Inside Investec’s investment outlook

Jeremy: Global economic growth remains resilient, and company profits are strong. Yet Investec's Global Investment Strategy Group has kept its global risk score at zero on a scale of plus three to minus three. Now, that reflects a balance between the strength of the global economy and the risks posed by stretched US share prices, rising inflation, and higher bond yields.

The group brings together Investec experts from the United Kingdom, South Africa, Switzerland, and India each quarter. They assess the outlook for the next 18 months and decide how much investment risk to take and identify the threats that could affect global markets. The findings are published in the quarterly Global Investment View.

Hello and welcome. I'm Jeremy Maggs. This is another edition of No Ordinary Wednesday, an Investec Focus Radio S.A. podcast.

In this episode, we're going to explore the thinking behind the latest risk assessment. Why has this group kept its score at zero? What are the biggest risks facing investors? And why does Investec's South African Asset Allocation Committee have a slightly more positive view with a risk score of plus one?

Joining me to discuss all of this is Chris Holdsworth, Investec Investment Management's Global Chief Investment Officer and Chairman of the Global Investment Strategy Group.

Chris, a very warm welcome back to No Ordinary Wednesday.

Jeremy: Chris before we discuss the latest score, can you explain what Investec uses this risk score for, and what does the current score of zero actually mean in practice?

Chris: Hi, Jeremy. Good to hear you again. As a starting point, the output from the Global Investment Strategy Group is used to dictate our risk appetite through our entire investment business.

So, if it were to be the case that we had a risk score of, say, three at the top of a range, that would mean that we would be about 15% overweight in equities. A minus three would be 15% underweight in equities. So, a score of zero means that we are neutrally positioned from a risk perspective. We're not taking on more risk than average, we're not taking on less risk than average, and that feeds through our entire business.

Jeremy: So, zero then means taking a neutral position on risk, if I understand you. When the group met, what were the main areas of agreement, and where did the debate become more contested perhaps?

Chris: Broadly speaking, there were four areas of agreement and one area of disagreement. And if we run through those, firstly the areas of agreement. The first was around economic activity across the globe. It was broadly accepted amongst the committee members that there's a very low probability of either the US or Europe going into recession in the next 12 months, which by itself is a remarkable result. If you think of oil, where it is at the moment, at the time of recording, WTI is about 90 and Brent is at about 100, you would think that GDP growth would be slowing.

Similarly, if you think of long bond yields up at about 5% and the Fed has been hiking and we've seen hiking from central banks across the globe, you would think that growth is slowing. But if you look at the latest indicators, it suggests quite the opposite. It would appear that the US economy is going to grow at about 2% this year, maybe a bit above that, and the global economy is going to be growing at about 3%. So global GDP growth has been robust, and it looks like it's still going to be quite good for the foreseeable future.

The second point of agreement was on fuel prices. It was broadly agreed by the committee that we think that crude prices will be lower in 12 months than they are now. Clearly, oil is very volatile and it's difficult to have a forecast over a short time period. But on the basis that the Strait of Hormuz is more likely to be open than shut in 12 months' time, and that we should see traffic returning to normal, and there are some indicators suggesting that it's already returning to normal, we expect that crude prices will be lower.

It doesn't necessarily imply that fuel prices will be lower, though. Refining margins are very high across the globe, and transit costs for fuel are very high too, and that means that an interesting disconnect is open between crude prices and gasoline and petrol. And that gap may well persist, but we do expect that at least crude will be low.

The third place of agreement was on the US deficit. The deficit is very large in the US. You've got debt to GDP running at above 100%, and the deficit at the moment is quite sizable, and we expect that it will continue to be sizable for the foreseeable future. We think it is a problem for fixed income at the moment, and we think it will be a problem for fixed income. That means further upward pressure on long bond yields. They've moved up a lot. We do think at some point they become a risk for equities, but we think there is some risk of them moving further higher.

