Global Report
China contagion risk.
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Local Report
Retail sales, inflation, interest rates and a recession.
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Global and local indicators.
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Global Report
By Nick Downing
China’s economy is under considerable pressure: From a zero-Covid policy, weakening export demand for its manufactured goods, a sinking property market, geopolitical isolation and now, to make things even worse, the most severe drought in 60 years in the south-west of the country. The drought is impacting agricultural production in an area that contributes a quarter of the country’s grain output. The Yangtze is China’s longest river and in some parts its water level is at its lowest since records began in 1865. It is a source of hydro-electric power and transportation. Supply chains have once again been affected due to power rationing and transport disruptions. The drought is expected to continue for another fortnight.
The drought occurred post the latest set of economic data compiled for July. These were gloomy enough, but it means they will deteriorate even more. July’s industrial production growth slowed to 3.8% year-on-year from 3.9% the month before. Retail sales growth slowed from 3.1% to 2.7%. New home sales fell 1.67% on the year and for an 11th consecutive month on a month-on-month basis. Fixed asset investment increased in the January-July period by 5.7% on the year compared with 6.1% the month before. Youth unemployment increased over the month from 19.3% to 19.9%. Authorities have admitted that their 5.5% GDP growth target for 2022 will not be met. GDP grew in the second quarter by just 0.4% year-on-year and worse is likely to come in the second half of the year.
Beijing’s zero-Covid policy is largely to blame, pushing consumer confidence to its lowest level on record. Second quarter GDP data shows consumer spending was almost flat on the year. Export markets are also weakening as the buyers of China’s manufactured goods shift their expenditure to services. At the same time, central banks around the world are choking off demand with higher interest rates, in their quest to keep inflation under control. However, the biggest culprit is China’s property market, which seems to be going from bad to worse.
The property bust in China has been brewing for a long time. Julien Garran from MacroStrategy Partnership blames China’s excess fixed capital formation, an excessive investment in infrastructure, factories and new housing. With a slowing pace of urbanisation, and a shrinking and aging population, the need has not been there. Garran says: “Fixed capital has continued growing inexorably, causing a surge in misallocated capital that doesn’t make a return and that has become a breeding ground for bad loans. The cumulative misallocation of capital in China has now reached 175% of GDP, with around two thirds of that in residential housing.” He cites a recent report from Deutsche Bank that suggests the bad debt problem in residential mortgages could be $350 billion but by his own estimate it could be twice that amount.
The dominos are starting to fall. Purchasers of pre-sold homes that have not been completed, due to the bankruptcy of numerous property developers, are threatening to withhold their mortgage payments. The mortgage revolt has spread to more than 300 unfinished property projects across 90 cities, threatening the stability of regional banks. There are already signs of mass withdrawals from rural banks, prompting harsh measures against depositors. The People’s Bank of China is trying to shore up housing demand with a second record sized cut to the 5-year loan prime rate. The China Construction Bank has sponsored lending for unfinished housing projects but there is little incentive for solvent developers to take up the offer, as completed projects are unlikely to be profitable. Evergrande, the world’s most indebted developer, defaulted in December last year with $300 billion in liabilities. It has still not delivered a debt restructuring plan. Around a third of China’s largest developers have either defaulted or negotiated debt restructuring.
How far could China’s property market decline? According to Garran, housing accounts for 78% of all assets in China versus 35% in the US. China’s GDP is 68% of US GDP, yet its property market is valued at twice the US property market. He believes China’s tier one city property prices could fall by two thirds and they would still be as overvalued as London’s property market is today. By these measures, China’s property implosion has barely started. The parallels with Japan’s property bust are unnerving. Japan’s property market was twice the value of the entire US market in 1989 and now stands at just one third. Over the same 33-year period, Japan’s economy has delt with decades of deflation and depressed equity markets. The Nikkei index, currently at 28,794 is still below its peak of 38,274 reached in January 1990.
There might be a global impact too. China is a vital engine of global growth. To the extent that it consumes over 50% of the world’s industrial metals, any slowdown in demand will affect commodity prices and commodity exporters, although this should also help alleviate global inflationary pressures. Still, the sheer size of China’s property market and the early signs of financial contagion, heighten the risk of deflationary pressure spreading around the world and with it a greater likelihood of global recession.
Local Report
By Gielie Fourie
INTRODUCTION: South Africa’s retail sales statistics (excluding vehicles sales) for July 2022 were published last week. They came in at -2.5% Year-on-Year (YoY), much worse than market forecasts of a 0.4% rise. This was despite a slight Y-o-Y increase in money supply (M3) and private sector credit extension (PSCE) between April and June 2022. The percentages for June were 8.33% and 7.53% respectively. It was the steepest decline in retail activity since January 2021, in part reflecting the impact of higher inflation and higher interest rates on consumer spending. The combined impact of higher inflation and higher interest rates on the economy is wide-ranging. Businesses are passing on increased wholesale prices and higher financing costs to the consumer. Consumers’ purchasing power is eroded by higher prices and higher interest rates. Inflation makes each Rand less valuable. This is inflation’s primary and most pervasive effect. For consumers, inflation often outstrips their income growth – it hurts the poor disproportionately more than higher income consumers.
