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Weekly Market Report
Tuesday 21 June 2022
US inflation shock.
SA high unemployment figures.
Global and local indicators.
By Nick Downing
According to consensus opinion, US inflation had already passed its peak. This was not to be. After easing in April, US consumer price inflation (CPI) surged to an annual pace of 8.6%. Worse still, on a month-on-month basis CPI gained by a whole 1.0%. Core CPI, excluding food and energy prices, eased from 6.4% to 6.0% y/y but the m/m gain was 0.6%, its fastest pace this year. There are signs that inflation is broadening beyond its usual culprits, which means it’s more likely to remain sticky. Inflation expectations, which contribute to wage demands, have also increased. The University of Michigan June consumer survey shows US households expect long-term inflation to settle at 3.3%, up from 3.0% the previous month.
The inflation data ignited a sharp drop in financial markets. The US S&P 500 index suffered its worst weekly decline since March 2020, falling by 5.8%. The US 10-year Treasury bond yield, the de facto global risk-free rate, jumped from 3.05% to 3.40%. The surge in the global risk-free rate cast a pall over all financial assets, with valuations undermined by the higher discount factor. The Bitcoin US dollar price collapsed by almost 30% over the week.
As inflation rates surge to their highest since the early 1980s, central banks around the world are launching their most aggressive monetary tightening in decades. The Federal Reserve, which had been expected to lift the fed funds rate by 50 basis points, ended up hiking by 75bps to a range of 1.50-1.75%, its biggest rate hike since 1994. Moreover, the Fed lifted its interest rate projection substantially compared to its March forecast. The Fed’s “dot plot” now expects the fed funds rate to reach 3.4% by year-end up from its earlier forecast of 1.9%, rising to 3.8% in 2023 compared to the previous forecast of 2.8%.
The Fed is not alone. At its June meeting, the ECB announced a 25bps rate hike, warning of a potentially larger hike in September. Markets are now pricing-in close to 150bps in hikes by year-end. Meanwhile the 10-year German sovereign bond yield has surged to over 1.7% from -0.4% as recently as December. In the same week as the Fed’s policy meeting, the Bank of England lifted its benchmark rate by another 25bps, its 5th successive hike despite data showing an economic contraction in the month of April. Last Thursday, the Swiss National Bank surprised markets with its first interest rate increase since 2007. The SNB, which normally battles deflation rather than inflation, announced a 50bps increase to help contain the highest inflation in 14 years.
The most aggressive monetary tightening in decades is increasing the risk of recession. Economists surveyed by the Wall Street Journal have noticeably lifted the probability of recession. They now put the probability of a US recession in the next 12 months at 44%. This is up from a 28% probability in April and an 18% probability in January. Survey respondents cite persistently elevated inflation, surging interest rates, supply chain problems, commodity price shocks and plummeting share prices, all conspiring to erode household and business confidence. Yet, economists still expect US GDP to grow by 1.3% in 2022, albeit down from 2.6% in the April survey.
Other economists are more optimistic. US Treasury secretary Janet Yellen conceded that economic growth will slow but said at the weekend that “most consumers, even lower-income households, continue to have buffer stocks of savings that will enable them to maintain spending…. I don’t think a recession is at all inevitable.”
Aggressive tightening is starting from a point of extremely low interest rates both in nominal terms and in real terms (after adjusting for inflation). Some economists believe that even if the Fed lifts the fed funds rate to 3.8%, this will not be much higher than the “neutral rate”. The neutral rate is that which neither restricts nor promotes growth.
