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Is China becoming uninvestable?

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Behavioural lessons to improve your financial success.

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Global Report

By Nick Downing

The Shanghai & Shenzhen CSI 300 index is the worst performing major equity market since the start of the year, falling by a precipitous 20.29%. This should be a concern, not just for direct investors, but for the world economy. China is the world’s second largest economy, it is by far the largest consumer of industrial commodities, Europe’s largest export destination, a significant cog in global supply chains, and substantial funder of US debt. Why is the market so weak and what is its outlook?

On the surface, economic growth appears robust. Official data confirmed year-on-year GDP growth of 4.8% in the first quarter, but how much can these numbers be trusted? Research firm Capital Economics has devised its own independent China Activity Proxy, which shows growth much lower. Besides, even the official numbers show retail sales falling in March by 3.5% on the year, even before Covid outbreaks in Shanghai. A rigid Covid zero policy and strict lockdown measures have shut down whole portions of the economy. Covid has spread to areas which generate 40% of GDP and ship 80% of exports. Consumers and businesses are losing the ability and the propensity to spend and invest. The residential property market, which has boomed for 25 years and been a source of tremendous growth in household wealth and economic activity remains in the doldrums following government measures to reduce excessive leverage in the sector. Government crackdowns on internet, technology, gaming and online education, have also affected consumer and business confidence.

Authorities are scaling back their “common prosperity” regulatory initiatives and delivering fiscal and monetary stimulus. However, stimulus is modest compared with previous measures as the government is wary of refuelling the property bubble and destabilising the financial system with too much debt. Moreover, under strict lockdowns there is little chance that stimulus will gain much traction and create the desired multiplier effects. Capital Economics predicts China’s GDP will only grow by 2% this year, a far cry from the official target of 5.5%. Export markets, which helped so much in 2020 and 2021, when global goods demand boomed, will also ebb as the world turns its attention towards expenditure on services.

There are also longer-term impediments to growth. Population growth has slowed dramatically since 2015 and is now close to zero. The population is expected to shrink over coming years. When Trump was replaced by Biden, it was expected that trade relations between the US and China would improve but the animosity is becoming more entrenched. China is rapidly “decoupling” from the West not just in terms of trade but also in technology. Western sanctions on technology transfers will affect China’s productivity. In the context of an ageing and shrinking population, productivity improvement will become increasingly vital to maintaining economic growth.

Russia’s invasion of Ukraine has made the global community even more distrustful of autocratic leaders. Xi Jinping will be elected at the end of this year for an unprecedented third term. He has accumulated enormous powers and a keen appetite for using them, evidenced by his foreign policy as well as domestic measures, including attacks on large business and entrepreneurs and military aggression in the South China Sea. Ken McCallum, Director General of Britain’s MI5 Security Service said in late 2020, while comparing Russia with China: “You might think in terms of the Russian intelligence services providing bursts of bad weather, while China is changing the climate.” (ECR).

China’s authorities are adept at moving investment goalposts, and with the nation in danger of increasing isolation from the rest of the world, some analysts have cautioned that its stock markets may become uninvestable. However, others have a more optimistic view. The managers of Scottish Mortgage Investment Trust PLC, the top performing London listed investment company, believe the regulatory crackdowns on China’s internet companies will in due course be replicated in other countries as they will enhance the competitive playing field. Competition is vital to technological progress. On this basis, Beijing’s policies will boost China’s productivity growth rather than diminish it.

China is unlikely to ever become uninvestable. Its economy is too dependent on trade and integral to the world economy for either its own or for foreign governments to render it so. According to research firm ECR, it is the most important trading partner for over 120 countries. China’s products account for 18% of US imports and 22% of EU imports. “A decoupling between China and the US and its allies may not be an impossible task if tensions continue to rise in earnest, but the consequences will be of an entirely different order than the already very considerable consequences of the struggle with Russia.” There is far too much at stake on all sides, so geopolitics will somehow muddle through.

