Q1 2021 – Tactical Asset Allocation – Full Article
Everyone is pleased to have seen the back of a very challenging 2020. Of course, each of us has had to face different challenges – personally, in business and in the various industries where we work. As with every passing year, lessons learnt, mistakes made, good habits and processes were reinforced.
While there were early signs of a health issue in China in December 2019, none of us could have envisaged the global impact that COVID-19 would have. Even in the face of a Chinese lockdown of a city the size of Wuhan, it would have been a far cry to envisage a world of lockdowns in democracies like Australia, Germany, the UK and our own Rainbow Nation, which was not in a financial position to support and shut down a spluttering economy. Weighing up fragile lives and fragile livelihoods, with limited but fast-evolving scientific proof (much of it conflicting) as well as unprecedented responses, have made 2020 a landmark year. The impacts stretch across civil liberties, policymakers’ responses (co-ordinated and uncoordinated), the way we think about policymakers’ behaviour (and the basis on which they make decisions) and of course on the way we work. Vladimir Lenin’s saying “There are decades where nothing happens and then there are weeks when decades happen” seems very appropriate as we consider the changes that the last year has brought about and how we envisage managing asset allocation over the shorter-term tactical horizon.
While we seek to manage our portfolios on multiple time horizons (Strategic, Tactical and Dynamic), each bringing insights, tilts and opportunities, it is fair to say that the majority of what we do is within a tactical horizon which we define as twelve months out. Our tactical process is the same across our entire book, including our Multi Strategy Funds, Absolute Return funds and our Hedge Funds. Hopefully you will see how managing these different capabilities forces us to look at our biases a little more closely than if we were managing only one of these capabilities.
The prevailing narrative
In our most recent tactical conversations, it was very clear from our own data, various individual viewpoints and our team discussions that we were thinking very similarly to the broader cohort (sell-side research, buy-side contacts and independent research subscription services that we utilise).
The broad narrative is aligned as follows. Interest rates will stay low for the foreseeable future since central banks will not or cannot raise short term rates, given the early stages of the economic recovery and continuing low levels of (formal economic) inflation observed around the world, despite base effects leading to higher levels of sequential inflation through the course of the second quarter into the back end of 2021 and early 2022. Fiscal support will continue to be provided by those countries that can afford it, and many that will struggle to provide support but will try anyway.
2021 is expected to be a year of decent economic growth relative to the 2020 COVID-19- and lockdown-driven economic contraction. The successful development of various vaccines and the expected rollout of vaccination programs throughout 2021 will spur confidence and even better than normal growth dynamics from a GDP perspective for the year. This will probably lead to very strong global growth versus more recent medium-term trends.
Market participants re-based corporate earnings to very low levels in 2020, so base effects and some top-line expansion as economies re-open and normalise should result in material earnings growth trajectories for equities. This removes much of the credit concern which existed earlier in 2020, with the associated capital raises and the impact that dilutions had on valuations.
Bond markets will continue to perform and, while some inflation will return, central banks will continue to support their own bond markets with Quantitative Easing processes, so any term premium impact (long end rising versus an anchored short rate) is unlikely to upset markets. However, the rising term premium will act as a tailwind for the value factor in equities, as opposed to the growth factor, which has outperformed value by an enormous margin over the last few years.
The final consensus theme we identified is the weaker US dollar. The weaker dollar theme is driven by increased risk appetite, perception of better opportunities outside the US (growth and interest rate differentials) and growing deficits in the US.
Based on historical correlations, evidence of a weak dollar should lead to a decent performance from risk assets (emerging markets, commodities and carry trades alongside falling or stable volatility). Many strategists and asset managers have labelled this broad context as the “reflation” trade.
Absolute Return Asset Allocation perspectives
We find it very hard to disagree with the “reflation trade” narrative. As we went through our own Tactical Asset Allocation (TAA) approach and then subsequently led the STANLIB TAA discussion (we do this as a wide investment platform every quarter), we found very few points or areas of major disagreement with the consensus. As ever, we find this consensus agreement uncomfortable. That does not mean the narrative is incorrect, but it does require us to scratch at our viewpoints more aggressively than we normally would and lean heavily on our tried and tested process.
