NDINAVHUSHAVHELO RABALI: Asset allocation requires a clear understanding of uncertainty

Investment asset allocation is a critical consideration for investors and is challenging to execute. Despite the strong market recovery, partly a result of the rollout of the Covid-19 vaccines, uncertainty remains about the direction of the economy and hence of financial markets as we come out of the fifth global recession since 1950.

Several scenarios can play out. The economy could continue on a steady recovery, with financial markets showing strong and stable returns. The recovery could falter and, like Japan, a period of falling inflation ensues. Alternatively, measures to stimulate the economy could result in higher inflation that continues as an extended period of stagflation. Uncertainty heightens around February each year during the state of the nation address and the budget speech, with millions of experts on fiscal policy emerging. Investors are asking: will SA sustain its expected recovery beyond 2021? Should investors allocate assets away from SA?

Global asset allocation adds value when there are differing levels of uncertainty among national economies and their financial markets. How do we make investments under uncertainty?

We need to understand what uncertainty means. Though investors dislike both uncertainty and risk, they are different. Frank Knight’s masterpiece Risk, Uncertainty and Profit and John Maynard Keynes’s The General Theory of Employment, Interest and Money were the first to focus on uncertainty being radically different from risk. Risk is measurable, and uncertainty is not. The Ellsberg paradox best illustrates this. Given two investment decisions — a 60% probability of losing money and an unknown probability of making money — investors almost always prefer the first choice.

There is a measurable chance of losing. Though investors are risk averse, they avoid uncertainty even more. This leads to an incorrect approach to dealing with uncertainty, such as assigning  probabilities to events with no scientific basis.

Additionally, in high uncertainty periods, investors overreact to past returns, leading to a buy high, sell low phenomenon. We saw this recently, selling out of equities or allocating more assets offshore when the rand was flirting with the R20/$ level after the coronavirus-induced financial market crash in March last year. Sometimes, despite our best research efforts, we must accept that we do not know. A scenario will not become more probable because we think it so.

Precious metals 

It is true that after the event, even a fool is wise. Still, we can learn from a disciplined study of history and the world’s economic affairs. For example, five years ago the precious metal industry was deemed uninvestable due to challenges in productivity, declining grades and rising costs as mines became deeper. There was a hostile labour force, double-digit inflation on utilities and government policies deemed unfriendly to investors. Stocks exposed to so much uncertainty tend to suffer more significant adverse return shocks during bad market states. Investors avoid these stocks during panic states, resulting in depressed valuations — such was the case for precious metal stocks.

In contrast, five years later, precious metal companies are reporting record profits and positive free cash flow. Some share prices have increased by a multiple of seven times over the past five years. The drive for a cleaner environment has created an enormous demand for precious metals. The resultant supply-demand market imbalance has led to some of these precious metal prices increasing by a multiple of more than three times. As panic eases, volatility falls, the market rebounds and investors buy back high uncertainty stocks. Consequently, the values of high uncertainty stocks rise sharply — this is true today for precious metal companies.

Lessons to be learnt

From investors’ behaviour towards the precious metals industry during periods of uncertainty, we learn that we should always consider that there is still a possibility of a silver lining.

Similarly, SA finds itself in a difficult position. The uneven distribution of vaccines across the world could still make the mutating virus challenging to contain. The weak fiscal position and elevated debt levels could constrain long-term economic growth. The impact of the recession may lead to unemployment levels that remain stubbornly high. But as the IMF pointed out in its recent World Economic Outlook, there is potentially some upside risk.

Favourable news on the vaccine could increase expectations of a faster end to the pandemic, boosting business and household confidence, leading to stronger consumption, investment and employment recoveries. Additionally, more fiscal policy support with favourable spillover effects for trading partners would further lift global activity. In a nutshell, SA may prove to be a fruitful investment destination despite its dire state and challenges. The world of probabilities only exists on paper, and no judgment or scenario that we or anyone else creates will influence the result.

The big question, phrased differently: should investors allocate more of their funds to SA assets? We believe strongly that investment decisions with high uncertainty (for example, currency) should not dominate a portfolio’s risk. Successful investment management is as much about discipline as it is skill. By all means, be negative or positive, SA, but do not put your mortgage on it!

• Ndinavhushavhelo Rabali is the chief investment officer at Lima Mbeu Investment Managers.