Financial markets are likely to bottom out and resume their long-term upward trajectory when the Fed and other central banks signal that they are close to the end of their tightening cycles. Fed chair Jerome Powell said policy makers would look for “compelling evidence of inflationary pressures easing”, which would entail a “series” of monthly declines, since month to month changes can be highly unpredictable and volatile. This suggests the fourth quarter is the earliest that the Fed might turn less hawkish. The good news is that this is not long to wait. It is good news that the Fed and other central banks are “front loading” their policy tightening. It is better to take a plaster off swiftly than in small incremental steps. Ahead of the Fed’s policy meeting, American investor Bill Ackman, the founder and CEO of Pershing Square was agitating for a 100bps rate hike, so that the Fed could get to neutral ground as quickly as possible. He would have been pleased that the Fed hiked by 75bps rather than 50bps, as had been expected.
By Carel La Cock
South Africa celebrated youth day last Thursday and as politicians were running around the country addressing crowds at various rallies, finding a solution to youth unemployment was a common theme. Unemployment figures released in May paints a grim picture for work seekers and an even bleaker future for our youth. The official statistics, which many agree underreports the true magnitude of the problem, showed that nearly 64% of people aged between 15-24 were unemployed while that figure stood at 42% for the 25-34 age group. The official national unemployment rate stands at 34.5% while the expanded definition which include discouraged work seekers is an eyewatering 45.5%, one of the highest in the world.
The Organisation for Economic Co-operation and Development released their Education at a Glace report at the end of last year which contained some insightful statistics. It found that attaining a tertiary education in OECD member countries, of which South Africa is not a member but a partner country, remains a significant advantage compared to those who haven’t. Tertiary educated workers in full-time employment have an earnings advantage of 57%. On average 68% of tertiary educated workers earned more than the median of all workers and on average 24% earned more than double the median. In OECD countries more comparable to South Africa the share of workers earning more than double the median is over 50%. Although the study did not include South Africa specifically there are some universal truths to take from the report.
There are more than 10 million South Africans in the 15–24-year age group, of which a staggering 7.7 million or 75% were outside of the labour force. The chief reason for this was discouragement, meaning that those youths have lost all hope of finding a job in their area or field of interest. More than a third were regarded as not in employment, education or training (NEET). Given that nearly half of the working population of 40 million are in the age group of 15-34, it is imperative for future economic growth that our youth are properly trained. For many learners living in remote areas, schools do not provide quality education and many leave school before completion. This fact flatters the national matric pass rate of 76.4% achieved in 2021, which excludes learners who drop out of the system early. The true pass rate according to the Democratic Alliance is more in the region of 50%.
Spending on education therefore is an investment in future growth. The government spends around 5% of GDP or 21% of the non-interest allocation which is above the OECD average. It is at the top of the spending list. Basic education receives nearly R300bn while secondary and higher education comes in at R132bn. However, spending more doesn’t guarantee better results as can be seen by our youth unemployment rate. Although a large portion of learners rely on government grants for higher education at colleges and universities, many students must foot the bills themselves. Flexible and more affordable distance and online learning have become more popular in the last decade as access to the internet and internet speeds have improved markedly. This process was further accelerated during the covid-19 lockdowns and even school learners were educated using online methods.
As education moves further online, established distance learning institutions stand to benefit and will be able to upscale at a much faster pace to keep up with demand. Stadio, the higher education institution, that “offer higher education specially designed to meet industry requirements and to accommodate our students’ diverse lifestyles” are well placed to address the short coming in tertiary education. It has decades of experience through its successful acquisitions of established registered higher education institutions such as Southern Business School Proprietary Limited (SBS), The South African School of Motion Picture Medium and Live Performance Proprietary Limited (AFDA), MBS Education Investments (Pty) Ltd (Milpark), Lisof (Pty) Ltd (Lisof) and Prestige Academy (Pty) Ltd (Prestige Academy). Together with Embury it owns six prestigious higher education institutes and are continually looking to expand their offering. Our clients have held Stadio in their portfolios since the unbundling from Curro and although it has been a rocky ride, it is a share that can’t be overlooked and one that offers incredible value. Speak to one of our highly qualified consultants to find out how you can own a piece of South Africa’s tertiary education growth.
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.