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Weekly Market Report
Tuesday 19 July 2022
Quarterly market review and outlook.
Favoured shares in inflationary and recessionary times.
Global and local indicators.
By Nick Downing
Inflation continues to menace global financial markets. Inflation thrives on a diet of war, disease, and famine. With one or two exceptions, including the Bank of Japan (BOJ) and the People’s Bank of China (PBOC), central banks around the world have become aggressively more hawkish in their monetary policy. Rising inflation and rising interest rates have caused government bond yields to surge, impacting the valuation of financial assets. At the same time, rising interest rates combined with higher inflation, which affects business and consumer confidence, have impacted economic growth forecasts and the outlook for company earnings.
Most equity markets are now suffering double digit year-to-date (YTD) losses. The S&P 500 index, representing the US, the world’s biggest market, fell 16.45% in the second quarter (Q2) taking its YTD loss to 20.58%. The German Dax fell 11.31% in Q2 and 19.52% YTD. Far East markets were surprisingly more robust, helped by the cheaper valuations on offer. The Nikkei lost 5.13% in Q2 and 8.33% YTD, while the Shanghai and Shenzhen CSI 300 index went against the grain with a 6.21% increase in Q2, reducing its YTD loss to 9.22%. China’s market benefitted from an easing in Covid restrictions and a boost in stimulus measures. As a result, the MSCI Emerging Market index outperformed the MSCI World index. The former lost 12.36% in Q2 and 18.78% YTD, while the latter lost 16.60% and 21.21% over the respective periods. The UK’s FTSE 100 index was a positive outlier, helped by the heavy weighting of oil and commodity stocks, mitigating its Q2 and YTD losses to a less severe 4.61% and 2.91%. Against rising inflation and interest rate expectations, the US 10-year Treasury bond yield maintained its sharp climb, lifting in Q2 from 2.33% to 2.97%, compared with 1.51% at the start of the year. Rising US interest rates and retreating risk appetite caused the US dollar index to gain by a further 7.05% in Q2, lifting its YTD gain to 9.48%. A strengthening dollar saps liquidity from the global economy. A rising oil price has a similar negative impact. The Brent oil price increased a further 6.39% in Q2, capping a 47.61% YTD surge.
So far, no country has entered recession and while economic growth will inevitably slow, economies are by and large expected to maintain growth despite the threats of higher inflation and interest rates. However, in its twice-yearly Global Economic Prospects report, published in June, the World Bank lowered its global growth forecast to 2.9% for 2022 and 3.0% for 2023. This contrasts with growth of 5.7% in 2021. The World Bank warned that higher than expected rises in interest rates and energy prices and a continuation of Covid-19 would cut global growth even more to 2.1% this year and just 1.5% in 2023. The three main economic blocks, the US, Eurozone and China face different challenges and outlooks. The slowdown in the US is likely to be relatively mild compared with the Eurozone, which has to contend with its proximity to the war in Ukraine, a full embargo on Russian oil and gas imports, and banking exposure to Russia. China is affected by strict Covid restrictions, a property slump and fading demand for its goods exports. Authorities are trying to reignite growth, but stimulus is mild compared to previous cycles.
The OECD, in its latest economic report published in June, forecasts inflation to average 8.5% across OECD countries in 2022 and 6% in 2023 and noted that price pressures were broadening. In the US, after easing in April consumer price inflation (CPI) shocked markets with a jump from 8.3% year-on-year to 8.6%, despite easing supply chains and demand rotation from goods towards services. Month-on-month, inflation gained in May by a sizeable 1.0%. The inflation shock prompted the Federal Reserve to hike the fed funds rate by a whole 75 basis points, the largest increase since 1994. The Fed signalled that the rate could rise from its new range of 1.50-1.75% to well above 3% by year-end. In Europe, markets are now pricing in 150 basis points of rate hikes by year-end and the Swiss central bank surprised markets with its first interest rate hike since 2007. The Bank of England lifted its benchmark rate for a fifth successive time to 1.25%, while warning that UK inflation would climb above 11% by year-end. By contrast the PBOC and BOJ continue easing monetary conditions, but these policies are causing turmoil in foreign exchange markets, placing the yuan and yen under significant downward pressure.
Considering rising cost pressures and slowing growth, earnings forecasts may still be too optimistic. Margin erosion will lead to further downgrades to earnings forecasts. Nonetheless, equity market valuations have already become attractive. The valuation excesses of the past two years have been erased and with the exception of the US and Switzerland, equity markets are now cheaper than they were prior to the Covid pandemic. Even in the US, the estimated forward price-earnings (PE) multiple is below its long-term average, although by other measures, such as the Shiller cyclically adjusted PE ratio, price-to-book and Enterprise value/EBITDA ratio, its equity market is still overvalued from a historical perspective. However, across Europe, Japan, China and emerging markets, valuations are well below long-term averages with respect to PE and price-to-book multiples.
Valuations may become even cheaper. The world is in a bear market and valuations tend to overshoot on the downside just as they tend to overshoot on the upside in bull markets. There is cause for further market declines. The oil price is expected to remain at elevated levels and possibly rise even further due to the embargo on Russian imports, the accumulated effect of years of underinvestment in new oil production and existing infrastructure, and the severe resource depletion of US shale reserves. In order to reach previous peaks, in real terms, the Brent oil price would need to rise by another 50% from current levels. In this context, the price target of $175, which some analysts have forecast, does not seem so farfetched. Meanwhile, central banks still have some way to go in hiking interest rates and the Federal Reserve, ECB and BOE will be accelerating the withdrawal of liquidity from financial markets through “quantitative tightening.” Through its monthly sales of Treasury bonds and Mortgage-backed securities, the Fed expects to reduce its balance sheet by a further $1-2 trillion over coming months. This will place further upward pressure on bond yields. US Treasury bond yields have traditionally been anchored by German bund yields and Japanese government bond yields, but these bond yields are also spiking higher. The 10-year German bund, which was yielding -0.50% as recently as August last year, turned positive in January and now yields 1.65%.
