Varying asset classes behave and perform differently during volatile times, making
the process of determining exposure of paramount importance. This requires asking some searching questions.
What is an asset worth? The basic theory has it that it’s the present value of all the future income streams that that asset is capable of producing over time. While this makes intuitive sense, of course it begs the question of why the prices of these assets seem to move around so much these days. Why are markets seemingly so volatile? Determining a future income stream is both an art and a science, as is determining the right discount rate to use in calculating what those income streams are worth in today’s money.
It’s precisely because the inputs to the equation appear to be so varied and so uncertain these days that the sense of worth also appears so volatile.
So what are these volatile inputs? On the income side of the equation the primary source of uncertainty in today’s market flows from an uncertain economic outlook both globally and locally. Uncertainty is evidenced by a lack of consumer confidence, which leads to a lack of spending and demand. Corporate revenues tend to be constrained in this type of environment and this, in turn, serves to stunt profit growth.
In the past few years profits have been supported by increasingly low interest rates (lower borrowing costs) and by the ability of corporates to drive down input costs. The big questions now are:
- How much lower can interest rates go?
- How stimulatory will these ultra- low interest rates prove in terms of incentivising people to spend money and thereby boost corporate revenues?
Can interest rates go deeply negative? Surely if they do then people will keep their cash under their beds and not in the bank? And if banks can’t attract deposits, perspective, if the expectation is that interest rates will stay low for a very long time, then does it not mean that you will be tempted to save more for your retirement, not less, because you may have to draw down on capital? This means less spending, not more.
From a cost containment perspective most of the benefits of low interest rates are now in the base and so the benefits for profit growth are becoming increasingly limited. On top of this there is evidence of decelerating productivity growth, which leads to squeezed margins.
What about the discount rate effect?
There is little doubt that low discount rates boost the present values of future income. But the bulk of this effect has already been felt. Indeed the shock absorbing capability of lowering interest rates to offset any economic shocks is becoming increasingly limited. At the same time, if interest rates started to rise in the absence of an improved economic outlook then this would certainly prove deeply unsettling to markets. There is still some concern in the market that the United States Federal Reserve may make a policy error by hiking rates prematurely, and this has added to the uncertain outlook.
How does one invest during these volatile times?
Recognising changing risk profiles is becoming increasingly important in today’s turbulent market. Different asset classes have differing relative values and their relationships with each other change from time to time. This means there will be an increased emphasis on tactical asset allocation in volatile times. Are equities cheap or expensive relative to a changing risk outlook? Is corporate debt a better value proposition than sovereign debt? Are emerging market currencies cheap? Are cyclical equities better than defensives?
Right now we are cautious. We have become somewhat more sensitive to the risks and are keeping some powder dry for opportunities as they arise. We are underweight equities and overweight cash in very broad terms. From a South African perspective we are of the view that the rand, while generally vulnerable and fragile, will have bouts of strength from deeply oversold positions. This means that even though we will tend to have a rand hedge bias within an equity portfolio over time, we may also be attracted to high yielding sovereign bonds that are likely to do well in times of rand strength.
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