CAPE TOWN – Those of you who have followed my articles will know that I have been an advocate of a risk-off strategy since the first quarter of last year. It does seem to me that the risk-off cycle is about to end soon and a risk-on cycle is on its way. Naturally the big question is how much of the bad news that caused the current risk-off cycle are already priced into the preferred risk-off assets.
Investors experienced three distinct periods of risk-off cycles over the past 9 years. The current risk-off cycle began in January last year and has been going for 21 months. The previous risk-off periods were 2011 to 2012 that lasted 13 months and the 2014 to 2016 risk-off period lasted for 20 months. Just on face value it means that in terms of duration compared to recent history the current risk-off cycle has run its course.
A risk-off cycle normally emanates from overvalued global stock markets, external shocks such as debt default in major economic blocks or situations like Brexit or economic wars between the major economies or outright wars. The major contributing factor is a stalling or contraction of global trade.
The asset classes preferred during a risk-off cycle are gold, consumer staple stocks and long-dated government bonds in developed markets. Least favoured assets are base metals, oil, emerging market assets and consumer discretionary stocks.
It is very difficult to anticipate when a risk-off cycle will end and a new risk-on cycle will begin. The best way is to look at how far down the line the risk-off cycle is and the way to do it is to compare how those assets which perform well during the risk-off cycles have performed in the current cycle compared to previous risk-off cycles.
Global bonds outperformed global equities over past 21 months by 13.4% as global trade weakened. During the 2011/12 risk-off cycle bonds outperformed equities by 18.4%, while bonds outperformance in the 2014/2016 risk-off cycle was 16.9%.
In the current risk-off cycle gold outperformed emerging markets by 41% over the past 21 months. It is very similar to the 37% in the 2014/2016 risk-off cycle and 31% in the 2011/2012 risk-off cycle.
Metal prices as reflected by the Economist Metal Price Index are down by 20% in the current cycle and compares to 25% in the 2014/2016 cycle and 13% in the 2011/12 cycle.
Consumer staples outperformed consumer discretionary by 11% over the past 21 months (the current risk-off cycle) and compares with a 17% outperformance during the 2011/12 risk-off cycle and 11% during the 2014/2016 risk-off cycle.
Global trade as calculated by global exports adjusted for US dollar strength/weakness was down by 7% in the first 18 months to June in the current risk-off cycle. It compares to a 20% drop in the 2014/16 risk-off cycle and 0% in the 2011/12 cycle.
It is therefore evident that outright and relative performances of assets up to now in the current risk-off cycle are close to the performances during the previous two risk-off cycles. It is therefore logical to expect that the current risk-off cycle is slowly but surely drawing to a close. That is unless a major unforeseen disaster occurs.
The messy Brexit is already on the doorstep. It has already taken its toll on the European economies as well as the UK’s. Furthermore it is evident that the elephant in the room – president Donald Trump - is eventually realising that protectionism can just go so far and that he will have to relent to ensure that the US economy, where the manufacturing PMI is already indicating a contraction in the manufacturing sector, maintain a relatively full employment situation up to next year’s election.
What does it mean for the markets? The Fed and the central banks of the other major economies are likely to become even more dovish and are probably on high alert ahead of Brexit. You can bet your bottom dollar that Sino-US relations will improve sooner than later because nobody knows what and how the actual economic and financial fallout will be.
There are two potential outcomes. If the Brexit eventually turns out to be less disruptive than currently anticipated in the financial markets and the US and China find a truce in their economic war, global trade will gain traction again. And so will risk assets. This will be the beginning of a new risk-on cycle with gold and developed market bonds the big losers and equities and specifically emerging market the main beneficiaries.
If Brexit turns out to be more messy and the tit-for-tat relations between the US and China continues, global trade will suffer more and will probably decline. Financial markets will see global investors becoming more risk averse and the risk-off cycle will continue and deepen. Huge sell-offs in the markets akin to 2008 are possible.
What about South Africa? The JSE was spot on with the market’s anticipation for real GDP growth in the second quarter of this year. The bourse’s weekly smoothed annualised growth rate indication of about a one percent quarterly smoothed annualised growth rate in real economic activity materialised. Currently the weekly smoothed annualised growth rate of the FTSE/JSE All Share Index indicates a slowdown in the smoothed annualised growth rate in real economic activity to about 0.5% in the third quarter of this year, equating to zero growth on a quarter on quarter basis.
The South African economy is likely to benefit from improved global trade but the ills of the past and specifically the lack of energy capacity will see the economy growing at far below its previous (pre-2015) potential.
South Africa will be in deep trouble if global investors become more risk averse and the risk-off cycle continue and deepen as a result of a worsening of Sino-US relations and a major Brexit fall-out.
South African equities continue to be under pressure. The FTSE/JSE All Share Index’s cyclically adjusted price-to-earnings ratio, developed by Nobel Laurette, Robert Shiller, where average earnings over the past 10 years are used, remains at the highest discount to developed market equities as measured by the MSCI World Index in US$. The JSE Financial & Industrial index’s 18% discount to global markets is at the highest since the 2008 global financial crisis.
Shrewd investors and market commentators will tell you that timing is what it is all about. From the little that I know it seems that there are a lot of South African shares trading at bargain base levels. A change in global investors’ stance from risk off to risk on can literally happen overnight. Nobody knows when it will happen but you may be left out in the cold if it happens as the covering of short positions by large global traders may see equity prices going through the roof.
Quite a few unit trusts have taken a lot of pain over the past 2 years while others held up reasonably well. Some of the weaker performers may recover little from a few shares that imploded but they will be under pressure to increase their performance by working harder – hopefully not with assuming above-average risk. Those funds that held up well during the risk-off cycle will be hard-pushed to remain at the top. Perhaps now is the time rebalance your holdings?
Ryk de Klerk is an analyst-at-large. Contact rdek@iafrica.com. His views expressed above are his own. You should consult your broker and/or investment advisor for advice.