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Weekly Market Report
11 October 2022
The anatomy of a bear market: earnings next.
Global and local indicators.
By Nick Downing
Global equity markets are fixated on the Federal Reserve “pivot.” Investors appear glued to every detail of every speech delivered by Fed Chair Jay Powell and members of his policy committee, the Federal Open Market Committee. Interest rates are important, they affect economic activity and they set the discount rate used to price company earnings, but where would we be without earnings. Earnings are even more important than interest rates and monetary policy. They ultimately drive dividends and share prices. Markets go through cycles of falling and rising interest rates but over time they keep rising in line with earnings growth.
The third quarter (Q3) earnings season has kicked off in the US. There have been some high-profile earnings misses and profit warnings, including Advanced Micro Devices, FedEx Corp, Nike, and CarMax. In 2020 and 2021, there was a global shortage of semiconductors, logistics capacity, trainers, and vehicles, amid a fiscally driven surge in demand. Demand is now easing rapidly as inflation cuts into household disposable income and companies are battling to pass higher costs onto their customers. Revenues are slowing and profit margins are shrinking.
Analysts have been steadily cutting earnings forecasts. At the start of the quarter, the consensus Q3 forecast for the S&P 500 index was year-on-year revenue growth of 9.7% and earnings growth of 9.8%. The revenue growth forecast has slipped to 8.7% while earnings growth has reduced sharply to 2.9%, indicating substantial margin pressure. According to FactSet, this represents the largest cut to earnings estimates within a reporting period since Q2 2020, at the peak of the Covid outbreak. Excluding energy, Q3 earnings would be even worse, predicted to decline by 3.8%.
Companies are facing slowing demand and rising costs, as well as difficult year-on-year comparisons. The deteriorating outlook is being compared with extremely buoyant conditions a year ago. The surging dollar is also reducing the value of overseas earnings. The dollar index has gained by 20% since the start of the year and 40% of S&P 500 revenues come from outside the US. A strengthening dollar lowers the value of foreign revenues and reduces global competitiveness.
The technology sector, which comprises around 40% of US equity markets, has the greatest proportion of foreign earnings. Materials and consumer staples are not far behind, while sectors with the greatest domestic exposure are the banks, financials, utilities, and real estate. Retailers tend to import a lot and so a strong dollar should help them mitigate other cost pressures. Profits recessions favour the more defensive sectors, such as consumer staples, utilities, and healthcare, which people cannot do without.
The S&P 500 index has declined by over 24% since the start of the year. Price-earnings valuations have returned to their long-term average. The estimated 12-month forward price-earnings multiple has dropped from 21x at the start of the year to 15.9x. This is below the 5-year average of 18.6x and the 10-year average of 17.1x. It lies close to the 20-year average of 15.7x. The big question: How accurate is the current 12-month forward PE multiple? After all, it is based on earnings estimates and we have seen how quickly the Q3 estimate has unwound. There is a strong likelihood that earnings forecasts will decline further. Interest rate hikes have an impact delay of 6-12 months and so their effect on earnings may only be felt in 2023.
We should not be surprised if there is an earnings recession. The Fed has stated its commitment to bringing down inflation and that it is willing to incur some pain in the process. JP Morgan CEO Jamie Dimon said on 10th October that the US and global economy could dip into recession by the middle of next year. Earnings will likely contract but the good news, in the US at least, is that a recession will be short and shallow. Banks, companies, and households spent the decade after the 2008/09 Global Financial Crisis mending their over-leveraged balance sheets. The deleveraging process combined with massive excess savings accumulated during the Covid pandemic has removed any structural imbalances. The economy is well equipped to deal with a cyclical downturn.
Bear markets typically suffer two down-legs. The first commonly arises after an economy overheats and monetary conditions need to be tightened. Interest rates rise causing a compression in equity market price-earnings multiples, resulting in a 15-20% market decline. At this stage economic growth can remain buoyant as it takes time for higher interest rates to take effect. A continuation of buoyant conditions often leads to a powerful relief rally, like the one that occurred between the mid-June and mid-August this year. A 15-20% market decline is often followed by a swift 10-15% recovery. The second leg lower takes place if earnings decline and depending on the severity of the recession can lead the market lower by another 15-20%. A new bull market will invariably be born while earnings are still dropping. The price earnings multiple will increase as the market looks through the recession to the recovery ahead, usually due to monetary and fiscal stimulus, and regulatory reforms.
Jamie Dimon said the S&P 500 could fall by “another easy 20%” from current levels, as earnings decline. This would result in exceptional investment opportunities. OAM’s portfolios are defensively positioned with substantial dollar cash holdings accumulated over the past 15 months as the bear market has unfolded. Portfolios can withstand the earnings recession and will exploit the investment opportunities that emerge.
