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Global Report

Is the US headed for recession and an equity bear market?

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Local Report

Challenges facing our Mining Industry in creating new jobs.

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Global Report

By Nick Downing

The US equity market has de-rated sharply since the start of the year despite continued earnings growth. S&P 500 earnings increased in the first quarter (Q1) by a robust 10.4% year-on-year, based on companies that have reported so far, comprising 80% of the index. Yet the S&P 500 index has declined year-to-date by 16.1%, almost enough to put it in “bear” market territory, defined as a drop of 20% or more from the recent high.

Equity bear markets usually do not occur without there being a recession. This scenario appeared absurd as recently as 5 months ago when US GDP grew in Q4 2021 by an astonishing 6.9% quarter-on-quarter annualised. How times have changed, with a war in Europe, surging oil and food prices, accelerating inflation and China’s Covid lockdowns all conspiring to lower the pace of GDP growth. In Q1 2022, US GDP contracted for the first time since 2020, at an annualised rate of 1.4%.

If GDP contracts again in Q2, the US economy will officially be in recession, identified by two straight quarters of economic contraction. However, this scenario is highly unlikely. Recent GDP weakness is attributed to changes in government spending and a deteriorating trade balance. Exports fell 5.9% and imports increased 17.7% in Q1, which stripped 3.2% from GDP but in fact signals strong domestic demand. Personal consumption which accounts for 70% of US GDP, grew by 2.7% in the quarter, up from 2.5% the previous quarter. Business investment grew 9.2% up from 2.9%.

Domestic demand is strong and will continue to be supported by replenished household and company balance sheets. The savings rate has eased back from its pandemic highs but at the current rate of 6.2%, savings are still accumulating and are now a whopping $2.4 trillion above pre-Covid levels. According to research firm BCA, the US private sector financial balance, measuring the difference between what households and firms earn and spend, still stands at a comfortable surplus of 3% of GDP. Recessions usually occur when the balance is negative. Ahead of prior recessions in 2001 and 2008, the private sector balance hit deficits of 5.4% and 3.9% of GDP.

US unemployment has dropped to just 3.6% close to the pre-pandemic low of 3.5%, yet there are about 4 million more job openings than in February 2020. Job openings climbed to a record 11.5 million in March almost twice as many as the 5.9 million Americans looking for a job. It will be a long time before unemployment starts to rise again. In the meantime, a tight labour market support strong wage growth and household spending.

The chief concern is inflation, which is running at its highest in 40 years. Yet, there are signs that inflation has passed its peak. In April, US consumer price inflation dipped from 8.5% to 8.3%. Month-on-month, CPI increased 0.3% compared with 1.2% in March. The shift in spending from goods to services means core goods inflation has started trending lower. Core goods inflation, one of the key culprits in the supply chain inflation shock of the pandemic era, fell in April by 0.4% on the month. Market based measures indicate a decline in inflation expectations. The closely watched breakeven rate, the yield difference between the 10-year Treasury Inflation Protected Security and conventional Treasury bonds of the same maturity, has dropped over the past month from 3% to 2.6%. The breakeven rate measures the market’s expected annual inflation rate over the next 10 years.

A tempering in inflation data and inflation expectations will take pressure off the Federal Reserve, which has becoming increasingly “hawkish” since the start of the year. As it is, the Fed expects it will reach a “neutral” fed funds rate, which neither speeds up or slows down the economy, by the end of the year. The Fed estimates the neutral rate is around 2.75%. Although comprising a further 175 basis points in rate tightening, the projected neutral rate would still be below the expected inflation rate and therefore not austere in monetary policy terms.

The conclusion is that the US economy is likely to escape recession at least for the next 12 months. Research firm TS Lombard’s US recession probability model indicates a negligible recession risk. Continued growth coupled with declining inflation should ensure further gains in US equity markets over coming months.

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: Last week our production figures were reported. Gold production for March and April was down year-on-year by 9.3% and 25.6%, respectively. Mining production was down by 6% and 9.3%. For a country with an unemployment rate of 35.3% and 7.9 million unemployed people, this is not good news. Mining is labour intensive and a major job creator. Our mines supply jobs to just over 500,000 people. Many more jobs can be created. Why can we not create more jobs? The Mining Indaba last week in Cape Town clearly highlighted what we need to do to create new jobs.

MINING INDABA 2022: Last week, from Monday to Thursday, we had our annual Mining Indaba in Cape Town. It was attended by 6,500 delegates from all over the world. The Mining Indaba is a platform for engagement and collaboration between all stakeholders in the mining industry. Pres. Ramaphosa delivered his keynote address on Tuesday. By all accounts he delivered one of his best speeches ever to woo investors to invest in South Africa. He received a standing ovation. He clearly understands the mining industry. It was an embarrassment that he was introduced to the Indaba by min. Gwede Mantashe as “comrade president”, showing off his roots as a communist. Mantashe’s own speech was a disappointment. South Africa’s mining sector was recently ranked as one of the ten worst mining investment countries in the world, according to the 2021 Canadian Fraser Institute Investment Attractiveness Index. South Africa fell to 75th place out of 84 countries.

BOTTLENECKS: This year mining’s surplus contribution to the fiscus is expected to be less than last year’s R92 billion. Last year R92 billion of the extra R120 billion in income tax collected, came from the mines. One reason for the expected drop in income tax is the drop in the company tax rate from 28% to 27%. Other reasons include problems with rail transport, bottlenecks at our harbours and loadshedding. Mines can now generate 100 MW power without requiring a licence but after one year there is still red tape holding back the introduction of this option. Another problem at our mines is security. The industry spends more than R2 billion per year on security. The construction mafia and gangs are a big problem. They block access roads to mines to bring mines to a complete standstill and then force mines to allocate contracts to them.

MINING LICENCES: Another major bottleneck is the delay in issuing prospecting rights, mining licences and the renewal of licences. There is a backlog of more than 4,500 prospecting and mining rights licences in the pipeline waiting for approval. Roger Baxter of the Minerals Council says R100 billion is snarled up in red tape. It takes on average one year (352 days) to issue a new license. Zambia, Namibia and Botswana have better systems. In Botswana the waiting period for a mining license is only three months. An investor must jump over several high hurdles before he can start mining in South Africa.

NO CADASTRAL SYSTEM: This may be our biggest problem. Unlike other mining countries, South Africa does not have a cadastral system. What is a cadastral system? The system provides transparent data (open to anybody who needs to view the data) of all prospecting sites and licences. It is vital and essential to support exploration and growth in mining. The system was discussed ten years ago, but nothing has happened yet. The result is that there is no central database where vital mining data can be accessed.

CONCLUSION: All this is happening while there are investors waiting to invest billions and create thousands of jobs. For investors South Africa is at the bottom of the agenda as an investment option. Western Australia is the most attractive destination for investing in mines. Mining has the potential of creating thousands of new jobs and new income streams, but not while Gwede Mantashe is our minister of Mineral Resources and Energy (which includes Eskom), Fikile Mbalula is our minister of Transport and Bheki Cele is our minister of Police. They are creating serious bottlenecks. Conventional wisdom is to ”throw all your resources” at bottlenecks to get them out of the way as quickly as possible. Mantashe, Mbalula and Cele are three of those bottlenecks. The sooner they go, the sooner mining can start creating thousands of jobs.

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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