A stand-alone, six-lens approach to our TAA can be summarised as follows:
Kevin Lings and his team have provided the following broad economic points for us to anchor onto as we push into 2021:
As we move into 2021, growth will be much higher than in 2020 and, according to Kevin and his team, inflation will remain muted, apart from base effects. We fully agree with Kevin. As a team and a wider investment platform, we have spent a lot of time discussing inflation in various meetings and believe the forward-looking inflation question is important, not just for 2021 but beyond, when bond yields at zero will no longer compensate for inflation risk.
We see bottlenecks in specific areas like transport globally and specifically in the US, food inflation in SA (which should correct quickly) and some supply-constrained commodities which could push inflation higher than expected. Importantly, the US inflation basket consists of around 33% from shelter or owners’-equivalent rent, which we believe will struggle to show meaningful YoY growth in 2021. High levels of unemployment, combined with people continuing to move to more suburban areas with the changing employment and work-from-home experience, caps this shelter component for now and ultimately underpins the benign US inflation outlook of our investment and research teams.
In SA, we have a much weaker demand picture, with structural issues which continue to point to more disinflationary than inflationary forces for the present. The rand is an undervalued but risky currency and real yields are juicy, which should lead to some capital flows into SA, providing some support for a cheap rand despite a dreary fiscal outlook. Without a very weak rand, we believe inflation in SA will also remain a “base effect story” within our tactical horizon and as a result we do not see inflation upsetting domestic asset markets.
The view on extending fiscal support directly to the global consumer is, we acknowledge, a very important evolution in the inflation and monetary debasement argument (Read more on Diversification and Gold in the Age of Financial Repression) and we have labelled this change a potential game changer. At the same time, the US Federal Reserve has changed its forward guidance to encompass a focus on an aggregate inflation rate of above 2%, so a reaction from US central bankers to subdue inflationary impulses, even when inflation breaches 2%, is unlikely.
The structural issues driving global disinflation remain in play. Both our own work and that of the STANLIB Economics team leads us to believe that excess capacity remains in the system and so-called output gaps due to unemployment and excess capacity will keep broad-based inflation in check. So, the “reflation narrative” should be seen for what it truly is, a broadening of economic growth driven by base effects and a pick-up in demand off a low base. It is a re-opening trade, not a reflation trade. As a team we recall the inflation narrative of 2009 and 2010, when QE programs were pursued around the world, yet inflation continued to undershoot forecasts. We believe the current environment is similar.
For a long time, we have openly discussed liquidity with our clients, its impact on market prices, impact on investor behaviour and why we have such a high degree of respect for liquidity as part of our investment process. Our various liquidity signals have served us well, limiting risk in our portfolios in a difficult 2018 and highlighting, towards the second half of 2019, the need to increase our risk appetite across our portfolios. We discussed these on our roadshows in early January 2020, and in our webcast in April 2020 we touched on the “opposing forces” of COVID-19 and the liquidity response driven by policymakers and central bankers, who acted much faster than expected in 2020.
Naturally, COVID-19 and the subsequent response has dramatically accentuated the positive liquidity environment. The effects have positively impacted asset markets, yet the enormous liquidity generated by huge rate-cutting cycles, fixed Income purchases and direct fiscal support is not yet translating into above-trend economic growth or, more importantly, a steady improvement in the velocity of money.
From an investor behaviour perspective, everyone is now aware of this liquidity impact. Market sentiment, reflected in the consensus narrative, is very bullish and the focus on potential risks is limited. There is no sure way to position for this. Is the liquidity support mispriced on the downside or on the upside? When will the market care, and what signs do we need to watch, to indicate a changing landscape?
The transfer from the extraordinary monetary policy support of QE to the unbelievable fiscal support at consumer and industry levels has had both a disinflationary and potentially an inflationary impact. The impact of the growing number of “Zombie Companies” in the global economy has had significant disinflationary impact, along with structural trends of disinflation driven by technology and higher levels of productivity, growing debt, demographic trends (ageing populations and wealth gaps), as well as the impact of people moving from urban to more suburban areas as work-from-home becomes normal.
