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Nico Marais: Uncertainty is investors biggest risk. How do you manage that?

Uncertainty is a given for investors, but it seems acute in global markets at present, notably in relation to China – and of course there is a particular sovereign crisis in South Africa.

How should we be thinking about uncertainty in these times? David Williams chats to Nico Marais, head of multi asset investments and portfolio solutions at Schroders.

Well, we’re at the Absa Investment Conference at the Inanda Club on the 18th of May 2016. One of the major speakers was Dr Nico Marais, Head of Multi Asset Investments and Portfolio Solutions at Schroders. I’ve heard a bit of your talk Nico. Let’s start with the thing all investors would like to master – uncertainty. Understanding it and mastering its effects, and maybe there are two dimensions for us. There’s global uncertainty and then we have some of our own particular uncertainties within that. Big picture: how do you advise approaching uncertainty?

We do think we’re in uncertain times, no doubt but stepping back, there is no such time as certain. Every year or every quarter brings its own challenges, either in a South African or global context. In terms of managing money, at this time it’s no different. You have to think about your investments, how you allocate risk, and how you build portfolios based on the premise that you’ll always have uncertainty.

If you look very specifically at what’s creating uncertainties (that’s relevant today), it all emanates from the global financial crisis – the post-crisis intervention of Central Banks.

Basically, what they’ve done is they’ve pushed all the asset classes to record levels. That’s clearly, uncertainty to investors. What’s next? We haven’t seen the fiscal reforms. We haven’t seen the regulatory reforms. In some ways, the monetary authorities are getting to the end of what they could do.

That creates uncertainty for investors. If the Central Bank’s not there (and we’re already seeing that with the Fed starting to move the other way), what’s going to save us? What’s next? The second big uncertainty is around China. To what extent could China, in a sustainable way, reduce its growth rate? Would it be able to do it without disruption? Would it be able to address its credit bubble in a prudent manner? That creates an anxious environment.

For South African and emerging market investors, as someone very eloquently described it this morning, it’s all about governance – the governance of these economies.

We have significant challenges in South Africa, Brazil, and Malaysia and across the board, investors are nervous. In uncertain times, it’s important to remember market could deal with facts but they find it very difficult to deal with that uncertainty of an outcome.

Well, I suppose that’s where people make their money in the markets…dealing better with uncertainty than other people do. As you say, if everyone was certain about things, there’d be no competition. Everyone would know what to do. Let’s go through those three areas, which you’ve identified. The Central Bank issue / the global financial crisis: it was always fascinating to see how many experienced, educated, knowledgeable, expert people got it so wrong with that crisis. Although there were some who warned and said, “No, trouble’s coming.” As you say, the Central Bank response has pushed all these asset classes to new highs. That’s a big uncertainty looming because when their room to manoeuvre runs out, are we looking at a great asset crash because there’s nothing else to do? Is that a possibility?

You could find yourself in a position where asset classes adjust to reflect lower growth. You also have a position where we’re in an environment where we’ve never seen negative rates on bonds. We’ve never been there. Our safest asset has become our riskiest asset.

What does it mean if we see economic growth and those rates snap back? What would it do to our portfolios? Yes, there is a possibility for an adjustment in those prices. There’s uncertainty around your safest assets.

How do we treat bonds, going forward? The key point is, “How do you build portfolios that could deal with these uncertainties?” rather than being the one that tries to predict the outcome of every single one of them.

As a group, our focus is intensely on risk management rather than forecasting returns because it’s just, very hard to do. That way, by trying to protect yourself as much as possible (to many of these outcomes), you do a better service to your investor.

Read also: Drikus Combrinck: Narrative’s changed. Emerging Markets aren’t in Kansas anymore.

Could you perhaps give an example of how that approach works in practice?

The most important way to think about it in risk (we think in risk space) is we would build a portfolio and we’d think really hard what risks we’re introducing to the portfolio and trying to make sure that those risks are uncorrelated. If you have a growth risk i.e. if asset classes sell off, what’s going to protect you? What’s going to be there for you if that happens?

What’s the answer?

Well, in many cases it could be bonds. It could be Canadian bonds. It could be Australian bonds. It doesn’t have to be treasuries. You can find bonds. You can find cash. If you think, $9trn of bonds are now trading at negative yields and some of that money might return to gold. There might be different asset classes but it’s how you combine these different asset classes to give you the best protection in the case of a negative event.

It also implies, perhaps a greater understanding than there was before among investors of sovereign risk.

Absolutely.

Bonds…Government bonds are okay. In several governments, they are not anymore. Look at Argentina. There was a default. Greece… You’ve got to look much more carefully at the sovereigns, don’t you?

You have to look more carefully and I do think that in many ways, you have to move away from the simplistic definitions such as emerging markets and developed markets. You certainly want to be very careful in South Europe in terms of how you treat them.

Yes, I absolutely agree that you have to become laser-like, understanding the individual idiosyncratic nature of these instruments rather than relying on pretty old-fashioned definitions such as ‘European bonds are safe’. They are not the same and you’ve got to treat them differently. It comes back to how you build that portfolio. What would you include? What would protect you and what would disappoint you?

What about Britain and the fears over Brexit (as it’s called) referendum in just over a month from now in Britain? This has never happened before. No one knows what the effect will be. When you hear the arguments on both sides, they seem equally persuasive. Boris Johnson, the former Mayor of London…when he talks about, “We must leave”, it’s very persuasive. Most of business, finance, and investment seem to be saying it could be a bad thing.

As an investor, my focus is on what would happen if they stayed or didn’t, rather than try to add wisdom to the pros and cons.

What would the effects be on either one?

