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Yield curve inversion.

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The concept of BEE and why it should be struck down.

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Global Report

By Nick Downing

The bond market tends to be a more reliable barometer of financial market conditions than the equity market. Savvy equity investors look to the bond market for clues. One of the most reliable clues historically is the one given when the yield curve inverts, which typically signals recession. The yield curve charts the different interest rates across the spectrum of Treasury bond maturities. When the curve inverts, long-dated interest rates drop below short-dated interest rates. Financial markets are currently anxious as the 2-10 year curve is teetering on the edge of inversion and as a result some observers are predicting the US economy will fall into recession next year. There is normally a lag time of around 12 months.

Other analysts are more optimistic. Yield curve signals are not completely reliable. As the saying goes, yield curve inversion has predicted 12 of the last 10 recessions. Perhaps the 2-10 year curve is less reliable that the 1-10 year curve, which is not as close to inverting. The curve which plots the fed funds rate compared with the 10-year yield is even further from inverting. The fed funds rate is 0.25-0.50% while the 10-year bond yields 2.68%, and so on this measure, a recession is still a long way off.

Recessions usually only occur once profit margins have dropped to levels which stop companies from investing and hiring. US profit margins have slipped a little but remain close to record highs. Amid robust demand, strong pricing power and depleted inventories, companies are unlikely to slow their hiring and investment plans. They are flush with cash after the deleveraging of the 2010s. By these measures, this does not look like a looming recession.

Moreover, the bond market may be sending out false signals. The Fed has just completed its most aggressive quantitative easing programme of all time, dwarfing the asset purchase programmes that followed the 2008/09 Global Financial Crisis. The Fed now owns 30% of all outstanding Treasury debt. The Fed’s purchases of US Treasury bonds have been concentrated at the long end of the maturity spectrum, the end which is in danger of inverting. Studies show that in the absence of the Fed’s QE purchases, the 2-10 year yield gap would be 100 basis points wider and therefore nowhere close to inversion. The skewing of the bond market is not unique to the US. The ECB owns an even greater proportion of euro area sovereign bonds, at 40%, and central banks in the UK, Canada and Australia are also around the 30% mark.

The debate continues. One concedes that consumers and businesses are flush with cash but what if they decide to sit on their hands rather than spend it? Admittedly, the unemployment rate is close to historic lows and jobs growth is very strong, but employment has always been a lagging indicator. The conclusion, whether one is predicting a recession or not, is that inflation has created a headache for the Fed. The Fed cannot fight inflation without incurring a cost, and that cost usually involves the loss of jobs and income, and ultimately lower equity markets. A slowdown which successfully lowers inflation while at the same time averting recession is called a soft landing.

Even if a recession does ensue, it takes time for recessions to take hold. It is recessions that cause equity markets to drop, not rising interest rates and so the equity market may still have many months, even a year or two before correcting. The precedent that most closely mirrors the current situation is 1978, when the nominal yield curve inverted but at the same time the real interest rate curve (after taking inflation into account) was still sharply positive. The same is true today. The nominal 2-year yield is 2.5% but in real terms after subtracting the current inflation rate of 7.9%, is deeply negative. So, what happened in 1978? Interest rates went up sharply but not enough to cause a recession, probably because the real interest rates still remained deeply negative, as would be the case today even if the Fed hikes the fed funds rate to 2.5%, as projected. However, two years later in 1980 inflation spiked to nearly 15%. The rest is history, Fed Chairman Paul Volcker hiked the fed funds rate to 20% in June 1981.

The US economy is unlikely to enter recession anytime soon but the current Fed Chairman, Jay Powell will be keen to avoid a repeat of 1980 inflation. The Fed’s toolkit includes Interest rate hikes and a reversal of QE. The projected scale of Quantitative Tightening (QT) at a pace of $1 trillion per year is unprecedented. QT may create some stock market volatility even if there is no recession on the horizon.

US consumer price inflation accelerated again in February, from 7.5% to 7.9% year-on-year, its highest since January 1982 when it registered 8.4%. Oil and energy prices were the main culprit. Gasoline prices gained 6.6% on the month but the data was collected before Russia’s invasion of Ukraine. Gasoline prices are expected to rise by a further 20% in March. Core CPI, excluding food and energy prices, also accelerated, indicating a much-feared broadening in inflationary pressure. Core CPI accelerated on the year from 6% to 6.4%, although the month-on-month increase in core CPI slowed to 0.4%, down from 1% in January and 1.2% in December. This may offer some comfort, but the inflation outlook is clouded by the Ukraine crisis.

