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Weekly Market Report
18 October 2022
UK gilt riot may signal Federal Reserve pivot.
Global and local indicators.
By Nick Downing
Newly appointed Chancellor of the Exchequer, Jeremy Hunt, the fourth in as many months, has brought stability to UK financial markets. The pound has steadied, and UK gilt yields have come down from their recent peak. It has been a calamitous three weeks for Bank of England Governor Andrew Bailey as he sought to address the rapid increase in gilt yields. As gilt yields rose prices plummeted, leading to huge margin calls at UK pension funds. Pension funds have increasingly used their gilt holdings as collateral to earn higher income rates. So-called “liability-driven investments” have grown rapidly in popularity from less than half £500 billion to just under £2 trillion in less than 10 years. The rapid surge in gilt yields was on the verge of creating a UK financial crisis, before the BOE stepped in with unlimited purchases of UK gilts and the new Chancellor reversed Kwasi Kwarteng’s misguided budget.
However, deeper problems remain. The zero-interest rate environment which ensued in the decade following the 2008/09 Global Financial Crisis (GFC) and continued during the Covid pandemic, has led to excessive household leverage and the creation of a housing bubble. UK mortgage debt is higher now than it was in the US on the eve of the sub-prime mortgage implosion, which heralded the GFC. Ever rising home prices were affordable because mortgage rates were close to zero. However, mortgage rates are surging in line with rising gilt yields. Mortgage rates, which used to be close to zero are now above 5%.
The UK is not alone. Canada, Australia and New Zealand also suffer from domestic housing and credit bubbles, which are in danger of sudden corrections from the fastest increase in interest rates in 40 years. Sweden and Norway suffer from similar vulnerabilities, but this did not deter the Riksbank in Stockholm from raising its policy rate by a full 100 basis points at its last meeting. Interest rates across these countries will need to be gradual but this may not be possible while inflation keeps surging. At its last policy meeting, the Bank of England raised the base rate by 50 bps to 2.25%. Interest rate futures predict the base rate will rise to 5.25% by next May, despite the budget U-turn.
By contrast, the US spent the years following the GFC repairing its household balance sheets. The credit binge which led to the sub-prime crisis has reversed. As a result, debt and debt financing costs, as percentages of household disposable income are at multi decade lows, which suggests households will be able to cope with rising interest rates. At the same time there are no signs of a housing bubble. This means house prices are unlikely to drop and create stresses at household level or at the financial institutions holding the mortgage debt. Moreover, bank balance sheets are in rude health. The Eurozone, like the US, is equally able to cope with rising interest rates. While the energy crisis is particularly close to Eurozone countries, savings rates, household indebtedness, and home prices are all at their healthiest levels in decades. There are exceptions. Italy and Spain suffer from excessive government debt and elevated budget deficits. However, the Eurozone is generally free from structural imbalances.
With the US better able to withstand rising interest rates, the Federal Reserve may be less inclined to slow its pace of monetary tightening. However, its actions are causing global dollar liquidity to shrink at an alarming rate, at its fastest pace since 1938. The strong dollar is compounding the liquidity drain. Even Paul Volker, who presided over the Fed’s attack on inflation in the early 1980s with a peak fed funds rate of 22%, kept money supply growing at a minimum 3-month annualised rate of 4.8%. It is currently dropping at an annualised rate of 2.8%. As liquidity is withdrawn, the risk of a liquidity or solvency crisis increases. The risk increases in a non-linear fashion and could therefore strike with little warning.
The IMF warned last week in its twice-yearly Global Financial Stability Report that the stability of the global financial system has “materially worsened”. Tobias Adrian, head of monetary and capital markets at the IMF warned that “There certainly are many vulnerabilities out there… When interest rates increase very rapidly, these vulnerabilities are exposed.” Fractures have already started appearing. Credit default swaps, used to insure against Credit Suisse liabilities, have surged. The ECB in July launched the Transmission Protection Instrument to prop up sovereign bond markets of vulnerable member states. Italy’s bond yield spread over German bunds has surged over the past fortnight.
