07 Nov 2012
If investment decisions are not based on valuations or fundamentals, what is driving them at present, is the question that Duggan Matthews, investment professional at Marriot Asset Management looks at the current situation.
He says if we look at both the equity and bond markets at the moment, we see that they are both suffering from weak fundamentals and low yields, yet they are both attracting fund flows.
By contrast, the money market is seeing a net outflow of funds.
Bond and equity valuations are stretched at the moment with bonds currently yielding 6.9 percent and the Johannesburg Stock Exchange All Share Index on a 3 percent dividend yield.
“Bond yields are driven by inflationary expectations as well as the supply of bonds,” says Matthews.
He says many commentators are looking to a rise in inflation.
Bill Gross, co-chief investment officer of Pimco noted that: “An authentic debt crisis – which the world is now experiencing – can only be ultimately cured in two ways: default on it or print more money in order to inflate it away”.
The gold price, which acts as an interesting proxy for inflationary expectations, is also pointing to a hike.
As quantitative easing began in 2008/9, the gold price started rising from around $900/oz to almost $1 900/oz in 2011, before settling around $1 750 in 2012.
At the same time the supply of bonds has exploded.
“We have witnessed gross central government debt as a percentage of GDP for the advanced economies rise to the highest level in over 100 years, a trend that has been echoed in South Africa.”
On the equity front, yields are driven by dividend growth fundamentals.
The Nielson Q2 2012 Online Consumer Survey reveals that global consumer confidence is declining as the Euro zone crisis continues to deteriorate, US job growth remains weak and China’s 2012 GDP forecasts are revised downwards.
In fact, more than half (57 percent) of global respondents believe they are in recession and half of those say it will continue for another year.
Clearly, we are not experiencing an environment conducive to galloping equity or bond markets, yet investors are favouring these asset classes over others, he points out.
In the 15 months to June 2012, R44 billion flowed out of money market funds and R47 billion was added to balanced funds, which represents a significant change in investor behaviour and a greater adoption of risk.
But why would investors be prepared to up the ante? Locally, no asset classes are producing high or even average levels of income and the environment is poor so the demand cannot be driven by valuations or by the fundamentals, explains Matthews.
Marriott believes that the major driver of this trend is the exceptionally low prevailing interest rates internationally.
The local investment trend is a reflection of the international flows and South African bonds have been a beneficiary of this movement too.
With global investors hunting for yield, there has been a consequent massive flow of funds into South African bonds from foreign investors.
Over the period 1993 to 2008, the South African bond market witnessed a net R36 billion outflow of foreign capital.
In the subsequent period from 2009 to 2012, there has been a net inflow of R126 billion, he says.
However, we are concerned that, at 4.5 percent, the yield on a balanced fund comprising 60 percent equities and 40 percent bonds is at its lowest level in 40 years and well below the historic average of 7.1 percent.
Added to this, the key elements within them – bonds and equities – are fundamentally weak, notes Matthews.
Marriott urges investors to consider carefully before withdrawing assets from the money market, particularly those who require income from their investments.
By switching into a more volatile asset class, particularly at a stage when yields are low, investors may be taking on excessive capital risk.
“We would guard against assuming such risk and recommend that investors err on the side of caution.”
There are better options for those investors who require income.
High quality companies with the ability to produce reliable, growing dividends in difficult economic conditions, both locally and offshore offer a far more appetising option.
Interestingly, he says they have seen fewer investors externalising assets this year: flows into offshore equities from South Africa are down 20 percent this year compared to last year.
With a yield of 3.9 percent, higher than the average yield of 3.1 percent and the South African equity market yield of 3.0 percent, combined with good quality dividends, offshore equities present an attractive investment possibility.
Matthews says with a solid offshore dividend yield, investors would do well to maximise their offshore equity exposure.
“They should opt for equities in defensive industries, for example those supplying household necessities with solid brands.”
Some examples of global companies which have shown steady dividend growth over time, through all market conditions, include Proctor and Gamble, BAT, Kellogg, Nestle, Unilever and Johnson & Johnson. Closer to home, the types of counters which display these investment characteristics include: Mr Price, SAB, Standard Bank, Tiger Brands, Spar and Clicks, he says.
There are also creative solutions for investors seeking income.
“At Marriott, we have found a blend of high yielding investments to maximise income and minimise capital loss.
“These instruments include high yielding equities, inflation-linked bonds, preference shares, corporate debt, structured NCDs in addition to cash and fixed deposits,” says Matthews.
He notes that they have noticed a shift out of money market funds, a move which is being driven by the low interest rate environment in which all economies find themselves.
“While we understand the rationale behind this trend, it is not necessarily the best move that an investor can make as this means they are assuming higher risk.
“We would urge them to exercise caution when making investment decisions,” he adds.
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