Over the four years since the COVID-19 pandemic, the world has had to contend with the biggest-ever rotation in spending between goods and services. This rotation – coupled with record levels of government stimulus – led to some of the tried-and-tested economic measures that analysts usually rely on, becoming unreliable.
Earnings growth expectations and entry point valuations are critical factors for forecasting prospective equity market returns – and hence for determining a portfolio’s optimal exposure to equities. But valuation does not exist in isolation and portfolio managers must consider it alongside metrics such as inflation and interest rates.
Initially, a significant increase in inflation in the years following the COVID-19 pandemic heightened expectations of a US-led global recession. Over this time Developing Market (DM) inflation as well as interest rates rose at the fastest pace in 40 years. Despite that, the US side-stepped recession thanks to record levels of fiscal stimulus and the aforementioned rotation in spending.
The more debt-funded stimulus the US and other DM countries deployed, the better the outcomes were for their economies on a per capita GDP basis. The great stimulus spanning 2020-2023 assisted in preventing things from turning out too nasty in the US. The record flows of cash into businesses and households distorted the economic signals that typically predict a recession, causing deviations from the normal experience.
Manufacturing-heavy economies such as Germany and Japan struggled more in the latter half of the period spanning the COVID-19 pandemic until December 2024, as these economies did not get as much support from the services sector as the US did. The larger US shift to services and bigger economic impact it had contributed to the outperformance of US equity markets, and on top of that the so-called Magnificent Seven technology stocks drove the S&P500 index to record levels in 2023 and 2024.
The GDP growth, equity market earnings growth, and DM equity market returns which we experienced in our view were driven by spending rotation from goods to services – with the US benefitting more, and the manufacturing-heavy economies generally lagging. A look at current consensus forecasts for DM GDP, suggests that investors can expect more of the same through 2025. Not only are US GDP forecasts for 2025 higher than those of other DMs but also continue to be upgraded, whereas GDP forecasts elsewhere continue to be downgraded.
The US upgrades may be warranted since the economy is benefitting from a recovery in investment spending and a relaxation of private credit extension standards. The question is whether estimates for much of Europe and Japan, which are still being downgraded, are not perhaps too pessimistic. Consumer spending in these economies has not been as strong as in the US, but household savings rates are well above long-term historical levels and real labour compensation is rising rapidly due to inflation that has slowed while labour markets are still tight and unemployment low.
Europeans have a lot to worry about, given geopolitical uncertainty, wars, deteriorating trade and cooperation agreements with the US, refugee problems, etc. But any development that leads to a slight improvement in sentiment could be a catalyst to unlocking a bit more consumer spending, which could result in positive surprises in both GDP and equity earnings growth.
In light of the inflationary impact of key US labour market statistics and US President Donald Trump’s protectionist policies, we can see why the US Federal Reserve is struggling to coax inflation back to its desired 2% level. As long as inflation stays above the 2-2.5% range we can expect the Fed Funds rate to remain around 4%, offering better cash returns than in the recent past; But that would generally put slightly upward pressure on global bond yields. And if fears about inflation had to grow stronger, there would be more risk to the upside for US and global bonds.
Over the second half of 2024, the Sanlam Investments Management Balanced fund had slightly heavier exposures to SA bonds and foreign equities than what its larger peers had on average, which was offset by lighter positions in foreign bonds and local cash. SA nominal bonds contributed most to the fund’s second-half 2024 performance of 8%, thanks to a decent exposure and an 11% return from the asset class. The second biggest contribution was from foreign equities, which returned 7%. The best-returning asset class was SA-listed property, though the fund’s exposure to the class was a modest 3%.
The fund’s half-year return validated our decision to retain exposure to SA bonds, which meaningfully contributed to returns over the period. Deciding on a construct for foreign equity exposure, was more challenging though. Although we seek to achieve consistent offshore equity returns over time, the impact of the Magnificent Seven on global equity indices, as well as the high correlation that certain growth assets currently have with global bonds, remain difficult to forecast.
Both our decisions earlier in the year to reduce our exposure to interest-rate-sensitive sectors such as real assets and to cover the unintended underweight in the Magnificent Seven that any such exposure would cause were also validated during the quarter. But despite this, the remaining exposure to real assets continued to cause a drag on performance during the quarter, relative to what pure index performance could have delivered. That exposure is however exceptionally well-priced and once the correlation with global bonds fades, we expect the investment to produce solid returns.
We remain cautious about offshore equity exposures, especially to US equity markets. Forward earnings forecasts are positive and quite strong, reducing the likelihood of a big derating in the S&P500, or in global equities generally. But expected earnings growth must materialise (and for more than just a year) to justify the current valuation multiples. If strong expected earnings growth materialised and then reduced back to trend growth levels thereafter, markets should naturally de-rate somewhat. As this happens, equity returns are unlikely to emulate the 20%-plus achieved in 2023 and 2024. Consequently, we think foreign equities are likely to deliver somewhat below-trend returns in the foreseeable future.
For 2025, the Sanlam Investments Management Balanced fund has tweaked its asset allocation to manage risk associated with the uncertainty and volatility evident in the global economy and major financial markets. We are now slightly below 30% exposure to foreign equities; whereas in the long-term this level will probably be in the 40-45% range, closer to the maximum that Regulation 28 permits. This somewhat underweight position is offset by a slighter higher exposure to local equities, at 38%.
SA bonds remain attractive, with expected returns comparable to that of equities, with Inflation Linked Bonds (ILB) equally attractive and capable of outperforming nominal bonds in a rising yield environment caused by higher inflation. However, rising local bond yields caused by debt concerns and/or ongoing budget deficits could see ILB yields rise together with nominal bond yields, in which case ILBs will under-perform nominal bonds due to a higher modified duration. We have therefore only partially reduced our nominal bond exposure to around 16% of the fund, with that exposure channelled to Inflation Linked Bonds (ILBs).
* White is a balanced funds portfolio manager in Sanlam Investments’ active management business.
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