The biggest fracture so far has been the gilt market riot in the UK that began on 23rd September. Although the UK’s problems are home grown, Fed policy could be the catalyst for a disorderly solvency crisis. A crisis in the UK or any of the other vulnerable economies, which MRB Research describes as the “weak links”, could ignite global contagion. The Fed’s mandate is primarily maintaining price stability, which means keeping inflation under control. However, it is also mandated to target full employment and to maintain financial stability.
The near financial accident in the UK may be enough to convince the Fed that it has to tread more cautiously with its hawkish policy stance. Perhaps it is the UK gilt riot that prompted global financial markets to rise sharply last week despite far worse than expected inflation data, if it means Fed chairman Jay Powell is tempted to call it a day on reducing money supply. Even in the robust US economy, stresses are growing. The US Treasury’s Office of Financial Research Financial Stress Index is near a two year high. The Bank of America’s credit market stress index is close to its critical level.
By Robert Wantenaar
With the end of October hurtling towards us like an out-of-control freight train, so too does the potential grey listing by the Financial Action Task Force (FATF) which ominously hangs over our heads risking our freedom as South Africans to trade effortlessly with the rest of the world.
Who are the FATF and what do they want with us? The Financial Action Task Force is the global watchdog fighting against and preventing money laundering. The intergovernmental body aims to prevent illegal financial activities by setting the international standards which governments should adhere to. FATF currently comprises 37 member states and two regional organizations with South Africa having been a member since 2003.
The FATF has long warned that we (South Africa) are at risk of being added to the grey list, but we have failed to heed this warning. A ruling will now be made later in October as to whether we will be added to the list with two options which may follow. The ruling can have one of two outcomes: (1) If the FATF is not satisfied with our progress we will be added to the grey list immediately. (2) The FATF is impressed with the steps taken to fight corruption at a governmental level and we are given a 6-month extension after which they will reassess the situation.
South Africa has long suffered at the hands of the ruling party with funds being syphoned off, used for personal gain rather than the purposes for which they were intended. Let us not forget the price we continue to pay for the damage inflicted between 2009 and 2019 at the hands of our former president and the Gupta brothers. Not to mention the insurmountable amount of corruption which happens at a lower level which we are not even aware of… therefore the FATF has identified us as a potential grey lister. Coincidently, we have recently seen an uptick in the number of financial cases being heard in the courts. Whether this is enough to delay or avoid being placed on the grey list, only time will tell.
History of grey listing: It may come as no surprise that Mauritius was added to the FATF grey list in February 2020 due to a lack of correct procedures in place to ensure proper anti-money laundering measures. Due to a high-level governmental undertaking, Mauritius strengthened its procedures to the satisfaction of the FATF and was removed from the grey list within 18 months. International business immediately rebounded upon its removal from the grey list.
What may come as a surprise to many is that Malta, traditionally accepted as a trustworthy financial jurisdiction, was added to the grey list for concealing the ultimate beneficial owner of a structure that aided tax evasion. They too were removed after improving the way they share data with authorities.
What are the effects of grey listing? By being placed on the FATF grey list enhanced due diligence becomes standard practice when individuals wish to transact internationally. Further reaching effects are that existing, long standing accounts are reviewed, higher fees are levied, and, in some instances, account holders are informed that their accounts will be shut on a prescribed date. At a national level, the economy is affected to a potentially greater extent than a credit rating downgrade. The local currency devalues due to disinvestment from the country, the International Monetary Fund (IMF) will not grant loans should they be applied for, and international investors will not want to consider future investment into the country until all issues are resolved.
What do we do next: Act now! If you are unable to take action immediately, do not be discouraged by the process that needs to be followed to open international accounts. Institutions will require more information from you, they may ask for the most trivial information as a result of their enhanced due diligence but ultimately once the account is opened and the source of funds has been cleared, international transactions will become far easier to fulfil. Here we can help. Contact one of our highly qualified and friendly 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.