Caution needed during this “risk-on” party

The party continues into 2015

The first quarter of 2015 was once again dominated by strong returns in the equity markets, both locally and globally. Locally the FTSE/JSE All Share Index delivered stellar returns of 5.9%, while the MSCI World Index returned 2.3% in US dollars.

For the past few years, local and global equities have had a substantial run, creating good wealth for investors. It is therefore not surprising that investor sentiment has become a lot more bullish since 2008, as indicated by the SA Volatility Index (see chart below).

Little fear among investors

The relatively low levels of the SA Volatility Index (SAVI) suggest that investors have been continually forecasting low equity market risk, implying a general preference for this higher yielding asset class and a ‘risk-on’ market sentiment. Historically, persistently low levels of forecasted equity market risk have been a good indication of possible market corrections. That indicates that, when market sentiment reflects perfect equity market conditions only, with no indication of capital loss possibilities, investors should rather practise caution and opt for capital protection.

This is clearly visible over multiple years associated with equity market downturns, including 1997 leading to 1998 and most recently 2007 to 2008, when the SAVI suddenly moved from levels just above current levels (19) to levels above 40, while equity markets depreciated by more than 35% over the same period.

Foreign investors have also shown an appetite for emerging markets over the past few years, with South Africa being a good destination. This has once again been the case over Q1 2015, with foreign flows to SA equities exceeding R10 billion for the quarter.

This ’risk-on’ trade has been fuelled by a weakening rand and very accommodative monetary policies, globally and more specifically within the Eurozone, where quantitative easing has helped the competitiveness of some of Europe’s key countries.

When the clock strikes 12!

The question, however, is whether the clock is about to strike 12 for the ‘risk-on’ party that we’ve all enjoyed over the last few years.

At the last US FOMC meeting, the Reserve Bank governor, Janet Yellen, indicated that over the short term, rates will remain on hold, but that a hike in the medium term (as close as June) could not be ruled out.

The recent GDP report out of China suggests that the Chinese economy has grown at the slowest pace since 2009.

Locally we have seen power outages, a drop in business confidence and commodity prices remaining depressed, which doesn’t bode well for the SA economy.

When looking at current SA equity valuations, we see that on a price-to-earnings basis, the local equity market is currently trading at a PE of 17.5 – well above its long-term mean of 12.1. Based purely on valuation, the SIM House View remains underweight SA equities.

In addition we’ve already seen an increase in volatility within equity returns, with four of the last 12 months’ performance being negative and a 9% swing from peak to trough over a two-month basis.

Time to curb the optimism

Taking all factors into account, investors should be cautious with regard to short-term returns and volatility within equity markets. Given that valuations are currently stretched if any of the above factors (business confidence, a substantial increase in power outages and US rate hikes quicker than expected, to mention a few) or any other exogenous factor spooks the market, the ‘risk-on’ trade locally and globally could easily reverse to ‘risk-off’, which will be led by an exodus to quality shares by foreign investors and could potentially lead to sharp drawdowns in equity markets.

Tactically, a lower allocation to equities would be a prudent decision right now, but this should still be viewed in the context of one’s investment objective or goal. It is our view that over a three to five-year period, real returns are definitely achievable through equities, but given current risks to the ’risk-on’ party, exercising caution around your longer-term investment strategy would be a wise decision.

Adapted from an article by Shaun Ruiters – Sanlam