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Weekly Market Report
Tuesday 14 June 2022
Making money in falling markets.
First quarter GDP figures.
Global and local indicators.
By Nick Downing
Nassim Taleb developed the now famous “black swan theory” to explain “the disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations”. These events are extreme outliers and have a severe impact. Interestingly, according to Taleb, the Covid pandemic was not a black swan event, as it was expected with a high level of certainty that a global pandemic would eventually take place. The Covid pandemic was instead, a “gray rhino”, a term introduced by Michele Wucker, in her book “The Gray Rhino: How to recognise and act on the obvious dangers we ignore.” Unlike black swans, gray rhinos are highly probably, high impact, yet neglected threats.
Investment portfolios need to protect against black swans and gray rhinos. Taleb’s advice is not to attempt to predict events which are unpredictable, but to build robustness against potential negative events. It could be argued that surging inflation, rising interest rates, and quantitative tightening are not gray rhinos as the threats have not been neglected, but the label is still relevant, to the extent that these risks have not yet been amply discounted in bond, credit and equity markets.
BH Macro Limited, listed on the London Stock Exchange in 2007, is the only way for investors to access the award-winning Brevan Howard master fund, one of the world’s leading global macro absolute return investment vehicles. BH Macro provides protection against market disruption. The managers use a black swan approach to investing, rewarding investors in the event of rising volatility in financial markets and providing a solid counterbalance to any portfolio. The managers limit losses by buying rather than underwriting option structures, which tend to be far out of the money and therefore very cheap. Gains can be impressive during heightened volatility. When the market environment is not suitable, losses are limited to the price of the “cheap” out of the money options, providing investors with little downside risk.
The track record is exceptional, producing an annualised net asset value (NAV) per share return of 9.33% (GBP) since its listing in 2007. Since then, positive monthly returns have been produced in 17 of the 20 worst months for the S&P 500 index. The strongest gains tend to be when markets are under stress. During the Global Financial Crisis in 2008 and 2009, BH Macro returned 23.25% and 18.0%, and then 12.34% during the European sovereign debt crisis in 2011. As markets corrected in 2018 due to rising US interest rates and quantitative tightening, BH Macro gained by 12.43%, and when Covid struck in 2020, investors were rewarded with a 28.09% return. In the year to end May, BH Macro has already increased its NAV per share by 14.34%. By contrast the MSCI All Country World Index has dropped by 17.91%. Bond markets, the traditional counterweight in balanced portfolios, have not fared much better. The iShares International Treasury Bond ETF has lost 17.86% year-to-date.
During years when there is little volatility, for instance the period from 2012 to 2017, returns have been pedestrian, ranging from a loss of 4.35% to a gain of 5.79%. However, the managers have extended the range of asset classes they trade, to generate more exciting returns in low volatility years. This entails peripheral exposure to equity, credit, commodity and digital assets.
The main strategies remain interest rate and foreign exchange markets, which this year have generated 95% of returns. The rate book is positioned to make money from rising US Treasury bonds, providing investors with protection from inflation and interest rates, the biggest threats today. There is currently 6x leverage to movement in the US 10-year Treasury bond yield and 4x leverage to rises in the US 2-year Treasury yield. BH Macro forms a cornerstone and proven risk diversifier in our clients’ portfolios. Its share price and its NAV do not always move in synch and like other closed-end investment companies, there is always the possibility that the share could trade at a widening discount to NAV. Investors should therefore be careful when investing privately and rather consult one of our wealth managers.
By Gielie Fourie
INTRODUCTION: After two years, GDP returns to pre-pandemic levels. This is very good news. South African gross domestic product (GDP) expanded by 1.9% quarter-on-quarter in the first quarter of 2022 (Q1 2022), representing a second consecutive quarter of upward growth. The size of the economy is now at pre-pandemic levels, with real GDP (R1.59 trillion), slightly higher than what it was before the COVID-19 pandemic. GDP is calculated from data gathered from ten separate industries. The ten industries are divided into three sectors: the primary sector, the secondary sector, and the tertiary sector. Growth was widespread as only two industries (mining and construction) recorded negative growth. We look at the three sectors and the ten industries.
THE PRIMARY SECTOR WAS DOWN 0.4%: (1) Mining was down 1.1%. This decline was dominated by iron ore, gold and PGMs (platinum group metals). Electricity loadshedding and logistical challenges (ports/railway) are weighing on this sector, in which real GDP reverted to 0.2% below its pre-pandemic real GDP level. Further volume expansions may be more challenging considering the aforementioned constraints. While the sector’s real GDP is close to its pre-pandemic level, it is still notably below preceding peak levels. (2) Agriculture was up 0.8%. Increased production for horticulture products was the key contributor to the expansion in the agricultural sector in Q1 2022. This was despite earlier concerns about disruptions from excessive rainfall in many areas and the impact of the Russia-Ukraine war (given the importance of Russia for select agricultural exports from SA).
THE SECONDARY SECTOR WAS UP 3.7%: (3) Manufacturing was up 4.9%. This was a very strong bounce amid quite extensive loadshedding, even if 2022 loadshedding has, more than usual, been biased towards times after typical office hours and as such should be somewhat less disruptive. Stats SA attributes the growth to the petroleum and chemicals, food and beverages, and iron ore and steel industries. By Q1 2022, this sector has recovered to just 1% below its pre-pandemic (Q1 2020) GDP level. (4) Utilities output was up 2.0%. Stats SA reported higher consumption of water as well as electricity. It is only 0.8% below its pre-pandemic (Q1 2020) level of real GDP. The sector is likely to contract in Q2 2022, given the worsening of loadshedding so far. (5) Construction was down -0.7%. Construction saw its fourth consecutive quarter of contraction, with underwhelming results reported for residential buildings and construction works. This was unexpected given anecdotal evidence of a recovery in construction activity. What has happened to government’s infrastructure program?
THE TERTIARY SECTOR WAS UP 1.8%: (6) Trade, catering and accommodation were up 3.1%, supported by a rise in economic activity in wholesale, retail, motor trade and catering and accommodation. (7) Transport and communication were up 1.8%, related in particular to land transport and communication services. (8) Finance and business services were up 1.7%. Stats SA attributed this sector’s expansion to insurance and pension funding, auxiliary activities, real estate activities and business services. (9) Personal services were up 1.1%. Stats SA noted increased economic activity for community and other producers. This is still the non-agricultural sector that has performed best since the start of the pandemic, with real (seasonally adjusted) GDP by Q1 2022 nearly 8% higher than in Q1 2020 (prior to the pandemic). (10) Government was up 1.4%: This expansion was attributed to increased employment in national government, which presumably reflects the appointment of participants in the various temporary (and often part-time) government employment programmes.
BOTTOM LINE: The net effect was a GDP growth of 1.9%. This growth is one of the reasons why our unemployment rate has dropped marginally from 35.3% in Q4 2021 to 34.5 in Q1 2022. Growth creates jobs. We forecast South Africa’s economy will grow by 2% this year, with domestic demand and household spending, rather than global demand (exports), to be the main drivers. We foresee a boost from production in the industries of domestic trade, tourism, and manufacturing, as the economy returns to normality and consumer demand picks up. At Overberg we look forward to the day when all ten industries can report strong growth. This country has so much potential.
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.
Spend some time with our team to find out which one of our portfolios is best for you.