The Russia/ Ukraine crisis has created a significant supply shock in commodity markets, including oil, gas, wheat and metals. Russia is the world’s second largest exporter of oil and wheat. Ukraine is the fifth largest exporter of wheat. The invasion sent the oil price to $139 per barrel, a 64% increase since the start of the year. On 7th March, the wheat price recorded a peak of $12.94 per bushel, marking a 70% year-to-date increase. Gains in European natural gas prices are even more extraordinary.

Fortunately, the inflationary pass-through from higher food and energy prices is less today than it was in the past due to rising living standards and better energy efficiency. According to research from TS Lombard, cars were getting about 13.5 miles/gallon at the time of the first OPEC oil embargo in 1973 compared to today’s 25.4 miles/gallon. The percentage of household budgets spent on food and energy has halved since the 1970s. This implies less inflationary pass-through from the current commodity price shock.

When the Federal Reserve concludes its upcoming monetary policy meeting on 15/16th March, it is likely to lift its inflation forecasts, while at the same time reducing its economic growth forecasts. The Ukraine crisis will undermine growth. Higher food and energy costs will reduce the disposable cash of both consumers and businesses. Sentiment will also be affected. Despite the added inflationary impulse, the Fed will likely be more cautious in reversing its policy stimulus. Instead of lifting the fed funds rate by 50 basis points on the 16th March, as had been expected, the Fed will opt for a 25 basis point hike and signal afterwards that it will be prepared to adjust its plans depending on the war’s impact on economic prospects. This may be good news for financial markets. Share prices have become so attuned to low interest rates and policy stimulus, that they are probably less susceptible to changes in the Ukraine conflict than they are to changes in monetary policy.

Stagflation is the new buzzword. Stagflation is defined as rising inflation at the same time as falling economic activity. This is an unenviable situation, and a toxic scenario for equity markets. Some economists are comparing the current scenario with the 1970s, as there are many similarities. Following a decade of policy stimulus, inflation started rising sharply in the early 70s. Policy makers said it was transitory but then inflation was exacerbated further by the 1973 Arab oil embargo on the US. However, most economists believe it is unlikely that we will get a repeat of the “Stagflation” of the 1970s.

According to Dario Perkins of TS Lombard: “While there are certain superficial similarities, there are much more important differences. Back in the 1970s, product markets were generally domestically focused and ‘closed’, while the workforce was young, militant and typically part of a trade union. Wages were often indexed to inflation……. Today we are in a totally different world……Our best guess – and it is only a guess at this point – is that US inflation will settle in the 2-3% range in 2023…… There will be ‘no repeat of the 1970s’ and there is no danger of wages and prices suddenly ‘spiralling out of control’”.

Local Report

By Gielie Fourie

INTRODUCTION: In February 2022, the Constitutional Court struck down the Preferential Procurement Regulations (the Regulations) gazetted in 2017 by then finance minister, Pravin Gordhan, under the Preferential Procurement Policy Framework Act (PPPFA). Why did it do so?

BACKGROUND: Min. Gordhan’s regulations allowed organs of state to set “pre-qualifying criteria,” under which a company wanting to tender for a contract had to have “a stipulated minimum Black Economic Empowerment (BEE) status level” if it was to be considered at all. BEE status is awarded according to a scorecard of points and levels – one hundred points will put you on level 1, the highest level. Sakeliga, a non-profit organisation representing around 10,500 firms, objected that these pre-qualification criteria were unconstitutional. The case landed in the Constitutional Court. According to the majority judgement of Judge Mbuyiseli Madlanga, the crucial question was whether “the minister has the power to make regulations of this kind. If he does not, the matter ends there; the regulations are invalid”. The minister (Pravin Gordhan) “cannot arrogate to himself a power he does not have”.

ECONOMIC REDRESS: The majority judgment however, at the same time stressed the importance of preferential procurement as an instrument of redress. If the Constitution had not made provision for this, the “history of economic disadvantage experienced” by the Black majority “would have meant the perpetuation of the disadvantage and possibly the widening of the gap”. The Constitutional Court had previously stated: “economic redress for previously disadvantaged people lies at the heart of our constitutional and legislative framework”.

WHY IS BEE FAILING? The government’s declared BEE aim was to spend billions of rands on delivering much-needed goods and services while simultaneously empowering Black business. But what many suppliers did was to pocket/steal the millions they received, buy better houses and “the biggest and flashiest 4×4 by far” and then use what little was left over to deliver on their contracts with the state. Which “entrepreneur” would not want to keep the BEE gravy train rolling for the privileged few in the name of widespread equity and “empowerment”? BEE, and the exploitation thereof, gave birth to “tenderpreneurs”.

