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Weekly Market Report
Tuesday 2 August 2022
Markets surge on expectations of a Fed pivot.
South African banks are an attractive investment.
Global and local indicators.
By Nick Downing
Financial markets surged in July. The US S&P 500 index gained 9.1% over the month, its biggest monthly increase since November 2020. The Nasdaq rocketed by 12.3% its sharpest increase since April 2020 when the Federal Reserve launched its pandemic relief stimulus. Markets around the world rallied, driving the MSCI All World index to a monthly gain of 7.9%. Sovereign bond yields continued to drop from their recent highs. The US 10-year Treasury yield moved from 2.97% to 2.64% over the month. Earnings results were slightly better than expected, which helped market sentiment. However, the primary cause for investor euphoria was a perception that the peak in inflation and the peak in interest rates is in sight. There is a sense that with central banks front-loading their interest rate hikes, they are at their peak level of hawkishness. There is sense that things can only get better from here.
The Fed’s decision last week to hike the fed funds rate by 75 basis points had been fully discounted. This marks the second consecutive 75 basis point hike, following a 50 bp hike in May and a 25 bp hike in March. Over just four months the fed funds rate has moved from 0-0.25% to 2.25-2.5%. Fed chair Jay Powell soothed market concerns by suggesting the pace of policy tightening may slow. At the policy press conference he said, “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” Fed funds futures, which in mid-June were discounting a fed funds rate of 3.9% by the end of the year are now discounting a year-end rate of just 3.25%. This means the market expects the fed funds rate only has another 75 basis points to go.
Inflation is at its highest in over 40 years, in the US and other developed economies, but the market expects it to decline from current levels. Inflation will cool down in response to a plateauing in oil prices, and a significant decline across metals prices. Meanwhile, in response to weaker consumer demand, retailers have started heavily discounting prices to clear their built-up inventories. The market is buying into the idea that inflation will indeed, after all, be transitory. The Fed has two months before its next policy meeting in September, by which time inflation may have fallen back, affording a return to 25 bp rate hikes.
The market may be becoming too complacent. In the same policy statement last week, Powell made hawkish as well as dovish comments. He said the Fed “wouldn’t hesitate” to implement a bigger rate hike if necessary and that at the September meeting “another unusually large increase could be appropriate.” The market chose to ignore these more cautionary announcements. The latest inflation data, released the day after the Fed’s rate hike, continued to exceed forecasts. Both the employment cost index (ECI) and the personal consumption expenditures index (PCE), the Fed’s most closely watched inflation numbers, were higher than expected. The ECI, widely viewed by policymakers as one of the best predictors of core inflation, accelerated in the second quarter to 5.1% year-on-year up from 4.5% in Q1. The headline PCE index gained in June by 1.0% month-on-month up from 0.6% in May, lifting the year-on-year rate from 6.3% to 6.8%. Core PCE, excluding food and energy prices, increased in June by 0.6% on the month, up from 0.3% in May. The market may be too optimistic in its current prevailing view that high inflation is transitory and that central banks are close to doing enough to bring it back down to target.
Over the past 35 years, starting with the 1987 stock market crash, developed economy central banks, led by the Fed, have capitulated in their monetary tightening at the first sign of trouble in asset markets. Investors have successfully bet on what is termed the “Fed put”, by buying the market dip in the expectation that monetary policy will come to the rescue. This policy pattern has been enabled by a decades-long low inflation regime. Unfortunately, the world may be moving into a high inflation regime, characterised by a broadening in inflationary pressures. In a high inflation regime, inflationary pressures are no longer transitory as they are in a low inflation regime. They become entrenched and the main focal point of consumers and businesses, above all else, becomes inflation. It is difficult to predict with certainty how the Fed will respond, as there has been no precedent of high inflation for such a long time, not since the 1970s, but it is probably safe to say that the days of the Fed put are over. The Fed will not blink this time around if the economy falls into recession or markets collapse. The central bank will continue tightening policy until inflation shows clear signs that it is returning to target. In the US this means an average rate of 2%.
US GDP fell in Q2 by 0.9% quarter-on-quarter annualised, following on from its 1.6% decline in Q2. The key culprits in Q2 were weakness in residential investment, business spending and inventory stocking. Inventory drawdowns subtracted a whole two percentage points from GDP. Even domestic sales, which exclude trade and inventories due to their volatility, declined in Q2 by 0.3% annualised. Two consecutive quarters of economic contraction meet the technical definition of a recession, further igniting the market’s appetite for the Fed put trade. However, the market may be disappointed. It is not uncommon for bear markets to experience sharp counter-trend rallies, like the one experienced in July.