By Gielie Fourie
INTRODUCTION: Demographics drive the world; it cannot be otherwise. The effect on the economy boggles the mind. Financial consultants must always inform their clients: “Past performance is not indicative of future results.” True, the past is not the perfect prologue to the future, but knowing the past helps us to understand the future. Demographics is a powerful change agent, capable of shaping our future by stealth.
Our demographic change, one may call it a crisis, is not a projection of the future. It is happening right now. Italy’s reality may be funny if it was not so sad. By 2050, 60% of Italians will have no brothers, sisters, cousins, uncles, or aunts. The Italian family, with the father who pours the wine and the mother who serves the pasta to a table of grandparents, grandchildren, and greatgrandchildren, will be gone, as extinct as dinosaurs. Yemen, on the other hand, a failed country in the middle of a terrible civil war, will show a population increase that is double Italy’s.
Africa will see a population explosion. Fewer babies will be born in all of Europe in 2023 than in Nigeria alone. More than half the increase of the global population projected by 2050 will be concentrated in just eight countries, mostly in Africa, according to The Economist: Congo, Egypt, Ethiopia, India, Nigeria, Pakistan, Philippines, and Tanzania. Nigeria will have more inhabitants than Europe and the United States. Demographics will change the face of Africa. (Source: Dennis Gartman Newsletter 29 September 2022).
AFRICA WEALTH FORECASTS: Total private wealth held in Africa is expected to rise by 30% over the next 10 years, reaching US$2.6 trillion by 2030. This growth will be driven by robust growth in the billionaire and centi-millionaires’ segments. First, during this period Africa’s strongest wealth growth is expected to come from Ethiopia, Mauritius, Rwanda, Kenya, and Uganda with 60%+ growth rates. Second, solid wealth growth is forecast in Namibia, Botswana, Mozambique, and Zambia with 40%+ growth rates. Last, moderate wealth growth is expected from South Africa, Ghana, Côte d’Ivoire, Egypt, Morocco, Tanzania, Angola, and Nigeria over the forecast period with 20%+ growth rates. The overall 30% growth forecast for Africa is relatively healthy when compared to most other regions globally. (Source: AfrAsia Bank AFRICA WEALTH REPORT 2021).
AFRICA’S WEALTHIEST CITIES: Johannesburg is the wealthiest city in Africa. Johannesburg’s wealth is largely concentrated in Sandton, which is home to the JSE (the largest stock market in Africa) and to the head offices of most of Africa’s largest banks and corporates. Major sectors in the city include financial services (banks) and professional services (law firms, consultancies).
Cape Town is home to Africa’s most exclusive suburbs including Clifton, Bantry Bay, Fresnaye, Llandudno, Camps Bay, Bishopscourt and Constantia. Also, home to several top-end lifestyle estates including: Steenberg, Atlantic Beach and Silverhurst Estate. Major sectors there include real estate and fund management. Then follows the other wealthiest cities: Cairo, Lagos, Africa’s largest city, Durban and Umhlanga, Nairobi, the economic hub of East Africa, and Paarl, Franschhoek and Stellenbosch. These three towns are located next to one another. Combined they form one of the fastest growing areas in South Africa for High Net-Worth Individuals (HNWIs).
SPOTLIGHT ON SOUTH AFRICA: South Africa is home to the largest luxury market in Africa by revenue, followed by Kenya and then Morocco. Major components of this include luxury hotels and lodges, luxury cars, luxury clothing and accessories, luxury watches, private jets, and yachts. Unfortunately, this is changing. SA’s performance has been poor, with total private wealth held in the country declining by 25% over the past decade, when measured in US$ terms. Performance was negatively impacted by a significant loss of currency value vs. US$ from around R6.80 per US$ in 2010 to R14.70 in 2020 (year-end rates). The current rate is R17.65 to the US$. This led to poor returns from the JSE all share index – down by 12% over the past decade when measured in US$ terms.
BOTTOM LINE: South Africa’s population growth has slowed down. The ongoing migration of wealthy individuals out of the country has contributed to our mediocre economic performance. Based on AfrAsia’s estimates, around 4,200 HNWIs have left SA over the past decade (2010 to 2020). Most individuals (including our children, brothers, and sisters) have gone to the UK, Australia, and USA. Some have also gone to Switzerland, Israel, Mauritius, New Zealand, the UAE, Canada, Portugal, Spain, Cyprus, and Malta. The upshot is a sluggish local prime residential market. Homes valued at over R10 million have become exceedingly difficult to sell. We cannot escape the negative effects of demographics. To protect your wealth, it is crucial to invest a percentage of your assets offshore. We can help you with offshore investments – the majority of our clients’ investments are offshore. Contact one of our highly qualified consultants for gratis 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.
Spend some time with our team to find out which one of our portfolios is best for you.