applying a disciplined and guarded investment approach.
What we do know is that it’s important to tilt the odds in your favor whenever you can. No one knows how the Trump election administration will perform, so we’re not making any big bets in any direction yet.
Knowing one’s investment goals, time horison and risk tolerance is the key to building an investment plan. We know that strategic long-term asset allocation counts for approximately 80% of the variation in portfolio returns whilst tactical asset allocation counts for about 10% and investment manager selection for another 10% in the variance of returns. We know how much risky assets each of our clients require to comply to their risk budgets and to meet their long-term targets. We also know that we have to adjust our clients’ portfolios in the short term when opportunities or risk arises but keep their portfolios alligned to their long-term goals.
We think beyond the optimal blend of asset classes for the long term, success will depend on our ability to implement tactical asset allocations, periodic rebalancings into strength and buying into the dips. Bargains don’t exist in the absence of fear. Therefore we need to always look to invest in attractively valued assets while fear and uncertainty, although elevated, begins to fall.
We also know that if we invest with quality and premium investment managers they will assist us to manage our clients’ expectations and thereby meet pre-defined performance targets within a well-managed risk budget. We have identified various investment managers which we will be allocating to this year which has not been in our client portfolios to date and we believe they will add material value to such.
Our ongoing advice will always be based on longer term opportunities that we see in the markets as well as where we find reputable and sustainable outperformance through the market cycle. Our advice to our clients are always to hold on in rocky times and stick to your well defined and modelled and robust investment strategy. Occasional negative performance and even relative underperformance is part of the investment path. Just stay the course and remain committed for the long term. It’s about time in the markets and not timing the markets.
MORE INFORMATION
If you have any question regarding our Research, Investment Consulting, Wealth Management or Reporting services please contact us today.
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OUR INVESTMENT TEAM
The core of our investment team has been working together for more than 10 years. Our collective investment experience exceeds a 100 years of advising to and managing most of the largest institutional client’s assets in South Africa. Since the inception of GraySwan have we not lost any investment consultants or senior members of the team making us one of the most stable and experienced investment teams in the industry.
