Positioning for the rebound – the case for active management

A number of key economic indicators are painting a rosy picture and suggest a rebound for the global economy is on track following the impact of the COVID-19 pandemic across the world. In the US, the ISM Purchasing Manager’s Indices for both the Manufacturing and Services sectors, key leading indicators of economic activity, hit 30-year highs. This reflects high optimism about the level of imminent overall US GDP recovery. Meanwhile, in China, their equivalent PMI indices have also recovered strongly and are well above their respective averages. The world’s two largest economies now experiencing synchronised growth, which bodes well for the rest of the world.

Back to the US, consumer confidence is bouncing after the hit taken in early 2020. With consumption accounting for almost 70% of US GDP, this also points to sustained economic growth. The fiscal stimulus programs have pumped money into ordinary people’s pockets. Household debt service ratios are at record lows and many households have seen their wealth grow during the COVID recession.

Many also look at the high yield bond spreads (how much extra yield a high bond offers over a government bond equivalent) for signs of confidence as these indicate investor perceptions on the health of corporate balance sheets – these are close to all-time lows. However, this could equally reflect a relative decline in confidence in US government paper.

Strong signs in the economy have caused elevated levels of expected inflation and the PMI numbers are evidence of this actually filtering through already. Global prices have been on the rise with freight rates, commodity prices and a rebound in the oil market indicating a rebound in both inflation and economic activity. Inflation has not been helped by temporary supply chain shocks such as lockdowns, the worldwide microchip shortage and the recent blockage of the Suez Canal.

In terms of asset prices, the next few weeks sees the beginning of earnings season in the United States, starting with the banks. We discussed the steepening of the US yield curve and 10-year US bond yields in my last newsletter but this should have been good for banks as they borrow short and lend long. They have indeed outperformed over the last 6 months and particularly since the discovery of new COVID vaccines and Biden’s election victory sparked the “great reflation trade” benefitting cyclical stocks, value plays and equities as a whole.

Things could scarcely be better in stock markets. In the U.S. the S&P 500 continues to surge to new highs, while the Nasdaq-100, representing the modern titans of the tech industry, has risen by some 500% since the pre-global financial crisis peak. The MSCI World is also at record highs as is our local market, the JSE.

So will global equities continue to perform so well?

Earnings season will be interesting. The actual reopening of the economy after lockdowns will likely prove more difficult than anticipated. Although vaccination programmes are proceeding well in some countries (US, China, UK, Australasia, the Far East, Israel and surprisingly Chile), in others they have barely started and do not bode well for a quick reopening (Europe, Brazil and sadly, South Africa). In the US, markets have already priced in recovery where elsewhere they have not – indicating that there could be better opportunities and less risk in areas where the recovery is yet to take hold, where asset prices remain subdued and valuations less demanding, and where surprises are likely to be more positive than potentially negative.

The vaccination program is far from over, and the same is true of the pandemic. But it is the job of markets to discount the future, and the initial recovery phase has already been priced in. That it has happened this quickly is because of the phenomenal pace of this cycle. The downturn was the fastest on record, and much the same can be said of the recovery. That scrambles perceptions, and raises the risk of mistakes. Base effects are such that you could see huge year-on-year growth numbers because economies were locked down this time last year.

Recently, the investor has been able to make good money by simply buying the market using a passive index or tracker fund. No manager needed to pick the stocks to be in because a rising tide lifts all boats and central banks, particularly the Fed in the US, offered an implicit guarantee that they would pump liquidity into the system if markets looked weak – as they did post-COVID. That was simple when yields were almost zero but not so easy when longer yields are closer to 2%.

Looking at multiples of expected earnings for the year as a whole, the S&P 500 is expensive as it has ever been, barring the very top of the dotcom boom, and a few weeks at the end of last year. Such high prospective multiples imply either an elevated confidence in continuing growth after this year, or a resolute belief that near-term earnings will be better than the consensus numbers forecasts.

This is the case not only in the US but across global equity markets. In the MSCI World index, which includes all the main developed markets, there is an even heavier bias toward extremely expensive companies than there was 21 years ago.

According to SocGen, the average stock in the MSCI World is up 20% from the end of 2019, and yet 12-month consensus forward earnings forecasts are only 3.7% higher. That implies relatively indiscriminate buying, which is what might be expected from people using passive funds to invest stimulus checks in the expectation of a big reflation. Stock valuations (price/earnings) are rising because the prices are rising but earnings are not. This could be dangerous, particularly for stocks and indices that have run hard in recent years and months.

In times like these, wherever you are investing, the message is “you need to be selective with your investments.” Investors need to let go of the idea that the stock market is one uniform entity. Such thinking implies that all shares are behaving in a similar way. They are not. A skilled manager can identify the areas of risk particularly prominent in a given environment whereas an index cannot.

It is true that you pay more for an active manager than a passive investment. History suggests that, in recent years and in some cases but by no means all, those fees have often not been justified. I would say that this was because of the type of equity market that we have seen during this period – almost zero interest rates, no inflation and the level of monetary stimulus provided by central banks ever since the Financial Crisis of 2008 which ballooned under COVID – have contributed to a scenario where all boats rise and passive worked.
The COVID crisis accelerated technological shifts which were underway beforehand and made the US “megacap” tech stocks the darlings of the market, pushing them to eye-watering valuations. These stocks now dominate most general indices and create danger for the passive investor in coming times. There are a multitude of stocks in other sectors which present as compelling but much more cheaply-priced investments cases which have less downside than the stocks dominating the indices. An active manager justifies their fees by successfully identifying those opportunities. That could be a unit trust manager or a discretionary portfolio manager.

In actual fact, we have already started to see that many active managers, particularly those with a value bias, have significantly outperformed their benchmarks in the short-term. This may continue.

While passive investing has grown in popularity over the last few years, in many cases active management may help investors improve their risk-adjusted returns.

Morgan Stanley have found that active managers can be especially helpful during periods of market stress, when outperformance can be most critical for investors.
The most favourable result may come from combining active and passive strategies Morgan Stanley also report that “generally, when the market is volatile, active managers may outperform more often than when it is not. When specific securities within the market are highly correlated or moving in unison, passive strategies may be the better way to go…. Market conditions change all the time, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments.”

This is exactly my point – now is the time to be selective, to include active managers in your portfolio and to brace for lower returns on indices going forward.

Please get in touch to discuss how to pick active managers and how to create a cost-efficient risk-optimised portfolio. +27 (0)79 551 5988 | tunin.roy@psg.co.za

 PSG Claremont | Tel: +27 (79) 551 5988 | tunin.roy@psg.co.za | psg.co.za

The opinions expressed in this document are the opinions of the writer and not necessarily those of PSG. The information in this document is provided as general information. It does not constitute financial, tax, legal or investment advice and the PSG Konsult Group of Companies does not guarantee its suitability or potential value. Since individual needs and risk profiles differ, we suggest you consult your qualified financial adviser, if needed. PSG Wealth Financial Planning (Pty) Ltd is an authorised financial services provider. FSP 728.