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Weekly Market Report
Tuesday 7 June 2022
Market bottom is in sight.
Infrastructure in South Africa.
Global and local indicators.
By Nick Downing
Bear market rallies lend optimism on the slippery slope of hope. The rallies are amplified by low trade volumes. There has been a powerful rally in global equity markets over the past fortnight. The S&P 500 index has gained by 7%. The reasons given: Inflation has passed its peak, economic activity is holding up, China’s lockdowns are over and the war in Europe does not seem to be escalating. It is common for bear markets to pause. No markets go in a straight line.
The million-dollar question: Have markets already hit the bottom? This depends on whether economies enter recession. Markets are still priced for earnings growth, albeit subdued. Whether we enter recession, in turn depends on inflation and central bank policy. If inflation comes down of its own accord due to slowing economic activity, central banks will be able to scale back interest rate expectations. Unfortunately, supply chain disruptions emanating from China and the war’s impact on energy and food prices will keep inflation elevated regardless of economic activity levels.
There is already division among central bank policy makers. The hawks are determined to bring inflation back down to 2% target levels, regardless of what damage this wreaks on economic activity. The doves are keen to pause once benchmark rates approach the neutral level, which neither slows nor accelerates growth. In the US, this would mean pausing in September after the fed funds rate has been lifted by a further 100 basis points to 2%. The Fed estimates the neutral rate is around 2.75%. Some economists believe it is closer to 3.5%.
Central banks will be especially keen in this economic cycle to avoid recession. They will err on the dovish side, preferring to live, for a period at least, with elevated inflation rather than recession. After rescuing economies from the Covid pandemic, policy tools for combatting recession have been depleted, whereas measures available for combatting inflation are limitless. It is likely that central banks will claim victory if inflation drops from 8% to 5%. Some economists have suggested the Fed may even lift its Average Inflation Target from 2% to 3%. The world’s major central banks would likely follow suit.
Inflation may remain undefeated, in the strict sense based on central bank targets. However, recessions are likely to be avoided and monetary policy will continue to remain accommodative. Therefore, global equity markets are likely much closer to the bottom than the top. We are probably more than two-thirds of the way through the bear market. It is time to prepare one’s shopping list so that shares can be purchased without hesitation at lower levels.
How will we recognise the market bottom? Investors point to signs of capitulation such as heightened volatility readings or contrarian indicators like excessive investor pessimism. The catalyst for a market bottom will probably occur once central banks signal an end to monetary tightening. Developed Western economies are not at that point yet. The Fed still needs to hit full speed with its quantitative tightening policy, which will erase $100 billion per month from financial markets. Share prices and equity markets are likely to falter but at least the market bottom is in sight. It is unlikely that recessions will need to be priced in.
Equity market valuations are already becoming attractive again. The estimated forward price-earnings multiple of the MSCI All Country World Index has dropped to 15x from 18x at the end of last year and a peak of 20x in 2020. A cheaper entry level means that 10-year prospective returns are greatly improved, and long-term investment risks considerably diminished. Independent research firm, Capital Economics, projected on 31st May, that global equities would decline a further 3.7% by year-end, a modest decline compared to what we have endured so far, and set up for annualised returns of 10.8% in both 2023 and 2024.
By Gielie Fourie
INTRODUCTION: Infrastructure development is the construction of basic foundational services in order to stimulate economic growth and quality of life improvement. Most advanced economies have gone through periods of intensive infrastructure building. Infrastructure improves the efficiency and competitiveness of countries. It is an important job creator.
TRANSPORT INFRASTRUCTURE: Ironically, you need existing infrastructure to develop new infrastructure. To build infrastructure projects you need transport in its broadest sense, which includes roads, railways, running water supply and reliable electricity supply. You cannot start new projects without it. Unfortunately, South Africa’s transport system is in such a bad state of repair that it is challenging and costly to build new infrastructure. “There can be no doubt that the transportation sector is the most critical sector of our economy”, Robert Brady, a US politician, once remarked. Railways are by far the cheapest way to transport people and freight. In this report we focus on the decline of our railways and exciting plans for their revival.
RAILWAYS – A TRAIN WRECK: Unfortunately, Transnet is one of the most neglected government services. Our mines are the biggest clients of Transnet Freight. Transnet’s annual report shows that mining’s contribution to freight constitutes 50% of Transnet Freight’s income. For the mines, Transnet is even more important than electricity. When Transnet’s services fail to deliver it has double the financial impact of an electricity crisis. During a commodities boom, when mining exports rocket, SA cannot afford to have its rail industry misfiring. The cost to the economy is huge. Transnet’s CEO, Portia Derby, (wife of Brian Molefe, previous Transnet CEO, and Saxonwold Shebeen regular) pointed out that stealing of overhead traction cables causes big disruptions. But these are external issues. Internal inefficiencies at Transnet are far worse.
RAILWAYS WHITE PAPER: A Rail Policy White Paper was approved by cabinet in March 2022, paving the way for further engagements with industry players. Government says it hopes to revive the country’s rail sector through private partnerships, which will overhaul ownership and participation patterns. On Thursday last week, 2nd June, the minister responsible for Railways, Fikile Mbalula, and the minister of Public Enterprises, minister Pravin Gordhan, launched the new national rail policy in Johannesburg.
FIKILE MBALULA. Mbalula said in an address to dozens of transport business leaders and government officials, that the country’s new rail policy will open up the industry to other players and examine structural reforms to bring about competitiveness. The policy document lists the challenges faced by rail over the years leading to its low market share of less than 20% for freight, and less than 10% for passengers. ”The policy addresses passenger rail capacity challenges, where ‘concessioning’ is introduced on other lines other than those run by PRASA (Passenger Rail Agency of South Africa) – where private sector players can operate their services. The white paper presents a multi-decade plan of how the railway sector will evolve over time,” Mbalula said.
PRAVIN GORDHAN: Gordhan reiterated the need for the transformation of the sector, saying the high level of concentration in the economy in a few hands is a challenge. “We’re going to require a lot of dialogue, a lot of exchange, maybe some arm wrestling as well, in order to come up with more creative ways in which there’s a greater diversity of participation and effective operational roles for people who have traditionally been excluded from these areas of the economy itself,” Gordhan said.
CONCLUSION: “We should not be waiting until trains derail, bridges collapse and people die to adequately fund our transportation infrastructure”, Elizabeth Esty, US politician. This is an exciting initiative. Unfortunately, Mbalula does not have a good “track” record. How can you share in infrastructure growth? You can either invest in builders of infrastructure projects, or in product suppliers. Examples are builders like Raubex and WBHO or suppliers like PPC, Italtile, Cashbuild or even Trellidor. Our clients own Raubex and Italtile. Contact one of our highly qualified consultants for a free consultation.
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.