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Taking profit in mineral resources.

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Inflation and Interest Rates.

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Global Report

By Nick Downing

As the spectre of stagflation looms, global investors are scrambling to raise cash in their portfolios. OAM has been gradually de-risking clients’ portfolios for several months. We are probably already two-thirds of the way through the global equity “bear” market, but there are still good selling opportunities. These are opportunities to raise cash, to be redeployed in a few months’ time at lower prices.

Mineral resources provide a selling opportunity and opportunity to raise cash. Research firm BCA has plotted dollar-based raw material prices over 200 years. Prices are 2 standard deviations above the long-term trend. Historically, commodity bull markets end when prices reach this threshold.

Some have argued that commodities are in a new “super-cycle” as occurred from 2000-2011. However, the demand is simply not there. At that time, China’s economic growth rate was in the double figures, culminating in astounding growth of 15%. China is crucial to the outlook as it accounts for a massive 50% of global mineral resource consumption. Its economy is flat-lining due to Covid lockdowns and a broken residential property market. China will be lucky to achieve 2% GDP growth in 2022. According to BCA, “Land sales, which make up about 40% of local government revenues, have dried up. This will hinder local governments’ ability to finance infrastructure projects.” On the CSI 300 Shanghai & Shenzhen stock market, mining resource stocks have plummeted. It is only a matter of time before world commodity stocks follow suit. Besides China, global manufacturing purchasing managers’ indices are rolling over, indicating a drop in demand for mining resources across the rest of the world.

Investor demand has been a significant factor behind the bull market in metals prices. Investors have flocked due to negative real interest rates and massive liquidity expansion. Metals are also seen as an inflation hedge. However, the outlook is becoming rapidly less supportive. Global liquidity has already started shrinking and real interest rates are turning positive. Metals do not pay an income yield, which matters little when real interest rates are negative but the opportunity cost of holding metals will rise in line with higher interest rates. Metals offer some protection against inflation but only on the premise that demand is rising, not when global demand is falling, as suggested by China’s bleak outlook, contracting global manufacturing purchasing managers’ indices, and shrinking global trade volumes.

Some research analysts maintain that metals are in a super-cycle, but by far the majority believe they are in grave danger of significant collapse, a risk heightened by their lofty valuations and significant outperformance versus financial markets. As the forthcoming global liquidity crunch gathers momentum, cash hungry investors will gravitate to profit making investments as a source of dry powder.

The S&P 500 index and MSCI World index have dropped year-to-date by 17.15% and 16.38%. By contrast, the CRB Commodity index has gained by 44.32%, although enhanced by oil and agricultural commodity prices. The IMF Commodity Metals Price index has gained YTD by 10.27%, a rare phenomenon in today’s market, and ripe for profit taking. The index is up by 107% over 2 years. OAM’s Global Growth portfolios have benefited from holding BlackRock World Mining Trust plc, which has rallied by 18.8% YTD (in £), providing an excellent exit opportunity.

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: The inflation rate for April 2022, announced on Wednesday last week, came in at 5.9%, unchanged from March. The next day the Monetary Policy Committee (MPC) of the SA Reserve Bank (SARB) lifted the repo rate by 50 basis points (bps) from 4.25% to 4.75%. The prime interest rate increased from 7.75% to 8.25%. The vote to lift the repo rate was split 4 – 1. Four members of the MPC voted in favour of a hike of 50 bps (they are called “Hawks”), while one member (a “Dove”) voted for a rise of only 25 bps. While the inflation rate is backward looking, interest rates are forward looking. The SARB looks forward – its forecasts for inflation rates are 5.9% for 2022, 5.0% for 2023 and 4.7% for 2024. These forecasted inflation rates, not the current inflation rate, are used in the bank’s Quarterly Projection Model (QPM) to determine the repo rate.

INFLATION DRIVERS: The Governor of the SARB, Lesetja Kganyago, said the decision to raise the repo rate was based on two factors that will drive the inflation rate higher in the coming months – the new Covid-19 outbreak and the sustained invasion of Ukraine by Russia. The SARB expects the war to persist for the rest of the year. The war has impaired the production and trade of a wide variety of energy, oil, food, and other commodities and will continue to do so for some time. It will dramatically worsen economic conditions for most emerging countries.

NEGATIVE REAL REPO RATES: The SARB’s target range for inflation is 3% – 6%. To avoid negative real repo rates, the repo rate should be higher than the inflation rate. Despite the repo rate being raised to 4.75%, it is still lower than the current inflation rate of 5.9%. The effect is that we have a negative real repo rate of 1.15%. Negative rates are inflationary – one of the dangers is that they devalue our currency, the rand. This may be the reason why four members of the MPC were rather hawkish in raising the repo rate by 50 bps – the steepest increase since 2016. A hike of this magnitude was an important milestone in the process of rate normalisation. To move the real repo rate into positive territory we can expect more rate hikes.

INFLATION TARGET: The SARB expects the inflation rate to breach the target range of 3% – 6% in the second quarter of this year. This breach will primarily be driven by higher food, beverage, electricity, and fuel prices. The lapse of the temporary R1.50 per litre fuel levy relief will add to the pain. In addition, consumers will also be hit with higher interest rates. They will have to pay more on their bonds, monthly premiums on vehicles, taxi fares and even monthly house rentals. Real incomes will drop. Runaway inflation can lead to a recession. Consumers are in for tough times. Price increases could have a spill-over effect on increased wage demands, social demands, and strike actions by labour unions. Economic policies need to be fine-tuned to avoid this.

ECONOMIC RECOVERY: Last year saw the ongoing recovery of the South African economy from the pandemic – the economy expanded by 4.9% in 2021. The economy is expected to grow by 1.7% in 2022, revised down from the 2.0% target set in March. This is due to a combination of factors, including the flooding in Kwa-Zulu Natal and the continued electricity supply constraints. The economy is expected to expand by 1.9% in both 2023 and 2024. We need to grow faster than this. A bright spot is that Kganyago expects the commodity price basket to rise by 9.5% for the year (up from 8.0%). As a result, the current account surplus is expected to reach 2.1% of GDP this year.

CONCLUSION: Kganyago said he expects tourism, hospitality, and the construction industry to benefit from an expanding economy. Listed companies that can benefit are hotel groups like City Lodge, Sun International, Tsogo Sun and HCI, restaurant groups like Spur and Famous Brands, and construction companies like Raubex and WBHO. With the increase in the repo rate and the prime interest rate, companies to avoid are those with too much debt on their balance sheets. Raubex is a successful construction company with no debt and a strong balance sheet. It would be an ideal candidate to invest in. If you need advice, contact one of our consultants.

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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