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Global Report

By Nick Downing

Bonds are not fulfilling their traditional role as risk diversifiers in balanced portfolios. The traditional balanced portfolio asset allocation between equities and bonds is 60:40. When equities tumble bonds usually rally, providing effective risk diversification. However, most government bonds such as US Treasury bonds, have become very expensive and are trading at negative real yields, which is a poor starting point for investors, especially when the Federal Reserve and other major central banks are about to embark on their most aggressive interest rate hiking cycle in 40 years. The imminent onset of quantitative tightening, when the Fed runs down its accumulated holdings of Treasury bonds by selling $100 billion per month onto the market, will apply further pressure on bond prices. Damage is already being wreaked on bond portfolios.

Year-to-date Treasury bond losses are the worst in decades, almost as bad as the 11% or so decline in the S&P 500 index, causing many strategists to question whether Treasury bonds may have lost their traditional role as risk diversifiers. Alternative asset classes can fill the gap left by bonds. A suitable alternative asset class is renewable energy. Renewable energy providers are especially favoured by the oil and gas supply shock stemming from the Ukraine war and Russian sanctions. Renewable energy prices have the added attraction of insulating against rising inflation as many pricing contracts are inflation linked. Moreover, global financial markets are placing a premium on ESG investments. Decarbonisation is expected to be a winning long-term investment theme over the coming decade.

Our clients’ global balanced and income portfolios benefit from the inclusion of Greencoat UK Winds plc, which trades on the London Stock Exchange under the ticker UKW. UKW is the largest listed renewable energy investment company in the UK with a market capitalisation of around £2.5 billion and is a constituent of the FTSE 250 index. The company invests in land-based and offshore UK wind farms. Investors are rewarded by a healthy 5% dividend yield. In addition, management aims to preserve capital on a real basis by reinvesting excess cashflow and prudent leverage in additional wind power assets. The business model is in a sweet spot, benefitting from the acceleration in global decarbonisation and from the “reflationary” trade, with the prospects of rising global inflation suiting UKW’s inflation-linked power contracts.

UK electricity prices have risen sharply in line with the surge in oil, coal and gas prices. The trend of rising inflation and power prices is expected to persist for some time. UK forward power prices for Summer 2022 and Winter 2022/23 are up significantly compared with just 4 months ago, by around 70% and 40%, respectively. A substantial portion of UKW’s output is unhedged, which means it will benefit from the power pricing windfall.

How has the performance of UKW stacked up year-to-date versus the S&P 500 index, which at time of writing (25/4/22) has dropped 10.94%, and the iShares US Treasury Bond ETF, which has lost an astonishing 9.16%. With bonds and equities exhibiting unusual but potentially protracted positive correlation, generating positive returns that exceed cash is no mean feat in the current environment. 

The UKW share price has gained a solid 7.1% YTD, which excludes the additional 5% annual dividend yield. The share not only provides a refuge from increasingly over-valued equity markets with far better returns than cash but will also flourish from the drive towards decarbonisation, which the war in Ukraine will undoubtedly accelerate.

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: We recently added MTN to our portfolios. The main motivations for our decision were MTN’s strong performance in Africa, especially in Nigeria, its exit from Middle Eastern countries, its venture into fintech and its improved balance sheet. MTN is growing and management is making excellent capital allocations.

MTN AND VODACOM: MTN listed on the JSE in 1995 as the second cell phone operator in South Africa. Vodacom was our first cell phone operator. MTN would always play second fiddle. MTN realised that the telecoms business is very capital intensive – not dissimilar to mining. Having scale is important. Drastic increase of units (users) would drive down unit costs. MTN’s strategy to reach more subscribers was to expand beyond our borders into Africa and the Middle East.

MTN STRATEGY: CEO Ralph Mupita says MTN’s strategy is to be the number one or number two player in any market. An example is South Africa where Vodacom has 44 million subscribers, while MTN has 30 million subscribers. Cell C and Telkom together have only 29 million subscribers. Being number three in the industry makes it tough to make the economics work. Being number one or two in the industry provides a barrier to entry, or a moat around your business.

MTN IN AFRICA: Expansion into the rest of Africa was successful. MTN later listed in Nigeria, Ghana, Rwanda, and Uganda. Unfortunately, expansions to the Middle East were fraught with legal challenges and massive fines. MTN eventually divested from the Middle East. After MTN made the decision to exit the Middle East, its strategy was to grow its network in Africa and become an entirely Africa-focused operation. Nigeria is by far the largest country in Africa in terms of population, with more than 211 million people in 2021. In terms of Fintech, it is the market to be in. Given its large and developing population, Africa is currently an untapped fintech expansion opportunity. Compared to other regional markets, the rise of fintech is not disrupting established traditional banking and payment practices; instead, it is building a new system from the ground up. The future of telecoms lies in selling data, rather than cell phone time (voice), and entering the lucrative fintech business. MTN has obtained a full FinTech licence in Nigeria. MTN Nigeria’s growth in both Data and FinTech business last year was 35%.

FINANCIAL: MTN was founded in 1994. Within 28 years it has grown into one of the biggest companies in South Africa. It is the eleventh biggest company on the JSE. It has a market capitalisation of R326 billion (bn). Some of the top ten companies on the JSE are more than 100 years old. In 2021 subscribers increased by 2.9 million. With 283 million subscribers it is the biggest cell phone company in Africa. Annual sales for 2021 were R181 bn. Profit after tax was R17 bn (2021). Its forward PE ratio is 13.4. The dividend yield is 1.7%. MTN is profitable. Headline earnings for 2021 were 987 cents per share, up 31.8% from the previous year. Return on equity (ROE) improved to 19.6% (up 2.6pp). 

MTN has a strong balance sheet. Interest debt is R65 bn. Cash is R40 bn, leaving a net debt of only R25 bn. The company makes an annual profit of around R20 bn, which should take care of the debt without problems. It is also in the process of selling non-core assets. The proceeds will be used to pay down debt. MTN’s debt has an investment grade rating.

CONCLUSION: We feel MTN is fairly valued and has attractive growth potential in the 19 markets it operates in. Nigeria has the potential to deliver strong revenues. Both the FinTech business and fibre business (with 100,000 km of fibre) will be separately listed in 2022 and 2023 respectively. This will further unlock value.

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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Reference: References can be supplied on request.

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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