Scenario modelling has formed part of Citadel’s investment philosophy for two decades. It enables us to better understand potential market outcomes and construct stronger portfolios. The Asset Management team has a three-year, core or “High Conviction” scenario view, which is expressed as macro and market assumptions. These assumptions include economic growth, inflation, interest rates, price-earnings (PE) multiples, and credit spreads amongst others. Our asset valuation models produce expected returns for various asset classes, based on these expectations. This section is used to summarise our High Conviction view and the resulting asset signals.
The global economy is expected to remain strong, growing above capacity, in 2022 and slowing towards capacity growth thereafter. Inflation is to remain well above central bank targets during 2022 but assumed to moderate thereafter. The economic environment is healthy, unemployment has fallen sharply, and inflation is at 40-year highs in the United States (US) – we assume there will be rate hikes by the US Federal Reserve this year, with gradual increases thereafter. Developed market 10-year bond yields are assumed to rise from current deeply negative real-yield levels to be in line with inflation three years from now – that is zero percent real yields.
Overall, this is still an accommodative macro environment for equities when viewed over three years and global equity expected returns are neutral and therefore attractive relative to fixed income. Earnings rebounded sharply in 2021 leaving market valuations (trailing PEs) much closer to our assumed exit or fair value PE assumptions in most regions. Earnings are projected to continue to grow at a healthy pace, underpinned by real economic growth. The investment horizon is crucial, as quantitative tightening and interest rate hikes are likely to cause volatility across all markets in the near-term.
The South African economy is assumed to grow at capacity over the next three years. Johannesburg Stock Exchange (JSE) earnings are now well above trend and little further growth is projected over the next three years. From a valuation perspective, the JSE stands out as very attractive. Inflation is assumed to remain stable, and interest rates are expected to rise gradually over the next three years. We assume a very steep yield curve, and high real long-term bond yields in recognition of local fiscal and structural challenges.
From a medium-term valuation perspective, and under our High Conviction scenario, South African equity has an above-neutral expected return outlook, while developed and emerging market equity is at neutral. Domestic bonds are above neutral, while US and global fixed income remain below neutral. SA and US cash are also currently giving below neutral valuation signals. The overall (medium-term) signal is therefore overweight equities and SA bonds and underweight cash and US fixed income. See the table below for a summary of our Asset Class Valuation Signals.