It remains to be seen whether fiscal support and a savings transfer will lead to spending patterns that drive inflation meaningfully higher, but liquidity supports asset markets at present. Whether it will be enough to drive markets meaningfully higher is uncertain, given current valuation levels, but we continue to scratch at the inflation question as a team and a wider platform. We are very much aware of the risks of inflation rising, showing its teeth and hence impacting portfolios that will probably have to be very different than they have been for the past few decades.
However, we do not believe inflation will be a bogeyman within our tactical horizon, even with this huge liquidity tailwind.
Across the board, in absolute terms, we would not classify asset markets as cheap. We believe that valuations matter, but they matter over the longer term. On their own, valuations are unlikely to cause a substantial correction in markets, although they may act as a headwind for returns.
In investing, it is always important to retain some margin of safety, and in the absence of large margins of safety, it is logical to acknowledge that valuations are unsupportive, so the downside risks are more acute than normal.
Relative valuations are, however, interesting. Only a few markets show valuations in bonds that are more supportive than in equities (Equity Risk Premium). For the first time in a number of years, South African equities stack up comparably to South African bonds. We continue to believe a longer-term structural issue exists with SA equities, but SA equities aren’t totally reflective of the South African economy and while the world improves, so will South African equity markets and the multiples people are willing to pay.
Very few bond markets are compensating an investor for the credit, duration or inflationary risk being taken, especially those with negative nominal yields. South African bonds show decent absolute value and relative value against their own history and relative to other fixed income markets. This valuation argument is well understood by South African investors, given the risks of the country’s fiscal situation highlighted by many analysts, including our team, our Chief Economist and our highly regarded Fixed Income team, led by Victor Mphaphuli. The collapse of cash rates across the world is notable. Even SA has a negative real cash rate, making South African bonds very appealing relative to South African fixed income history, global bonds, emerging market bonds and South African cash.
South African equities offer comparable returns to South African bonds, but better outcomes if the rand weakens. We look slightly more favourably upon South African bonds now than a year ago, despite the well-known fiscal risks, but valuations in comparison to such low cash rates in SA and low bond yields around the world cannot be ignored in the macro environment which we believe we are facing in 2021. However, South African bonds are a “dance partner” at best, given the increasing fiscal risk and potential for our curve to steepen or shift meaningfully higher. As a global investor, we continue to advocate South African bonds on a currency-hedged basis. Victor and the Fixed Income team believe that SA’s 10-year yields continue to compensate investors at 8.5% and, with some small development, could fall in 2021.
Listed property in SA remains a difficult asset. The bad news is well known, and balance sheet issues are slowly being addressed. While our team believes property offers some valuation support, the structural issues around COVID-19, REIT status dynamics and a stressed consumer elicit mixed responses, based on NAVs and balance sheets, both from the Absolute Return team and wider STANLIB TAA community. Keillen Ndlovu and the Listed Property team believe the valuation arguments are becoming more compelling on a medium- to longer-term time horizon. As a team leaning heavily on tactical asset allocation, we continue to look unfavourably upon the sector but there is no doubt that the advent of a vaccine requires a less bearish stance toward listed property than a few months ago.
Momentum keeps us humble. We want to own more of what is working and less of what is not. When equity earnings are being revised higher (either YoY or by analysts), we are more inclined to be holders of equities if using momentum in isolation. Momentum, however it is measured, can be a very effective risk management tool to help avoid large losses. Our current outlook is broadly positive across major asset risk classes and reinforces the economic and liquidity arguments summarised earlier.
Our volatility signals paint a mixed picture for different asset classes. We find volatility is elevated versus history. Our cross-asset signals are skewed by equity, commodity and longer-term fixed income volatility remaining higher than normal and what we would term “sticky.” We expect both realised and forward-looking equity volatility will drift lower from here. While the risk/reward of increasing asset exposure here is less compelling than a few months ago, at these volatility levels we would still lean towards risk over the medium term.
Elevated volatility could be a function of the US election in early November and concerns around electoral challenges that followed the initial victory announcement. November’s very rapid market moves after the announcement of COVID-19 vaccines also has market participants paying for upside insurance (risk happens both ways). As a result, upside risk is mispriced compared with the downside cost of insurance, once again highlighting the uniformity of views and potentially investors’ complacency in the shorter term.
There has been a notable shift in sentiment since the last quarter. Equity and credit sentiment are very strong, with currency sentiment more in the middle of the range, but skewed away from the dollar.
