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Point of View

Tread softly through the field of dreams

Charlie Parker, Head of Portfolio Management


Financial markets look set to enter 2018 in euphoric mood. Even after eight years of rising share prices many of the world’s largest financial institutions are confidently predicting double digit returns over the year ahead. This enthusiasm is underpinned by strong synchronised economic momentum, supportive new tax policy in the US and an only modestly rising cost of money.
We at Sanlam hope these optimistic voices are proved right. Indeed it is entirely plausible that economic momentum will stay strong, expectations will stay high and prices will continue to rise over 2018. But as we enter 2018 a quieter voice is also whispering in our ears; tread softly. We represent clients who care profoundly not just about capturing the full force of a bull market but also about preserving their wealth. The money we run represents the futures of thousands of clients. So we tread carefully at times of euphoria like this. As Yeats puts it ‘tread softly for you tread on my dreams’.
The challenge though for those whose inclination is towards caution and scepticism is finding any data point to support this view. For some 18 months measures of forward economic momentum and sentiment have been consistently improving. Purchasing Manager Indices now stand close to all-time highs. Yet we now have a modest 5% relative underweight to equities. So why the reticence? Why spoil the party with a note of caution?
We have three primary reasons for our position – none of which mean we are bearish, or that we have lost faith that good returns can be made in 2018. Taken together though they support caution.
Firstly, we take valuation very seriously when purchasing securities on behalf of private clients. Valuation is a poor market timing tool – shares can stay irrationally expensive or irrationally cheap for periods of time. Yet over the long-term we believe the price paid for a security has a profound long-term impact on a client’s expected returns. Our models suggest that securities bought today, at these prices, have a significantly lower prospect of strong absolute returns than a year ago.

Indeed it has rarely been the case that equities, government bonds and credit have all looked this expensive simultaneously. That creates the risk of a co-ordinated drawdown in the event of a market shock. Looking across global markets we emphasise the fact that US equities are now at the top of their ten-year range when you look at the price investors have to pay relative to the underlying company’s earnings (P/E ratio). In contrast we do see reasonable valuations in emerging markets and this – coupled with the bottom-up opportunities in evidence – is the reason we are overweight to emerging markets.
The second reason for caution is simpler. We do not believe that a great deal of money is often made in the final phase of equity bull markets, so our opportunity cost is lower from running this position. This is underpinned by our focus on the business cycle which shows the importance of capturing equity market gains during the period of rapid P/E expansion that accompanies economic recoveries. We are pleased to have achieved this for our clients.
The final reason for caution rests on our belief that the market has almost forgotten about the very real risk of an inflationary spike. Despite all this economic momentum, at the current time there is little pressure from inflation for central banks to tighten monetary policy. Yet we believe that over time growth will translate into rising wages and higher demand for goods which could put pressure on inflation, a risk that is largely ignored by markets. However, if something were to cause the market to increase inflation expectations the prices of bonds could fall as with yields so low only low inflation rates are reflected in bond prices. We have all been fighting the deflationary demon for so long that we are ill-prepared for the eventuality of a rapid switch in policy towards tackling inflation.
Taken together these factors lead us to remain well-invested in carefully-selected risk assets that retain fair valuation, but hold us back from joining the euphoria in evidence in some quarters. We believe this places our clients well to conserve their wealth whilst still capturing further market gains.

Investing involves risk and the value of investments and the income from them may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.