Markets are unlikely to hit bottom until bond yields have peaked or central banks signal that they are close to ending their monetary tightening. However, this may only be a matter of months away. Most analysts predict the Fed will be close to its neutral policy rate by the end of the year. Some independent research companies have already turned bullish on the markets, recommending an overweight exposure to global equities. In the US, “insider buying” by corporate executives registered its strongest levels at the end of May since the market bottom in March 2020 when the Covid pandemic struck. Strong insider buying tends to be a good indicator of market bottoms. Famed investor, Warren Buffet has significantly picked up his buying activity, taking heed of his own advice, to be “greedy when others are fearful.” At the other end of the spectrum, some analysts predict a further 10-15% decline in financial markets due mainly to the untested consequences of quantitative tightening, but even they concur that the market bottom will likely occur by early 2023, when monetary policy turns from being restrictive back to being accommodative.
By Gielie Fourie
INTRODUCTION: At Overberg Asset Management we have a long-term investment horizon – we play the long game. We first do a top-down analysis of the market to determine which sectors will outperform. Then we do an analysis of the best companies in the sector – a bottom-up approach. In the current economic cycle, we expect energy (oil), emerging markets and banks to outperform the market.
RESEARCH: Wells Fargo, a US bank, looked at 15 major asset classes and calculated which ones did the best and worst during inflationary periods since 2000. Its research shows that the two best asset classes to hold during times of high inflation are Oil and Emerging Market Stocks.
Banks could be another type of stock to buy during times of high inflation, as an unexpected spike in prices introduces the possibility of an interest rate hike by central banks. Bank lending margins increase in line with rising interest rates. In 2022, the policy tightening cycle has already started, with central banks around the world, including the Bank of England, the US Federal Reserve Bank and the Swiss National Bank, responding to inflationary pressures by raising interest rates and tapering bond buying programmes. We look at investments in Energy and Oil, Emerging Markets, and Banks.
ENERGY AND OIL – SASOL: Sasol is a global chemicals and energy company. Recent macro events, like the Russian/Ukraine war have had a negative effect on Russia’s supply of oil. The EU ban on Russian oil imports has applied further upward pressure to the oil price. Furthermore, 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. The oil supply shock has been brewing for a long time. The price of oil doubled from $60.00 to $120.00 per barrel. Analysts’ oil price forecasts differ wildly. Some analysts forecast a price of $170 and upwards, which could tip the world into a recession. JP Morgan analysts warn global oil prices could reach a “stratospheric” $380 per barrel. Should the oil price increase to $170.00 per barrel, Sasol’s share price could increase by 50%. Sasol’s investment case has de-risked considerably. A higher oil price and a weaker rand will be supportive. Sasol’s biggest risk in our view is the June – November Caribbean hurricane season. Sasol still appears to offer reasonable value on a forward PE ratio of 7.1 times and a forward dividend yield of 4.5%.
EMERGING MARKETS – MTN: The bulk of MTN’s income is generated in emerging markets, mainly Nigeria. MTN is the biggest mobile phone service provider in Nigeria. MTN is listed on the Stock Exchanges in Nigeria, Ghana, Rwanda, and Uganda. MTN has recently obtained a FinTech licence in Nigeria to launch its Mobile Money (MoMo) service. The future of telecoms lies in selling data, rather than cell phone time (voice), and entering the lucrative FinTech business. MTN’s growth in both Data and existing FinTech business last year was 35%. It will use its massive footprint in Nigeria to roll out FinTech across Nigeria, even to the most remote areas. MTN has R25 billion net debt on the balance sheet. This is covered by fixed assets valued at R200 billion. MTN is highly rated. Rating agency S&P has given MTN an investment grade rating. MTN has received the most positive feedback from consumers for its response to queries during the Covid-19 crisis, according to a new study by research firm Brandseye. MTN grew into the largest telecoms company in Africa and by far the most valuable African brand in Africa with a brand value of $2.7 billion. We believe MTN is a leader in the telecoms industry and has potential for strong growth. MTN has a forward PE ratio of 11 and a dividend yield of 2.1%
BANKS – FIRSTRAND: FirstRand (FSR) is our preferred bank share. FSR is a market-leading financial services group. It is the highest-ranked banking brand in the Africa edition of Brand Finance’s Most Valuable Brands survey. As a 183-year-old business, FSR has stayed true to its legacy of being a trusted bank and partner to its retail and commercial customers, as well as its unwavering commitment to helping society. FSR has historically under-promised and over-delivered. FSR has a forward PE ratio of 10.5 and a dividend yield of 4.9%.
BOTTOM LINE: We are invested in Sasol, MTN and FirstRand as hedges against inflation and the risk of a recession. Inflation could be transitory (short term) or structural (long term). Whichever form it takes, we have protected our portfolios against inflation and the risk of a recession. If you need any investment advice, please contact one of our highly qualified consultants to assist you.
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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.
Spend some time with our team to find out which one of our portfolios is best for you.