The CSI 300 index has undergone a massive derating since 2020 when it was the world’s top performing major equity index. It now trades at very attractive levels that are well below long-term averages. The 12-month forward price/earnings ratio is 10.4x compared with the long-term average of 13.7x and the price/book ratio is 1.59x also well below the long-term average of 2.6x. For long-term investors, with a 10-year investment horizon, current valuations almost guarantee superior returns. However, valuations may become even cheaper. Markets can remain undervalued for considerable periods. Beijing is stepping up stimulus, but it is tame compared with previous cycles and Covid lockdowns will subtract from the intended multiplier effect. Investors will probably be rewarded for waiting for even lower entry points in the market.

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 Werner Erasmus

I was introduced by a friend of mine, to a new investment & personal finance book called The Psychology of Money, written by Morgan Housel. I am very grateful for this introduction because it just happens to be one of the best investment and personal finance books I have ever read. The best part about it is the fact that the book is not overly complicated and is written in layman’s terms making it an easy and enjoyable read.

In the book, Morgan Housel shares various lessons about wealth, greed, and happiness. The core lesson of the book is about behaviour and how people’s wealth or how well they manage their money is not necessarily determined by how much they know (IQ or education) but by how they behave. For example, highly intelligent individuals unable to control their emotions can be financial disasters while ordinary individuals with no financial education can be wealthy if they adopt certain behavioural skills. Below are some of the lessons in The Psychology of Money that stood out:

Never enough: Stop moving your goal post. Expectations rise with results but if expectations rise faster than results you will never be satisfied and keep on moving your financial goalpost. It is like a dog chasing its tail, it never ends. The capitalistic world we live in is great at creating wealth and envy. Wanting to surpass your peers may provide you with the motivation to work hard but life isn’t satisfying without a sense of enough. Happiness as they say is results minus expectation. Morgan Housel says “an insatiable desire for more – will push you to the point of regret”. Freedom, family, friends, being loved and happiness is invaluable and the best chance one has to keep these things is to know when to stop taking chances that might harm them. In other words, knowing when is enough financially.

Confounding and compounding: Many books have been written about the best investor in the world, Warren Buffet. But Warren Buffet does not have the best return record of all time, that title belongs to Jim Simmons (66% compounded annual return). Nevertheless, Warren Buffet is far wealthier. Why, because he has been investing successfully for over a very long period. Long enough for the magic of compounding to take place. Housel summarises it as follows: “Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be once-off hits that can’t be repeated. It is about earning pretty good returns that you can stick with, and which can be repeated for the longest period of time because that is when compounding runs wild”. Start investing early because time is the most important factor in investing. As Housel puts it, Time makes little things grow big and big mistakes fade away”.

Tails you win: Tails drive everything. For people not familiar with the term, it refers to events in statistics with a low probability of happening i.e., outliers. These events are plotted in the tails when looking at probability distributions which means they are far from the average or expected outcome. The idea is similar to the 80/20 rule which means 80 of your returns come from 20% of the invested time. Your decisions as an investor most of the time will not have a significant impact on your investments, but what you do during the abnormal days – the 1% of the time or less – when the market around you is going crazy. Housel sums it up by saying the following,” A good definition of an investment genius is the man or woman who can do the average thing when all those around them are going crazy”. Tails drive everything which is why many things can go wrong in investing.

Freedom: Freedom in this context refers to the ability to control your own time. Housel mentions Angus Campbell a psychologist in 1910 at the University of Michigan who wrote that “Having a strong sense of controlling one’s life is a more dependable predictor of positive feelings of well-being than any of the objective conditions of life we have considered”. In other words, doing what you want, when you want, and with whom you want is the broadest factor that makes people happy. More than their high-paying job, luxurious house, or fancy sports car. The biggest benefit that money has is the ability it gives you to control your own time. That is real freedom. “Using money to buy time and options has a lifestyle benefit few luxury goods can compete with”, notes Housel.

Save money: According to Housel “Saving is the gap between your ego and your income, and wealth is what you don’t see”. Investment returns can make you rich, but often are uncertain and out of your control because of market, economic and political factors. But saving is in your control and has a guaranteed chance of being as effective in the future as it is today. Wealth is the money that is left over after you have spent what you generated. You can save even though you might not have a high income, but you cannot build wealth if you do not save a lot.

Conclusion: To summarise, in the world of money, financial outcomes are often driven by luck, independent of intelligence and effort, and two, financial success is not a hard science it’s a soft skill, and how you behave is more important than what you know.

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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