The last point where there's agreement is that we do expect that the dollar will weaken, and that's in part because of the US fiscal position. In addition to that, however, if you look at the latest high frequency data, as referred to the beginning, it does look like the US economy is growing quite rapidly, so we might have to revisit this view. If the US economy, in fact, does continue to grow at, let's say 3%, that would be an environment which would be quite helpful for the dollar. So, while it is our base case, the dollar will weaken, it is something that we're monitoring pretty closely.

Finally, where we do disagree is on the impact of AI for listed entities. There was an argument made that there would be a productivity boost, when perhaps we're already starting to see that, and that should lead to greater earnings, and that should be very helpful for listed equities.

But there's also a camp within our Global Investment Strategy Group that believes that the rollout of AI will lead to lower barriers, and that will level the playing field for corporates, and that may in fact mean more competition, which wouldn't be as good for shareholders.

So, it's an open question for us. It is something we're doing a lot of work on, and we're monitoring quite closely. Well, I'd say that was the one area of disagreement.

Jeremy: You're describing an economy that's holding up surprisingly well in spite of higher oil prices and interest rates, with company earnings also growing strongly. How much of that good news is already priced into shares?

Chris: I think that is the right question to ask, and that is in one of the reasons why we underweight the US. If, for example, you look at Q2 earnings, which were extraordinary. Q2 earnings in the US were up over 50%, yet the US equity market over the past one, three, six, and 12 months has performed roughly in line with global equities.

 I think the reason for that is that a lot is in the price. If you look at the multiple for the US market, it's trading on a forward PE of just a bit below 20, and that is pricing in a lot of good earnings growth, and it's going to take quite a lot to surprise on the upside.

So, I would say that the US, even though it's derated because of very strong earnings growth, is still quite richly priced, and that is somewhat uncomfortable.

Jeremy: One of the central tensions in the latest outlook is that higher bond yields create more attractive opportunities for investors but also make shares less appealing. Maybe you could explain why.

Chris: There's two parts to the story. For one, if we look at it from the perspective of fixed income investors, over the past 15 years, it's rarely been the case that fixed income looked attractive, certainly not in our eyes. We've had very low yields, and not enough, we thought, to generate sufficient return to compensate for any risks, like, for example, inflation risk.

Those yields have moved. You now sit with a 10-year in the US above 5%, and that's now, for the first time in a long time, offering some margin of safety, and that gives us greater comfort looking at fixed income because it will necessarily be a large part of our portfolios.

It does, however, also become a problem for equities, and the reason for that is twofold. For one, it raises the cost of capital, and a number of companies will now be at the margin where their return on capital is equal or slightly below the cost of capital, and that's typically very bad for share prices for those companies.

But more generally, you're raising the discount rate. To get a fair value estimate for equities, typically you would discount future cash flows. Those future cash flows may be higher because of faster growth or greater earnings expectations, but that's being offset by a higher discount rate. And as that discount rate goes up, it does put downward pressure on equities.

So, in summary, it's an environment that's made fixed income investing potentially a bit more comfortable than it would've been before, but it is posing a risk for equities. And at some point, given the scale of moves that we've seen for the 10-year, there is a risk that something in the global economy is going to break.

Jeremy:  All right, Chris, you remain underweight on US shares and overweight on European, Japanese, and emerging market equities. So, what's the thinking behind that positioning, and what could cause you to change your view?

Chris: There's two primary parts. The first is valuation. If you look at the US market, again, as mentioned before, forward PE of just a bit short of 20, it's looking at about a 15% premium to the 15-year median. If you look at the rest of the world, you look at emerging markets, you look at Europe, they're all trading much more closely to normal valuation, and still we're getting good earnings growth from those regions, too.

So just from a valuation perspective, we're willing to look outside of the US. But in addition, given that we expect the dollar's likely to weaken, a weaker dollar is typically associated with rest of world equities outperforming the US. Now your question is what would cause that to change? Well, if the US economy were to grow, and it looks like it will for Q3, grow at 3.5 to 4%, and if it were to do that for a couple of quarters, we would need to revisit our view.

