Diversification protects capital and returns in an uncertain environment
Equity markets, both in SA and the US, have shrugged off the social and economic suffering caused by the COVID-19 pandemic over the past two years. In 2021, they notched up record highs.
Boosted by worldwide central bank support, South African equities delivered 21% in 2021, measured by the JSE SWIX. Global equities, as measured by the MSCI World Index, delivered 32% in the same period, in rands.
After the euphoria, markets are showing nervousness that the party will come to a sudden halt, perhaps even reverse, over the next few months, as central banks respond to rising inflation with interest rate hikes.
For the managers of a successful balanced portfolio, which invests in all asset classes and both locally and globally, we have to decide in early 2022 whether to stick with the strategy that delivered for us in 2021, or de-risk client portfolios.
It is important to remember that a diversified portfolio is resilient through market cycles and provides protection against any significant loss of capital. We also have a deep conviction in the long-term resilience of our investment philosophy and processes.
The International Monetary Fund is currently forecasting global growth will be 4.4% in 2022, down from 5.9% in 2021. It has shaved half a percentage point off its previous forecast in October 2021. It is also forecasting that inflation will persist for longer than it expected in October, because of ongoing supply disruptions and high energy prices.
In our view, this outlook is not likely to trigger a significant equity market reversion in 2022. Share price gains in 2021 were underpinned by solid consumer demand for goods and services, which enabled corporates, both in SA and the US, to widen profit margins. Global growth will remain positive in 2022 and we believe that monetary and fiscal policy will remain sufficiently accommodative to enable corporates to continue to increase revenue and profits.
We are constructive on global growth and we see this playing out in corporate earnings as business have managed to strengthen balance sheets. With increasing employment rates and wages, as well as banked savings, in the US and other developed markets, consumers are in a good position to spend and demand both goods and services.
Our deep analysis on South African equity provides evidence that larger corporates have taken the time to grow revenues over the last few years while reducing debt and expenses. This bodes well for further earnings and growth. Covid has highlighted the inherent strength and competitive positioning of the SA Inc. listed corporates. Apart from insurers, the bulk of SA Inc. companies have matched or beaten pre-Covid revenues and are generating more free cash flow.
From an earnings perspective, we see SA Inc.’s earnings as sustainable, although growth rates will return to more pedestrian levels. With little earnings multiple expansion over the past few years, we do not see valuations as very vulnerable. Our base case is for real returns over the next year, underpinned by earnings growth, justifying a moderate weighting in our balanced portfolios. With dividend pay-outs also normalising, we expect that total returns of the order of 12% to 15% are achievable.
From a fixed income perspective, South African bonds are expected to deliver a return of almost 10% over the next 12 months, which is similar to their return in 2021 and well ahead of the returns that will be earned from cash. We expect interest rate increases from the South African Reserve Bank will protect the currency.
This means investors in balanced portfolios can benefit from a relatively low-risk asset and earn a healthy real return.
We are obviously concerned about rising inflation, but because underlying demand in 2022 remains good, corporates will be able to price for it and maintain margin growth.
We believe we may already have reached peak inflation and we see it unwinding over the next months. As inflation becomes more manageable, market sentiment will firm, and keep asset prices high.
Some of the other risks we have identified this year are a rising oil price and tightening Chinese policy as the authorities aim for lower, but better quality, economic growth. Chinese policy tightening could affect commodity prices and sentiment towards emerging markets in general. South African equities have benefited from strong commodity prices over the past year, and a sell-off of South African assets would place pressure on the SARB to raise interest rates faster than currently expected.
We remain confident that the current pickup in inflation will give way, in due course, to structural disinflationary trends. Despite recent moves towards normalisation, monetary policy should remain accommodative. In combination with continued earnings growth, where our forecasts remain optimistic, this should continue to support decent returns from risk assets like equities and credit over the next 12 months. That justifies our decision to remain in the market.
In summary, we expect South African and global equity markets will continue to generate inflation-beating returns, underpinned by strong earnings. We believe interest rate hikes in SA will be less aggressive than the market is currently pricing in, and our bond market currently offers an attractive risk premium which makes it compelling compared with the returns from other emerging markets.