We use our sentiment scores as shorter-term counter signals to avoid taking risk when it may not be priced correctly. Similarly, these scores act as a signal for us to potentially take risks when others are fearful. Our sentiment signals are elevated, urging some shorter-term caution with better opportunities for adding to our tactical view lying ahead.
The chart below shows investors’ lack of concern relative to the last 10 years, with buying of puts (downside insurance) versus buying of calls (equity market upside) at extremely low levels.
Where we are different to the consensus
As mentioned previously, we are broadly aligned with the consensus narrative, but with some subtle differences.
- We do not believe in “reflation”, but in re-opening. We do not consider it is time (yet) to skew away from fixed income due to inflation concerns. We think that inflation is a potential risk but it is a low-probability evolution in our tactical scenarios. We understand the monetary debasement arguments and the direct transfer of cash to consumers’ pockets is an early-stage evolution towards Modern Monetary Theory (MMT) and subsequent money debasement (or inflation) but it probably sits outside our current tactical horizon.
- Given our view is less reflation than re-opening, we are not yet big believers in the Equity Value Factor over Equity Growth factor. Our Quantitative team is more predisposed to value than they have been for a while, but we think the cash flow dynamics of growth continue to outweigh value for now. Of course, there will be some overlap. Rademeyer Vermaak and the Quantitative team point out that South African resource companies display a large overlap of value and growth, which is unusual compared with the rest of the world where value is generally captured in financial stocks.
- We do not yet believe that US assets are less appealing than global assets. It is true that from a valuation perspective US markets are more expensive than most other global markets and if the dollar weakens other assets may do better (if history is a guide). We postulate that US margins remain world class and return on equity numbers remain high relative to the rest of the world. A weaker dollar is not necessarily a bad thing for US equities, with roughly 50% of the S&P 500 earnings being generated outside the US (a weak dollar should mean better earnings) but a strong dollar means we would be protected by the flow of capital back to the US, supporting dividend yields and buybacks. This should not be read as “US better than everywhere,” but we remain positive on the US equity market and would still make substantial allocations to the region in unconstrained portfolios.
Scenarios & risks
As part of our TAA process, we have always considered granular market scenarios around forward-looking environments that could force us to shift our asset class views or portfolio construction inputs.
While multiple risks could emerge, the macro environment is very supportive of asset prices. As summarised above, our framework is very constructive for us to take risk within our portfolios. The consensus “narrative” that we largely agree with is only differentiated in a few areas – many may say our viewpoints are not very different.
A lot of this discussion centred on inflation risk. As a team, we believe inflation is largely muted and disinflationary forces will keep inflation in check. Apart from inflation and its impact on portfolio construction, the wider team was more focused on other risks, with heightened inflation ranking only third on our list of tactical concerns.
The single biggest risk, identified by both the Absolute Return team and subsequently by the STANLIB TAA discussion group, is related to the vaccine, its potential side effects, logistical challenges (storage, transport, lack of sufficient dosages etc) and the speed of the vaccination process (logistical and safety or behavioural issues). Should vaccine efficacy be questioned, all the positive macro dynamic discussed above would have to adjust.
Other risks that the team consider to be under-appreciated are the stubbornly high unemployment rate and low participation rate, given ongoing (expected) stimulus cheques. At what point do job losses become structural and consumers stop spending and begin hoarding the fiscal support they are receiving? This could materialise through the ongoing lockdowns seen in Europe and regions of the UK and the damage these lockdowns could do to employment or confidence.
Similarly, the team felt that a policy mistake of providing too little fiscal and monetary support to economies, businesses, consumers (and markets) would leave the market susceptible to disappointment.
Q1 2021 TAA view
Our tactical asset allocation view is informed by numerous factors including liquidity, volatility, sentiment, valuations, momentum and economics. Additionally, we build scenarios to help inform our thinking around what multiple future environments could look like, in addition to ascribing probabilities and risks to each of those potential future paths. Our quarterly tactical asset allocation stance represents our current 12-month view at the end of the quarter on a range of asset classes and geographies within our universe. Importantly, these views do not consider risk budgeting for portfolio construction but rather represent our relative preferences, and hence might not reflect our actual portfolio positioning. This output should not be considered advice.