Powell will be more alerted to the risk of a high-inflation regime than the risk of recession. Recessions are fairly common events. There have been 12 US recessions since 1948, but only one high-inflation regime. The main purpose of central banks is to avoid the return of a high inflation regime. Price stability is the overriding priority and the bedrock of sustainable growth. Powell has repeatedly stated a greater concern about stamping out high inflation than tipping the economy into recession due to excessive interest rate hikes. The managers of Ruffer Investment Company Limited made a startling observation, that previously, downside risk was limited by the Fed put. A market decline of 20% would prompt monetary policy easing. In today’s high inflation environment, the reverse is true. The need to keep a cap on inflation means that upside risk is limited, with market gains capped by the ensuing spectre of higher inflation and tighter policy.
By Gielie Fourie
INTRODUCTION: The banking sector is vital to the world economy. Because they are vital to the economy, banks are well regulated, and are generally regarded as safe investments. Warren Buffett loves banks. He believes a bank’s business model is relatively straightforward and can be extremely lucrative if managed well. “If you can just stay away from following the fads, and from really making a lot of bad loans, banking has been a remarkably good business in America”, he said in 2013. Although Buffett has lightened his investment in banks, he still keeps around 25% (or $83 billion) of Berkshire Hathaway’s funds invested in banks. So far this year Buffett has been actively buying banks again.
SOUTH AFRICA: South Africa’s banks are well regulated and well capitalised. During the Great Financial Crisis of 2008 our banks survived without requiring government bailouts. Central banks around the world, including the Bank of England, the Bank of Canada, the US Federal Reserve Bank, and the Swiss National Bank, are responding to inflationary pressures by raising interest rates. The SA Reserve Bank has followed the example of other central banks and hiked interest rates by 50 basis points on 19 May 2022, followed by another 75 basis points on 12 July 2022.
As we enter a period of high inflation, followed by higher interest rates, our banks have strong balance sheets. In a scenario of high inflation and rising interest rates banks will make bigger profits. Our banking system is world-class and remains in good health. Our banks offer good value for investors. Our six biggest banks have a combined market capitalisation of more than one trillion Rand. We look at our six biggest banks.
1. FIRSTRAND: We have bought FirstRand (FSR) for our clients. FSR is the parent company of FNB. With a market capitalisation of R367 billion it is South Africa’s biggest bank. It is also the highest-ranked banking brand in the Africa edition of Brand Finance’s Most Valuable Brands survey. FSR’s share price is up 20.5% over the last year. It has a forward PE ratio of 10.81 and a dividend yield of 4.73%. The consensus view amongst analysts is that FSR is a buy or a hold.
2. STANDARD BANK: Standard Bank (SBK) is South Africa’s second largest bank with a market capitalisation of R268 billion and Africa’s largest lender by assets. The industrial and Commercial Bank of China (ICBC) holds 20.1% of SBK’s shares. SBK’s share price is up 30% over the last year. It has a forward PE ratio of 8.16 and a dividend yield of 5.44%. The consensus view amongst analysts is that SBK is a buy.
3. CAPITEC: Capitec is our third largest bank with a market capitalisation of R231 billion. It’s share price is up 26% over the last year. Capitec has a PE ratio of 27.29, and a dividend yield of 1.83%. The consensus view amongst analysts is that Capitec is a hold.
4. ABSA: Absa is South Africa’s fourth largest bank with a market capitalisation of R144 billion. Its share price is up 26% over the last year. Absa has a forward PE ratio of 6.82 and a dividend yield of 4.62%. Using these metrics, of the six major banks, Absa poses the best value. The consensus view amongst analysts is that Absa is a buy.
5. NEDBANK: With a market capitalisation of R110 billion, Nedbank (NED) is South Africa’s fifth largest bank. NED’s share price is up 29% over the last year. NED has a forward PE Ratio of 7.63 and a dividend yield of 5.49%. NED offers good value. The consensus view amongst analysts is that NED is a buy.
6. INVESTEC: Investec PLC is our preferred bank. It has a market capitalisation of R61 billion. We have bought Investec for our clients’ portfolios. Investec’s balance sheet is healthy. Over the last year Investec PLC’s share price is up 63%, more than any other local bank. Investec has a forward PE ratio of 7.33 and a dividend yield of 5.03%. The consensus view amongst analysts is that Investec is a buy.
BOTTOM LINE: South Africa’s highly rated banking analyst, Kokkie Kooyman, says SA consumers’ debt levels have risen sharply recently and that would make banks more cautious to grow this segment of their loan books. “The immediate outlook for loan growth isn’t great,” he says, though he concedes that President Cyril Ramaphosa’s power crisis plan may be an impetus for corporate lending. Kooyman says that given the economic climate, Absa and Nedbank are relatively cheaply valued compared to their history. Like Warren Buffett, we also love banks. If you want to invest, please contact one of our highly qualified consultants.
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.