Exactly. Either way. That’s my focus. The biggest risk we have is uncertainty. If the UK Electorate were to decide to leave Europe, what does it mean? Markets hate uncertainty. It would be very, very difficult. For me, it’s a question of the sooner we get certainty (either way)…

However, I do think that if the Electorate decides to leave, there will be a prolonged period of discovery to try and understand what that means. What’s going to happen to trade arrangements? What’s going to happen to import/export arrangements and visa requirements, etcetera, which would be tough on the markets? For me, it’s a focus on the consequences rather than trying to influence the debate itself.

Read also: Why investors now obsess about politics in Emerging Markets, SA included

Now, that is what I think I was asking for. Let’s go onto China and then we’ll talk a bit about South Africa. In the interviews we do, often people raise questions about the validity of the data. It is a command economy. Its opened up to some extent but there is a feeling that not all the numbers can be trusted. There’ve also been interventions by the Chinese and I’ll never forget Christine Lagarde of the IMF saying (about a year ago), “You must understand that the Chinese are still getting used to letting prices rise and fall. They’re not used to it. They like to control things.” It’s not just the growth of the economy. It’s how they communicate about the growth and how the intervening markets, which western (if we can use that term) investors are not accustomed to it. They’re not accustomed to governments doing that. It’s quite a profound uncertainty from China.

It’s a profound uncertainty and I think we should be very careful, just putting our own judgements and experiences onto an economy, which works very differently. Many people have predicted the demise of China and that hasn’t happened, and it cost them dearly. It is a risk when you don’t have information.

Markets do not like the uncertainty of not having information and we treat China accordingly. The big challenge for China is very simple. Could they take a command economy with a massive output gap that was export-orientated and in a relatively seamless way, turn it into an economy that delivers its domestic demand.

That’s what they’re trying to do. That might happen in fits, with some uncertainty and volatility but what we have to understand is they can make decisions much quicker than in a democracy. One should never underestimate their ability to do just that. I am concerned about credit.

I am concerned about housing. I am concerned about continuing to stimulate the economy (the grade of banking in China). We handle this one very cautiously. We are actually short Asian currencies but I would be hesitant to just judge them. I do think that one should treat them very carefully, given the lack of precise data, but many have lost money on trying to permanently, better themselves.

Read also: China built debt mountain to keep growing. Now GFC, Japan-style slide looms

Let’s move on to South Africa. The Nene issue – the Finance Minister issue – in December really came out of the blue. It was one of those Black Swan type of events. It wasn’t expected although there were other things that might be expected. At the time and after that, one of the experts said ‘the Rand weakness that happened after that’… Sometimes, we’ll say, “We’re not sure what the Dollar is and what’s local”. He said, “It’s 99% political” at that period – the weakness in the currency. That was a kind of symptom of the uncertainty that we’ve had, and still have. As we speak today, there’s a sense of a civil war within the Government. Things are said, but behind the scenes, you wonder what the reality is. This is (and I use the word again) profound uncertainty in a way that we haven’t had – ever – in South Africa, even in the bad old days of Apartheid. There was still clarity on what the Government wanted to do. This kind of uncertainty is unprecedented.

There are two reasons. One would affect the Rand and one would affect policy.

It was during that particular period when it weakened our…

I think the reality (and it’s very important for all South Africans to understand) is that you’re part of a global community that will deal harshly with any behaviour that which is not consistent with governance, which is generally approved of and South Africa’s no exception. We need to hope and pray that sensibility prevails.

People say it doesn’t matter if the currency collapses. It does matter. It does matter for ordinary South Africans. Absolutely. They are the ones who are going to feel this, first and foremost. I think it’s really important that the global market looks at it in a very neutral way. If the risk is unacceptable, they move away from the risk but it would be really unfair to the ordinary South African if they can’t get their act straight.

You’ve used a simple word, which we use in corporates a lot but it’s actually the country as well – its governance.

It’s governance. It’s completely governance. I trust in governance and I trust in their ability to execute in a transparent way. You’ve seen the same playoff in Brazil. You’ve seen the same playoff in Malaysia.

Markets are global. If South Africa could achieve more transparency in governance, there’s tremendous pent-up demand for investments. If you think about baby boomers wanting yield and income, they would love South African instruments but they need to feel comfortable that they’ll be treated fairly.

Read also: African Governance stalls: 21 states deteriorated since 2011, Mauritius tops

Just to take one of the headlines from your presentation: “At a time like this, people are risk-averse or uncertainty can lead to that.” Of course, it can lead to you doing nothing, which can be as bad as doing something. One of the phrases you use here is, “Being a risk-based approach is not necessarily passive.” Let’s talk a little bit more about that.

If you allocate a new investor according to risks, those risks change and you as an investor continuously evaluate each of these risks, why do I look at them? If I take a risk, I need to get paid for that risk – as simple as that. If I feel the risk elevates to a point where it’s not worth the return, I will move away from that specific exposure.

Overweight emerging markets: we’ve slightly tilted away from it. The risk is elevating and we’ll move away. It’s not a case of passively sitting down, having exposure and risk, and never tilting to where you think you’ll be rewarded where the reward is most effective. That’s what’s meant by not being passive in our risk. It’s not a risk-parity approach.

It’s truly, thinking hard. Coming from a risk perspective is, “Am I happy with the risk? Do I think I will be rewarded for the risk rather than just lying and thinking about returns?” If you have six percent yield, what’s the risk of that six percent? Am I willing to take it? What’s the liquidity risk? What’s the political risk? Based on that type of judgment, we would shift the portfolio.

Dr Nico Marais, thank you very much for that conversation.

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