TENDERPRENEURS: Tenderpreneurs had to ‘grease the machinery’. They had to make donations to the … ANC, plus donations to the ANC youth league, the ANC women’s league, and the SACP. Those who failed to make the necessary payments either in cash or ‘in kind’ – find themselves excluded from future state contracts. The Treasury’s acting chief procurement officer, Willie Mathebula, told the Zondo Commission in 2018: “The procurement rules intended to ensure cost-effectiveness are deliberately not followed in roughly half of all state contracts.” Mr Mathebula added “And once some excuse has been found to bypass normal procurement requirements, “a contract which starts at R4 million is soon sitting at R200 million”.

“TO BEE OR NOT TO BEE, THAT IS THE QUESTION”: In 2004, the Constitutional Court in the Van Heerden case laid down three tests for the validity of all affirmative action measures: (1) whether they target the disadvantaged; (2) whether they are designed to advance them; and (3) whether they promote the achievement of equality. Preferential procurement fails all three tests. Dr Anthea Jeffery, head of Policy Research at the Institute of Race Relations, writes: “It is high time that the courts began recognising this reality and strike down BEE procurement rules – primarily because they fail the Van Heerden tests and are hurting, rather than helping, the vast majority of Black South Africans.” We can no longer afford the luxury of BEE.

The World Bank, in its bi-annual Global Economic Prospects report, forecasts a slowdown in world economic growth in 2022, from an estimated 5.5% in 2021 to 4.1% in 2022, due to new Covid variants, rising inflation, reduced stimulus measures, labour market shortages and supply chain disruptions. Growth is expected to slow again in 2023 to 3.2%. The two largest economies, the US and China, are expected to slow from 5.6% to 3.7% and from 8% to 5.1%, respectively. Some economies, however, are likely to exhibit stronger growth this year, in particular the Far East economies including Japan, Thailand and Indonesia, which were relative laggards in 2021. However, the report cautioned against growing inequality between developed and less developed economies, exacerbated by varying stimulus support, vulnerabilities to rising inflation and interest rates and the imbalance in vaccine access.

The World Bank, in its bi-annual Global Economic Prospects report, forecasts a slowdown in world economic growth in 2022, from an estimated 5.5% in 2021 to 4.1% in 2022, due to new Covid variants, rising inflation, reduced stimulus measures, labour market shortages and supply chain disruptions. Growth is expected to slow again in 2023 to 3.2%. The two largest economies, the US and China, are expected to slow from 5.6% to 3.7% and from 8% to 5.1%, respectively. Some economies, however, are likely to exhibit stronger growth this year, in particular the Far East economies including Japan, Thailand and Indonesia, which were relative laggards in 2021. However, the report cautioned against growing inequality between developed and less developed economies, exacerbated by varying stimulus support, vulnerabilities to rising inflation and interest rates and the imbalance in vaccine access.

 

The World Bank, in its bi-annual Global Economic Prospects report, forecasts a slowdown in world economic growth in 2022, from an estimated 5.5% in 2021 to 4.1% in 2022, due to new Covid variants, rising inflation, reduced stimulus measures, labour market shortages and supply chain disruptions. Growth is expected to slow again in 2023 to 3.2%. The two largest economies, the US and China, are expected to slow from 5.6% to 3.7% and from 8% to 5.1%, respectively. Some economies, however, are likely to exhibit stronger growth this year, in particular the Far East economies including Japan, Thailand and Indonesia, which were relative laggards in 2021. However, the report cautioned against growing inequality between developed and less developed economies, exacerbated by varying stimulus support, vulnerabilities to rising inflation and interest rates and the imbalance in vaccine access.

The World Bank, in its bi-annual Global Economic Prospects report, forecasts a slowdown in world economic growth in 2022, from an estimated 5.5% in 2021 to 4.1% in 2022, due to new Covid variants, rising inflation, reduced stimulus measures, labour market shortages and supply chain disruptions. Growth is expected to slow again in 2023 to 3.2%. The two largest economies, the US and China, are expected to slow from 5.6% to 3.7% and from 8% to 5.1%, respectively. Some economies, however, are likely to exhibit stronger growth this year, in particular the Far East economies including Japan, Thailand and Indonesia, which were relative laggards in 2021. However, the report cautioned against growing inequality between developed and less developed economies, exacerbated by varying stimulus support, vulnerabilities to rising inflation and interest rates and the imbalance in vaccine access.

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The Bottom Line: Innovation and the Magic of Compounding

By Carel La Cock

The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.

Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.

After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.

Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.

As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.

Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.

Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.

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