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Global Report
Europe exposure reduced.
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Global Report
By Nick Downing
The world economy was enjoying unusually strong momentum before Russia invaded Ukraine. The factors supporting strong growth remain intact, notably strong household balance sheets, excess savings, a retreat of the Covid threat, a reopening of service sectors and supply chains, and depleted inventories which need to be replenished. Despite the solid economic backdrop, there are three “firsts”, which give pause to unbridled optimism. The yield difference between the 10-year US Treasury bond and the same maturity Treasury Inflation Protected Security (TIP), which measures the market’s expected annual inflation rate over the next 10 years, increased to 2.94% its highest level ever.
The Federal Reserve, undeterred by increased geopolitical risks, has guided that it will begin “quantitative tightening” (QT) in May. This is another first. In the past, in 2018, the Fed reduced the size of its balance sheet by allowing its bond holdings to “run off” upon maturity and not reinvesting the proceeds but it has never before actively sold its bond holdings onto the market. The QT programme will reduce the Fed’s balance sheet at an unprecedented pace, to the tune of $100 billion per month, a significant draining of liquidity from the financial system. The tide of global liquidity expansion which powered all financial markets higher in 2020 and 2021, has started to ebb. A higher oil price and stronger US dollar also dampens liquidity, but the effects of upcoming QT are an unknown quantity.
Third is Russia’s invasion of Ukraine, the first invasion and conflict of its magnitude since WW2. The longer the war continues, the more dangerous it will become. Putin, showing all the signs of irrational behaviour and who believes his life will be in danger of he loses power, is likely to escalate the crisis in the event of a stalemate either by expanding its boundaries or with the use of non-conventional weapons.
Despite positive underlying growth momentum, we are trimming equity exposure in our clients’ portfolios by 2-4%, depending on the risk profile. This is only a minor adjustment. Portfolios are already structured to withstand worst-case scenarios. This is achieved through effective diversification across asset classes, industrial sectors, geographical regions and currencies. We remain confident that global equity markets will end the year at higher levels but will use the cash proceeds to take advantage of expected volatility over coming months to re-enter the market.
We are trimming equity exposure by adjusting the regional tilt of portfolios away from Europe. Europe is most at risk due to its geographical proximity to Russia and Ukraine, its bank exposure to these economies and its dependence on Russian oil and gas. The likelihood of a sharp economic slowdown in the rest of the world is low but there is a distinct possibility of outright recession in Europe. Although European markets are cheap, especially versus the US, earnings are already being downgraded and so valuations may not be as cheap in 6- to 12-months’ time. The sale of European exposure coincided with a strong 2-week rally so that prices achieved were well above recent lows. Proceeds will be held in cash over the short-term.
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
SMALL, MICRO and MEDIUM ENTERPRISESS (SMEs or SMMEs): The terms “SMEs” and “SMMEs” are used interchangeably in South Africa. According to the World Bank, SMEs play a major economic role, particularly in developing countries. South Africa is lagging. Why?
POLITICIANS, BUREAUCRATS AND REGULATIONS: Politicians and bureaucrats can make life extremely tough for SMEs. Ms. Stella Tembisa Ndabeni-Abrahams, Minister of Small Business Development and her department of bureaucrats are rule-based and rule-bound. The minister has a criminal record for a non-compliance offence. She told the public on 24 Jan 2022, “We have a responsibility to enforce regulatory compliance in the SME sector and close businesses that are trading illegally.” Jan de Villiers (DA MP) retorted: “The last thing SMEs need to hear is that the minister will be leading the witch-hunt against business owners who do not comply with government red tape.”
THE WORLD BANK’S OBSERVATIONS: The World Bank, on the other hand, sings the praises of the role of small business in terms of economic development and job creation: “SMEs play a major role in most economies, particularly in developing countries. SMEs account for the bulk of businesses worldwide and are important contributors to job creation and global economic development. They represent about 90% of businesses and more than 50% of employment worldwide. Formal SMEs contribute up to 40% of national income (GDP) in emerging economies. These numbers are significantly higher when informal SMEs are included.”
THE ATTITUDES OF BIG CORPORATIONS AND GOVERNMENT: It is so much easier for a politician to deal with a large corporation than with a spaza shop. Deals with big business are often a lucrative option as well. They can finish their ‘public’ career and find a cushy politically connected job with one of the corporations that helped them regulate markets. It is good for big business, and it is good for politicians – it is a win-win relationship. It just is not good for the country or the unemployed. Politicians and bureaucrats know who is most likely to offer them a R3 million salary when they retire, and it isn’t the spaza in the township or the street vendor downtown.
It is nothing more than a subtle form of corruption.
INFORMAL SMEs: Informal SMEs are unlicenced businesses, like many house/spaza shops. They are regarded as illegal traders. But they are often the only lifelines poor South Africans have for goods and services. So, a crackdown on illegal SMEs doesn’t just increase poverty for those who feel the wrath of bureaucracy, it also harms the customer base they serve . Often the people who fail to read the regulations are the very people who have the least education to begin with and are the most desperate to find a way to economically survive. These are people who have been failed by the current and previous governments their entire life. Instead of waging war on them, the minister would best serve the country by finding ways to help them survive, not close them down.
THE CONSEQUENCES OF OVER-REGULATION: Government will provide spaza shops with R7,000.00 repayable seed capital. Spazas need to be registered with the SA Revenue Service, the Unemployment Insurance Fund and the Companies and Intellectual Property Commission. The spaza shops must be owner-managed and must have a bank account. They must be willing to submit monthly management accounts for at least 12 months. Spazas must hold a permit to trade from the local municipality. It is critical for government to start eradicating irrelevant requirements to make it easier to register. Even those aware of the roadblocks to success set up by the state often have no choice but to operate informally and illegally, at least partially.
SUMMARY: The International Finance Corporation (a member of the World Bank Group) has urged the South African Government to try “reducing bureaucratic complexity and the costs involved with registration”. Government should be more business friendly. It should roll out red carpets for new businesses, not more red tape – government has more red tape than a red tape factory. Compliance has become such a big issue that it scares off many aspirant businesspeople. Callous bureaucrats have the power to cut off enterprising traders’ only source of income, holding back our vast economic potential. Who would dare to set up shop in such an unfriendly business environment?
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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