Weekly Market Report

Tuesday 31 May 2022

Global Report

Oil price could go to $175 per barrel.

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Local Report

Investing in property.

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Market Indicators

Global and local indicators.

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Global Report

By Nick Downing

Inflation is the biggest threat in today’s financial markets. There is a broadening consensus that inflation in developed economies has reached a peak and is starting to decline, helped in large part by the base effect of elevated year-ago readings. If inflation starts to decline, central bank monetary policy may become less hawkish. A rising oil price might spoil this benign outlook. There is a strong correlation between the oil price and inflation.

Analysts’ oil price forecasts differ wildly. Consensus is a long way off. Some, including Capital Economics and BCA, forecast the oil price returning to the $80-90 level within a year. This would be extremely helpful in bringing down inflation and interest rate projections. Others forecast $170 and upwards, which could be enough to tip the world into recession and central banks, with their hands tied by the inflationary impulse, would be powerless to stop the economic decline.

The EU ban on Russian oil imports has applied further upward pressure to the oil price. The agreement, signed on 30th May, is expected to cut off 90% of all Russian imports by the end of the year. By that time, the temporary exemptions granted to Hungary, Slovakia and the Czech Republic, will have been met. The EU will have to replace Russian oil from other, already strained markets, driving prices even higher.

The oil market is already very tight, prompting the US at the end of April to announce the largest ever release from its Strategic Petroleum Reserves. Simultaneously, International Energy Agency member states announced a record release from their reserves. Extreme price backwardation tells the story. Future delivery prices are traditionally higher than spot delivery, due to storage and financing costs, but in today’s market, spot prices are as much as $20 per barrel higher than 1-year forward contracts. This level of backwardation is almost unprecedented, indicating the premium buyers are willing to pay to secure supply.

The oil supply shock has been brewing for a long time, well before Russia’s invasion of Ukraine. Despite international pressure on OPEC+ to lift production more rapidly, the cartel has stuck to its long-held trajectory of monthly increases of 400,000 barrels. Yet even these modest quota increments are not being filled. Several OPEC countries are woefully behind their quotas due to poor infrastructure maintenance and insufficient investment.

The worst culprit is probably Russia itself. The country’s oil production capacity has been undermined by decades of corruption, under investment and chronic skills shortage. This sounds far too familiar to South Africans. To fix the problem, Russia has depended on foreign oil majors and technicians to keep production flowing, but these companies and skills have all left. Some say it may take decades for Russia’s oil production to return to its prime.

Much hope is pinned on the US shale producers, which characterised the decade of the 2010s with their massive output surge. At its peak, US shale production on its own, excluding the country’s conventional production, was second only to Saudi Arabia in output. However, the top shale basins are all suffering severe resource depletion. The easiest and cheapest oil has already been extracted and there are few if any new basins to fill the gap. A funding drought amplifies the production shortfall. Rather than reinvesting their profits, shale producers are paying shareholders outsized dividends. There is very little appetite for debt funding either, from the debtors or the creditors, attributed largely to ESG considerations and the race towards decarbonisation and renewable energy. This is where the funding is headed.

At the same time, demand is as strong as ever and due to keep rising in line with global GDP growth. At some point, higher oil prices will lead to demand destruction, but this point is a long way off. In the developed world, the percentage of GDP spent on oil is around half its level of previous oil price peaks. In the US for instance, oil spend is around 3.5% of GDP versus previous peak levels of 7%. This suggests significant upside in the oil price before demand destruction starts creeping in. Moreover, in order to reach previous peaks, in real terms, the Brent oil price would need to rise by another 50% from current levels. Seen in this context, a price target of $175 does not seem so farfetched. For investors, whose top priority is capital preservation, they would do well to factor this scenario into their asset allocation models.

Local Report

By Gielie Fourie

INTRODUCTION: Conventional investment wisdom says that you should invest part of your wealth in property. There are several ways to invest in property. You can invest in physical property. This is risky, but some people are very good with this. If this is not your strong point, you have the option of investing in property shares on the JSE.

PHYSICAL PROPERTY: Many people will buy at least one property in their lifetime, their house. The advantage is that you can get a bond and pay it off over say, ten years. You can go further and buy a house as an investment and rent it out. Your tenants will in effect pay off your bond. But there are risks. Tenants may not pay their monthly rentals, or they may neglect the property. They can contact you in the middle of the night to fix a broken toilet or leaking roof.

LISTED PROPERTIES: The alternative is to invest in listed property companies. You can invest in prime properties, like the V&A Waterfront in Cape Town, Sandton City in Johannesburg or anywhere in the world, and you will have professional managers managing the properties. You will not get a bond to invest in listed properties – “gearing” is not available. You should start small and build up a diversified property portfolio. Many property companies are registered as Real Estate Investment Trusts (REITS). REITS are strictly controlled and are safe investments. They may not incur excessive debt and they must distribute 75% of their income to shareholders.

DIVERSIFICATION: Listed property allows you to diversify your property portfolio between several property sectors, like offices, retail property (mostly malls), residential property, hotels and industrial property. Each sector has its own subsectors. Geographical diversification further allows investors to invest anywhere in the world.

STELLAR PERFORMER – INDUSTRIAL PROPERTY: Retail and commercial properties are still clawing their way back to pre-Covid-19 rates. The outlook for industrial properties is far more positive. Sub-sectors like logistics and warehousing are outperforming segments like manufacturing and industrial parks. While office space and malls are in oversupply – SA has the 6th highest number of shopping malls in the world – industrial properties are in short supply. Between 2019-2022 the number of building plans passed for industrial buildings decreased by 39%. Buildings completed dropped by 23%.

TOMORROW’S TENANT: What is tomorrow’s tenant looking for? The industrial sector’s look is slowly evolving. Increasingly tenants are seeking to offer a more user-friendly environment for workers. New warehouses will have a modern and corporate look mirroring the brand and products of the tenant. Off-grid power is also important. Larger corporates are setting up a campus-style environment that allows for the cross-pollination of ideas and relaxed interaction between different business units. There is also a growing demand for smaller units with additional parking that mimics the “office park” environment. Good security and location in a well-maintained area are important. Combining retail with a warehouse is also popular.

CONCLUSION: There are a host of superb REITS listed on the JSE. The biggest REIT on the JSE is Growthpoint with 432 properties, which include five hospitals and the successful V&A Waterfront in Cape Town. It also owns industrial properties and gives you offshore exposure as well. Two pure industrial companies are Equites (warehousing) and Stor-age (small storage units). Both Equites and Stor-age have exposure to the UK. Sirius is the leading operator of branded business parks in Germany. Irongate has exposure to 27 properties, including industrial properties, in Australia.

The following REITS will not give you exposure to industrial properties but are nevertheless attractive options. MAS Real Estate has a big exposure to shopping centres in Romania. Vukile has a big exposure to shopping centres in Portugal. NEPI Rockcastle is the premier owner and operator of shopping centres in Central and Eastern Europe, with a presence in nine countries. Liberty Two Degrees has a predominantly retail focused portfolio which includes the iconic Nelson Mandela Square and Sandton City. Attacq owns the Mall of Africa shopping mall located in Waterfall City, Midrand, industrial properties, and hotels. If this overload of information is confusing, please contact one of our highly trained consultants for a free consultation.

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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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