Adriaan Pask, Chief Investment Officer at PSG Wealth
Cycles such as seasons change and repeat themselves routinely, and are identifiable by their characteristics, for example wet and dry spells, or hot and cold. Markets, economies, businesses, interest rates and inflation are also cyclical, and to maximise your wealth creation outcomes you need to understand the changing nature of markets and the impact this has on your investments.
For example, an economic cycle depicts the swings in the economy between expansion and contraction. This is normal for any economy and is characterised by changes in important economic variables like gross domestic product (GDP), interest rates, inflation, and consumer spending. Similarly, markets go through periods of growth and contraction, slowdowns and acceleration, overvaluation (expensive markets) and undervaluation (inexpensive markets). Even investor behaviour goes through cycles of negative and positive sentiment, often defined as fear and greed respectively.
Many investors find navigating these cycles difficult
Restrictive global monetary policy, persistently high inflation and the local electricity crisis have caused increased volatility in our markets, and investor sentiment has also been poor. This is similar to what we have seen in past interest rate cycles, however, after sustained periods of successive interest rate hikes, sentiment turns negative, the economy cools down, and markets often do so as well.
However, there are three important aspects worth noting. Firstly, the slowdown is by design. Monetary policymakers increase interest rates with the deliberate aim of combating inflation by cooling the economy down, and the unfortunate consequence of this squeeze is poor sentiment.
Secondly, it is cyclical. A period of rate hikes is proven to be followed by a period of rate stability and eventual interest rate declines. This cycle has repeated itself for decades.
Finally, and perhaps most importantly, interest rate cycles are typically much shorter than investment horizons, which has important implications for investors. While a typical interest rate or business cycle is normally seven years on average, the typical investor’s investment horizon is usually multiples of this, and investors should therefore expect periods during their investment horizon where interest rates are higher than usual, times when the economy is under pressure, and seasons when sentiment is negative.
When investing over the long term, investors can thus expect to see many cycles. Some will be easy to navigate, while others will be more challenging. However, tough periods should not induce panic. Not only are they normal, but they can even be positive from an investment perspective as they create opportunities for long-term investors.
Moving forward, our data suggests a positive longer-term outlook for most financial counters – both domestically and abroad. Valuations are currently cheap (especially in the local market), and interest rates are probably peaking. When sentiment is poor, opportunities often arise.
Not all cycles are correlated – but that is a good thing
Although there are frequently periods where local and international cycles are closely aligned, there can be nuances around valuations that change the outlook. US markets have, for example, been cyclically optimistic in recent times. Earnings projections for the S&P 500 are overly optimistic in our view. However, we are keeping a close eye on these aspects as volumes, operating leverage, and margins will be tested when the effects of recent interest rate hikes start to fully affect the US economy. Analysts’ current consensus projection for S&P 500 earnings per share to reach $276 (from $196 currently) is overly optimistic in our view, especially if the US enters a recession. The optimistic view is reflected in markets already (it is in the price), and any negative surprise will be frowned upon by markets.
The period of US counters carrying lagging domestic assets is likely to end as the cycle turns. This cyclical rotation between emerging and developed markets is also nothing new. We have seen it many times before. Neither market outpaces the other indefinitely and, similar to other cycles we have looked at, these cycles create opportunities to take advantage of more attractive valuations. That said, it is worth noting that risk can also be managed more effectively by diversifying across areas.
The political and economic environment in South Africa weighs on markets
Concerns around tensions between the US and SA together with the ongoing electricity crisis continue to hinder local growth. However, South Africa’s general elections next year offer a critical opportunity to alter perceptions about our country, and solving loadshedding challenges could also provide fertile ground for improved investor sentiment. The challenge, however, is that investing in strained areas often causes investors to feel uneasy and instead they seek out the perceived certainty of winning markets. This behaviour of only investing in what is comfortable by looking at what worked previously results in what is called ‘chasing performance’. Since markets function in cycles, one can often achieve better outcomes by considering a counterintuitive approach and investing in what is struggling, a task that is much easier said than done. Media also plays an important role here as news headlines may supress opportunistic thinking, leaving investors with a sense that ‘winter will never end’.
A typical market cycle and emotions investors experience at each stage
Source: Russel Investments (2023)
Current opportunities we see in the markets
A peak in the SA interest rate cycle is expected before the end of the year, and we believe there may even be a slight interest rate cut this year, which the market has probably not yet factored into prices. Improved output from Eskom’s power plants in the coming year could not only cause a reduction in loadshedding but, with re-ratings likely in South Africa, could also favourably impact local ratings.
History has shown that bond yields decline as interest rates stabalise and decline. The same holds true for property yields and stocks in general. The risks to the upside are disproportionate, given the elevated South African yield curve. Despite being under profit pressure, listed property reaps the rewards of lower yields and higher ratings. Even if earnings are steady, a stable mood and falling interest rates should boost ratings and the positive long-term forecast for domestic and international financial counters.
Sentiment can be a barrier but is also the key to opening up investment opportunities. Given the increase in yields, cash is becoming a little more appealing, with income and preservation strategies benefiting from this increase. We do, however, caution against excessive cash holdings in investments that are aimed at long-term growth.
Cardinal rules of investing to create a lasting legacy
As discussed in the previous edition of The Wealth Perspective, investors should be cautious of making hasty investment decisions. The longer one stays invested in the markets, the more likely it is that the power of compounding will work in one’s favour. While there are risks associated with investing, planning ahead and being aware of market cycles can help prevent costly investment mistakes.
Diversifying one’s investment portfolio is equally important. Spreading investment risk across a variety of different investments helps ensure that investments will navigate market turbulence more effectively and with less stress.
We may not know exactly when cycles will turn but, as sure as seasons change, so too will favoured and unfavoured areas of the market. This highlights the importance of diversification and the difficult task of maintaining a long-term mindset during both favourable and unfavourable periods– a task best undertaken with an objective and experienced guide. Contact a trusted financial adviser to assist you in making sure that the different market cycles rather work in your portfolio’s favour, than against it.