If it grows at that sort of rate, for one, that would be associated with dollar strength, which is typically associated with US equities outperforming. But for two, if the US economy grows at that rate, it means that their debt problem is less of a problem, that they're growing out of it. And if that's the case, we would need to reconsider our concern around the US fiscal position, and that, too, would come with a reconsidering our view around US equities and US fixed income.

 So, it's the US growth numbers in a nutshell. We need to keep a very close eye on those, and those are going to be all-important over the coming six months or so.

Jeremy: Chris, the US dollar is expected to weaken over the next 18 months. Why does the dollar matter to South African investors, and what could a weaker dollar mean for global and emerging market portfolios?

Chris: There's three primary ways that it matters for South Africans. The first is the ZAR is largely determined by the dollar. So, if the dollar's going to weaken, the rand will strengthen, and that by itself is very helpful for a number of different measures in South Africa. Chief amongst them, inflation. And this is the second measure that it's important for. So, a weaker dollar would all else equal be associated with better inflation, lower inflation, and with that, lower interest rates.

So, the first point is we get a stronger rand. The second point is that we get lower interest rates, which are clearly helpful. And then the third point is a weaker dollar is normally associated with stronger commodity prices, which in turn provides a boost for the rand again, and in addition to that, will provide a boost for the SA economy, revenue for SA exporting companies, and a tax revenue benefit for the South African government.

So, it's very important for the SA economy. All else equal, a bit of dollar weakness helps a lot. Dollar strength doesn't help at all, and it's probably the most important call for the SA economy over any given time period, but particularly over the coming 12 months or so.

But first, a quick reminder to follow Investec Focus Radio SA wherever you get your podcasts or subscribe on YouTube. A new episode of No Ordinary Wednesday drops every fortnight, bringing you analysis from Investec experts on the economic and market developments affecting investors and businesses. Now let's get back to our conversation.Jeremy

Chris Holdsworth, let's continue. We've discussed strong growth on one side and higher interest rates on the other. When the group weighed those up, what ultimately kept the global risk score at zero?

Chris

In very brief summary, it was a trade-off between a faster GDP growth and earnings growth and much higher discount rates. If we felt either one of those was dominating, it would have affected the score. If we thought that higher rates more than offset faster growth, we would be negatively positioned. If we thought faster growth was more than offsetting interest rates, we'd be positively positioned. But at the moment, they're finally balanced, and we think the most appropriate positioning is neutral.All right, Annelise, back to you now. With equity valuations elevated, is fixed income now a return asset rather than just a hedge? And where do you see the best income for the risk?

Annelise: Absolutely Jeremy. As previously said, the yields at 4.7% for the next 10 years is a nice return, and in America that is, they even have some tax breaks on it, so that makes sense.

However, you will take some dollar risk. In Germany you can earn 3.2%. Even Switzerland is paying you a positive interest rate on the 10-year bonds of 0.38%.

And remember that the last 10 years you have not been able to buy a Swiss bond with a positive return. And in pounds, you can buy 4.98%. Now, the US dollar, I think we probably have a view on that, that it, in the next few years we will probably see dollar weakness just because of the fiscal position and the fact that America has to have an equity market that stays robust in order to attract dollars.

But the euro, the Swiss franc, and the pound seem fairly valued, and I think if you just take the currency combined with the yield that you earn in these countries, you can get good diversification by having a nice suite of bonds in your portfolio, and that can actually give you guaranteed income for the next 10 years at these levels.

Jeremy: But which argument could, I wonder, tip that balance? And does the AI debate that you mentioned a little earlier hold the biggest potential surprise?

Chris: There's probably some upside. If the AI story pans out in leading to faster earnings growth, faster US growth with that stronger dollar, and we land up with much greater equity returns, that would mean that we were wrong, and that is something that we need to keep a very close eye on.

