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Citation - Third Quarter 2022



Investment Strategist and Portfolio Manager
Estimated reading time: 2 minutes 43 seconds read

Scenario modelling has formed part of Citadel’s investment philosophy for two decades, and it enables us to better understand potential market outcomes and construct stronger portfolios. The Citadel Asset Management team has a core, or “High Conviction” scenario based on a three-year view, which is expressed as macro-economic and market assumptions, including economic growth, inflation, interest rates, price-earnings (PE) multiples, and credit spreads, to list a few. Based on these assumptions, our asset valuation models produce expected returns for various asset classes. This section is used to summarise our High Conviction view and the resulting asset signals.

Major central banks have indicated that they will do what it takes to bring inflation back under control and are rapidly hiking interest rates into restrictive territory. Global economic growth has already started slowing to below capacity, but the extent of the downturn remains highly uncertain. With seemingly structural higher inflation present, and year-on-year inflation rates still far above targets, it is unlikely central banks will “pivot” (which means turning from tightening back to easing monetary conditions) easily. Inflation is arguably one of the most lagging economic indicators, and with central banks indicating they will be “data dependent”, there is a high probability that they will make a policy mistake and overtighten. We continue to highlight the need to consider a range of potential economic outcomes, with multiple scenarios feeding into our asset allocation process.

Our “High Conviction” scenario assumes that global economic growth will be below capacity for the next two years, before recovering. Inflation is assumed to lower towards target as base effects, higher interest rates and slower economic growth take effect. United States (US) interest rates are assumed to continue rising in the near-term but will then come down again within our three-year horizon. US bonds have sold off sharply and yields are above our fair value assumption. Below capacity economic growth translates into low company earnings growth over the next three years and our company earnings projections are more conservative than current consensus numbers, which have remained strong. After a sharp selloff year-to-date, equity valuations (trailing price-earnings ratios) are more attractive and below our fair value assumptions in all regions.

The South African (SA) economy is assumed to grow slightly below capacity. Johannesburg Stock Exchange (JSE)-listed companies’ earnings are well above trend and little further growth is projected over the next three years. However, the JSE is attractive from a valuation perspective. Local interest rates are assumed to continue rising in response to the global tightening cycle and current local inflationary pressures. Looking at SA bonds, we assume a very steep yield curve, and high, real long-term yields in recognition of South Africa’s fiscal and structural challenges.

The investment horizon is crucial. Reduced liquidity and increased recession risk are likely to continue, causing weakness and volatility across markets in the near-term. On a three-year outlook, and with conservative assumptions, expected returns on global equity are rated neutral. Signals vary amongst regions, with South Africa and emerging market equities providing a stronger signal than developed markets. South African and US dollar fixed income assets are more attractive after sharp selloffs. See the table below for a summary of our Asset Class Valuation Signals.

Source: Citadel. The outlook shown reflects the signals from Citadel Asset Management’s asset valuation models and is based on each asset class’s three to five year expected return. The model’s expected return is compared to what investors historically expected from these asset classes. As example a Neutral Outlook will be roughly 1% real return for Cash, 3% for Bonds, 4% for Gold and 6% for Equity and Property. Noted that no currency views are taken and currencies are assumed to change in line with inflation differentials for modelling purposes.