SIMON FILLMORE: US equity markets sell-off provides offshore opportunities

Markets are under pressure, mainly because the US Federal Reserve has hiked interest rates faster than expected to curb runaway inflation pushing the US economy towards recession.

The Fed made a mistake by staying too low for too long, and now it is making the mistake of going too hard too fast.

Higher interest rates and the Fed’s aggressive monetary tapering have led to  assets repricing. The stock market is nothing but a discounting machine, and the value of cash flows discounted back at a higher rate translates into lower valuations. Cheaper valuations now offer tactical investment opportunities for offshore investors.

There are several reasons offshore investments remain a sound diversification strategy, notwithstanding the volatility and uncertainty prevailing this year. One of these is the recent changes to SA Reserve Bank regulations, which now allow retirement funds to invest up to 45% offshore.

The best-performing global asset class for the year to date has been dollar cash, which usually is not the case with high inflation, but the dollar has reigned supreme this year as investors sought safety in the world’s reserve currency and taken advantage of significant increase in US interest rates, especially relative to other developed markets.

Bond yields have risen substantially this year, to the point where bond investors experienced bear market returns because when yields rise bond prices fall. With the MSCI World index falling 27% and the S&P 500 down 25% year to date, equity investors are deeply embedded in a bear market.

Investors generally remain pessimistic about the market. The latest retail and institutional investment surveys indicate that investor sentiment is extremely negative. Historically, however, these surveys have proved to be contrarian indicators. So when these investment surveys reach such low levels the subsequent returns are extremely rewarding. Savvy investors are taking advantage of market moves by looking to the US market for tactical investment opportunities.

The value of currencies can significantly affect investment returns, and asset manager views vary on the rand outlook. We believe the rand’s volatility shouldn’t be why investors defer investing offshore. It is impossible to time the market correctly, and one should invest for the long-term. That means investors should not necessarily wait for a strong rand to take advantage of offshore investment opportunities.

The long-term trend of the rand is glaringly obvious. Besides the Chinese-inspired commodity boom of the early 2000s, the rand has generally weakened. Foreign investors have been net sellers of SA equities for eight years. Unless there is a radical change in management style from the governing party (a low/negligible probability) or the hydrogen economy results in excessive demand for SA natural resources, the rand is highly likely to maintain its long-term trajectory.

We see value in risk assets for the next six to 12 months, and believe equities will provide capital growth for investment portfolios. Inflation has surprised investors on the upside, and in our view will probably surprise them on the downside too. US housing prices, a lagging indicator, are near record highs, but US mortgage rates are at 20-year highs. Clearly something has to give. We believe housing prices will come off the boil over the next year, significantly alleviating inflationary pressure. This will catalyse the Fed to become less hawkish and be positive for risk assets.

Lower inflation will be positive for bonds as yields fall. Equities will benefit too. We see greater value in equities and believe it is the asset class of choice, depending on specific clients’ risk profiles. Particular sectors in equities that we think will add value to investment portfolios in future are mega-cap shares in technology due to the strength of their balance sheets, which are under no stress now, generate positive cash flows and are highly profitable. Most importantly, many of them are trading at reasonable valuation levels.

Software as a service companies were the poster boy for the major technology rally we saw over the past few years. The inflationary environment has increased the cost of capital, contracted margins and put pressure on balance sheets of many companies. But we see significant value in mega-cap stocks such as Microsoft and Adobe. Microsoft has been resilient through the stock market sell-off. In the fintech sector, we see great entry points in Mastercard/Visa and PayPal, and expect them to generate capital growth for investment portfolios.

Another way of diversifying risk while generating returns may be through incorporating alternative investment strategies. Market-neutral hedge funds can be a valuable addition to one’s investment portfolio, smoothing out investment returns in periods of high volatility.

Geographically, we believe the US and Asia offer better returns than Europe, with its many structural problems and considerable sovereign debt. Europe’s population growth is slow and ageing. Younger generations consume and spend more, contributing to faster economic growth.

China is optically extremely cheap, but has a higher risk profile. Issues such as its zero Covid policy, the technology company crackdown, US Securities & Exchange Commission (SEC) audit concern and Taiwan have weighed heavily on investor sentiment. But zero Covid policy cannot run indefinitely, and the regulatory crackdown appears to have run its course.

The first team from the SEC is conducting audits in Hong Kong, and if this is successful it will remove concern about delisting of Chinese American Depositary Receipts on US stock exchanges. Access to global markets has uplifted Chinese per capita GDP exponentially over the past four decades, and has been one of the major factors behind their renaissance. We don’t believe it is the intention of the Chinese Communist Party to stop the long-term trajectory despite their many recent own goals.

From an emerging market perspective, SA equities are cheap, with a price-earnings ratio below 10. The PE ratio tells investors how a company is valued, and the SA long-term average is 15, so a lower PE ratio is considered cheaper.

Another global sector that offers value is the energy sector, specifically oil. Even before the Ukrainian crisis we had identified that oil companies had significantly reduced their capex over the past decade, and concluded that markets were overestimating long-term global oil supplies. The Ukrainian crisis has worsened this problem. With less supply we foresee sustained high oil prices, and investors can take advantage of these by adding energy exchange traded funds to an investment portfolio.

• Fillmore is CEO of Independent Securities.