As I said, it is an active debate within the committee. We're not yet settled on that view, but that is a place of keen attention for us.

Jeremy: Chris, I want to bring us home to South Africa now. The local committee is still overweight equities but has cut its risk score from one and a half to plus one. What made it a little more cautious?

Chris: Primarily, it was the inflation outlook. We see inflation getting to over 5% by year-end and then drifting up a little bit at the beginning of next year too. It's difficult to see how the SARB does anything but hike in that environment, and we expect that that would put downward pressure on SA consumption expenditure, and there's more reason for caution with regards to the outlook than there was three months ago.

Jeremy: Chris, you've mentioned the pressure higher inflation and interest rates could put on consumers. All well and good. The committee has also moved the interest rate-sensitive exposures from double weight to neutral. So, explain to us what that means for portfolios and how much is also being driven by changing spending habits.

Chris: What does it mean? It means that throughout our portfolios, we've been reducing our exposure to SA discretionary consumer spend. We've had an increased preference for defensive counters within that space, and also, we've been shifting away into other sectors in the listed equity space. For example, our global consumer plays or global commodity price plays.

There are two primary reasons. The first is that we have noted a shift in spending priorities for South African consumers. Gambling, as an example, is now up to about 2% of discretionary income, up from just below 1% pre-COVID. That's a sizable shift. In addition, as mentioned, we think that the SARB is likely to hike. So, we'll see downward pressure on discretionary spend in SA from two different channels. And for that, it means that we think that there's reason to rein in the call a bit on SA Inc., so we become more defensively positioned than we were before.

Jeremy: Chris, why do local equities then still look attractive overall while the committee remains neutral on bonds?

Chris: SA bonds have done very well. The structural reform programme that we've seen so far over the past couple of years has been very successful. We can see the lights are now on continuously, as an example. We've seen some improvements in the ports and the railways too. A lot of that has been reflected in an improvement in our bond yields, and that's also come about in part because the inflation target has been shifted down by the SARB, and there's now expectations of South African government debt being upgraded.

 All of that has now led to our bond yields trading much closer to developed market peers than they have at any point in the past five or so years. So, there's been a massive revaluation in South African fixed income, and now we think it's gotten to the point that it's around fair value.

South African equities, in contrast, we think are still very cheap. We mentioned that the US equity market trades on a forward PE at just a bit below 20. The South African stock market trades on a forward PE of around 10, with still strong earnings growth we see here.

So, there are some issues, and we mentioned some of them with regards to SA Inc. But nonetheless, there are some bright lights too in the SA economy. For example, you look at tourism. Tourism, the numbers are very good. The number of tourists coming through from overseas are up just between 5 and 7% year on year. You look at construction; there are signs that construction is ramping up too.

So, there are signs of growth, and we think given how cheap our market is, plus the diversified nature of our market, the fact you get commodity exposure and global consumer names too, there's still ample reason to be overweight South African equities in aggregate.

Jeremy: And finally, as we wrap up this conversation, you've pointed to both opportunities and reasons for caution. Before the next meeting then, what is the biggest risk you'll be watching out for, and what would give the global and South African committees confidence to take more risk?

Chris: The primary risk we'll be watching out for is the knock-on consequences of much higher yields. History has shown that environments like this, when you see a move as rapid as this, that somewhere something is coming under pressure, and we haven't yet seen what that is. And that's a reason just to sit on the sidelines a bit and be cautiously positioned for now.

But we're probably not too far away, six to eight months, from inflation starting to drift down. We do think it heads up globally up until about April next year, but then it starts to head down. And that should come with it central banks being less keen to hike and maybe even a couple of months after quite keen to cut, and that should provide some form of opportunity.

And with regards to the outlook for South Africa, we're waiting for inflation to turn, and we think that again comes around about April next year because that takes the pressure off the SARB. So, in terms of risks, an iceberg is probably rates related. In terms of opportunities, probably rates related too, but a little bit further out.