WHY DID RETAIL SALES DROP? Retail sales movement, Y-o-Y for the last three months were: May up 4.3%, June up 0.1% and July down 2.5%. The trend is clearly downward. Inflation readings for the same three-month period: May 6.50%, June 7.4% and the consensus for July is 7.8% – a steady upward trend. To make things worse, inflation drove interest rates higher. The prime interest rate rose to 7.75% in March, to 8.25% in May and to 9.00% in July. Retail sales are negatively correlated to both inflation and to interest rates. Any retailer will confirm – the moment prices go up, sales drop in tandem.
THE THREE LARGEST CONTRIBUTORS TO THE DROP IN SALES: The largest contributor to the drop in sales were retailers in the category of hardware, paint, and glass (-8.6% Y-o-Y). The second largest contributor (-5.7% Y-o-Y) was the category of general dealers, where the bulk of food and grocery retail is found. The third largest contributor was the category of retailers in pharmaceuticals and medical goods, cosmetics, and toiletries (-4.3% Y-o-Y). Consumers can, and do, postpone expenditure on non-essential goods like hardware and clothing, therefore these sales tend to be cyclical. Purchases of essentials like food and medicine cannot be postponed, so sales are typically non-cyclical.
MODERATE INFLATION IS ACCEPTABLE. HIGH INFLATION IS UNACCEPTABLE: The average rate of inflation in the US between 1914 and 2022 has been 3.27%. Consumers and businesses have accepted moderate inflation as an unpleasant fact of life. But high inflation, like the 7.4% we are seeing in South Africa right now, is economically disruptive. It tends to impair the economy’s long-term performance. Lower-income consumers normally spend a higher proportion of their income on necessities than consumers with higher incomes. Poor people have far less of a cushion – mostly no cushion at all – to protect them against the loss of their money’s purchasing power. Economists often focus on “core” inflation, which excludes the prices of food and energy. Lower-income wage earners spend a relatively sizeable proportion of their income on food and energy (electricity and fuel), which are hard to substitute, or go without. The poor are less likely to own property or have savings, which have traditionally served as an inflation hedge for higher income consumers. South Africa’s social security grants (SASSA) for the poor are not inflation protected. Inflation is harsh on poor people.
EFFECT ON SHOPPING CENTRES: John Loos, property sector strategist at FNB, said: “Larger regional centres may ultimately be at a relative disadvantage compared to many (smaller) neighbourhood and convenience centres, because they (larger centres) often have a greater focus on clothing, footwear, fashion, entertainment, household furniture and appliances, all of which can be quite cyclical and experience pressure in tougher times.”
EFFECT ON RETAILERS: Retailers of essentials, like food and medicine, are to a degree sheltered from the negative effect on sales caused by inflation. Their sales tend to be non-cyclical. Retailers in the food market segment include Pick n Pay, Shoprite, Spar, and in the medical goods, cosmetics, and toiletries segment, Clicks and Dis-Chem (which we hold). Retailers selling hardware, clothes and luxuries are less protected against rising inflation. These products are not essential, and consumers can postpone purchases – sales tend to be cyclical. Companies in these two market segments (hardware and clothing) are Cashbuild, Italtile (which we hold), Foschini, Truworths, Woolworths, Rex Trueform, and Pepkor.
RECESSION: South Africa’s household wealth decreased by R1.23 trillion in the second quarter of 2022 after a fall in financial asset values. (Momentum Unisa household wealth index). Momentum economist, Johann van Tonder says this will contribute to slower growth in household consumption expenditure, which in turn should adversely affect economic growth. It raises fears of an economic recession amongst consumers, van Tonder says. Are we heading towards a recession? US billionaire Howard Marks, CEO of Oaktree Capital says: “Since 1920 there have been seventeen recessions, one Great Depression, and one World War. The S&P 500 has returned about 10.5% per year over that century-plus. When asked whether we are heading towards a recession, my usual answer is that whenever we are not in a recession, we are heading towards one. It is time (in the market), not timing, which leads to real wealth accumulation.”
BOTTOM LINE: In an economic environment of rising inflation and rising interest rates, we expect the stock market to move lower. The recent market rally may have been a bear market rally – a temporary increase in the stock market. We do not think we have reached the bottom yet. Our strategy is to keep a bit more cash than usual in our portfolios. We will phase this tactical cash into the markets when we have more clarity about the direction of the economy and the markets. Do not try to do this at home. Rather contact one of our highly qualified consultants for advice.
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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.
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