As 2018 draws to a close, we’re taking a slightly more defensive position on behalf of our clients, with capital protection underpinning many of our investment decisions. Here we explain why we’ve further reduced our exposure to equities, and what we see as the key risks to economic growth going forward.
Interest rates and bond yields continue to give cause for concern
In recent months we’ve highlighted the negative effects of rising interest rates and bond yields on equity markets. Recent market volatility has given us a taste of what that might look like, and we believe we’re on the cusp of a bigger adjustment to equity prices as investors seek less risky alternatives elsewhere. Predicting when this will happen is extremely difficult, but we’re confident we’re close enough to that point to justify our defensive position.
“We expect volatility in equities to increase as the market grapples with the implications of higher bond yields and potential inflation. That means taking a slightly more cautious position on behalf of our clients.” - Philip Smeaton, Chief Investment Officer
Global economic slowdown
This year has been all about the US growth story. When the US does well, the rest of the world is pulled along. But inflationary pressures (such as wage growth due to low unemployment) are rising, which could ultimately force the Federal Reserve to further increase interest rates – a catalyst for slowing down growth. Key indicators are already showing a global economy on the turn, and the US is by no means immune to that.
The importance of valuation
When it comes to investing in equities, attractive valuations can provide a margin of safety in case longer-term expectations for a particular company prove to be incorrect. Current valuations only make sense provided elevated earnings expectations are delivered, but with the outlook for the global economy somewhat opaque, we’re yet to be convinced that current business projections are achievable.
The Sanlam view
We think it’s prudent to position client portfolios for slower growth and further volatility in equity markets. This means increasing our focus on capital protection, while continuing to find good growth opportunities without taking undue risk.
Investment view: The importance of capital expenditure
Capital expenditure (capex) is the money a business spends to fuel growth. This might be the investment in new products or infrastructure or upgrading existing infrastructure. Such expenditure is usually met with investor approval. In the year the investment is made, it appears as an asset on the company balance sheets, with the cost then spread out over the life of the asset. Assuming it is an investment well made, it will have a positive long-term impact on company growth, as new revenue and profits more than offset the costs.
This year we’ve seen the US government hand businesses significant incentives to increase their capital expenditure. Corporation tax cuts, relatively low interest rates and an increase in fiscal spending have all had the desired effect. As you can see from the graph below, non-residential investment in the US increased by 10% last year. However, what the chart also shows is that expenditure has tailed off again.
As financial conditions become more restrictive, risks to company growth increase, as does the cost of financing it. It looks like these risks are starting to counteract the incentives, and as investment spending is one of the most volatile components of GDP, weaker investment would lead to weaker overall growth.
A word on Brexit
Last month we painted a reasonably positive picture for the UK in the face of Brexit. Manufacturing looked healthy and wage growth is on the increase, meaning consumer spending and confidence should improve.
Since then, we’ve had a tumultuous month from a political perspective, and negative media coverage has been rife. While that does nothing for consumer confidence, as investors we remain unfazed. The reality is that we invest in a globally diversified portfolio which is largely shielded from the vagaries of Brexit. We do have a small exposure to domestic UK companies, but we deem these to be solid companies with a good balance sheet.