Weekly Market Report

25 October 2022

Global Report

Xi Jinping’s China.

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Global Report

By Nick Downing

Xi Jinping has cemented his leadership for an unprecedented third 5-year term, making him the most powerful leader since Mao Zedong. A third term was made possible when under Xi’s watch parliament changed the constitutional limitations in 2018. He has purged all remaining moderate law makers from the 7-man Politburo Standing Committee, including China’s Premier Li Keqiang who has been replaced by Li Qiang. Li Qiang was responsible for overseeing punitive Covid lockdowns in Shanghai and like the other members of the committee is a staunch Xi loyalist. With all rivals forced out from the standing committee and the 24-member politburo that sits below it, Xi Jinping has effectively paved the way to rule for life. To emphasise his grip on power he arranged for his predecessor Hu Jintao to be unceremoniously ejected from the Congress meeting. The ruthless maneuvre appeared stage-managed to coincide with the announcement of the standing committee and the arrival of the press in the Great Hall of the People.

Xi Jinping’s growing power has alarmed world leaders. Despite the war in Ukraine the US National Security Strategy stated that, “The People’s Republic of China presents America’s most consequential geopolitical challenge.” Ken McCallum, Director General of Britain’s MI5 Security Service said in late 2020, while comparing Russia with China: “You might think in terms of the Russian intelligence services providing bursts of bad weather, while China is changing the climate.” Xi’s address at the Congress omitted the standard reference to “peace and development”, instead referring to “security” 26 times, creating a strong impression that national security has replaced economic development as the communist party’s main priority.

His most controversial economic policies include rigid Covid-zero measures, crackdowns on the private sector, in particular the technology industry, which is a major engine of growth, and forced deleveraging of the all-important property sector. The impact on the economy has been dramatic. Covid-zero has drained the ability and willingness of consumers and businesses to spend. Residential property accounts for 80% of household wealth so its demise will also affect consumer spending. Consumer confidence has dropped to its lowest level on record. The crackdown on internet, gaming, online education and private sector wealth forms part of Xi’s drive for greater state control at the expense of more dynamic entrepreneurialism.

His target is to double the size of the economy by 2035, requiring an annual growth rate of almost 5%. This seems unlikely given the decoupling from the West and growing state control, an unlikely backdrop for the productivity boosts required to compensate for China’s shrinking population. In the third quarter, GDP grew year-on-year by 3.9%. For the first 9 months of the year, GDP grew by 3.0% on the year, well below the official target of 5.5%. The IMF cut its forecasts earlier this month, to 3.2% in 2022 and 4.4% in 2023. In Q3, property investment was down 8%. Retail sales were only up 2.5% and the unemployment rate increased from 5.3% to 5.5%. In the first nine months of the year, property sales measured by floor area fell by 22% on the year and new construction starts fell 38%. Over the past decade, economists have predicted that China would overtake the US as the world’s largest economy by 2030 if not before, but this now seems extremely unlikely. Demographics, excessive debt, and autocracy indicate the economy will be lucky to achieve an average growth rate of 2-3% over the coming decade, which means it would be lucky to catch up the US by 2060.

While Xi was powerful before, he is even more powerful now. According to Mark Williams, chief Asia economist at Capital Economics, “the official line appears to be that China has a leadership that will be united and stable. I suspect it will prove rigid and inflexible.” The checks and balances from the past 40 years of reform will likely disappear. The backdrop does not appear appealing for investment prospects. In May, OAM sold Fidelity China Special Situations across its global portfolios, while maintaining a halved exposure to the share in Growth portfolios. In July, Templeton Emerging Markets was sold in its entirety across global portfolios, due to its large exposure to China’s equity markets. The selling decisions have been vindicated by recent signals of autocracy and state control.

Although it is hard to find, there may be a silver lining in Xi’s supremacy. China’s slowing growth trajectory and forced deleverage will be deflationary and therefore helpful to the West’s battle with rising inflation. It could also be argued that fixing China’s structural imbalances, notably its inflated property sector and excessive debt, will require powerful leadership and unshakeable conviction. China’s national debt has surged to 275% of GDP. Although sustainable as the bulk of the debt is held domestically, its excess will crimp long-term growth and needs to be addressed. China’s property market is valued at twice the US property market despite its GDP being less than 70% of the US. According to MacroStrategy Partnership, 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.

The economic outlook has clouded, and some believe that under the current regime, China’s equity and bond markets should be avoided. However, as the second largest economy in the world, it is too big to ignore, and its economy will inevitably continue to generate growth, earnings and dividends. The CSI 300 is trading at increasingly attractive valuations that are a long way below their long-term averages. The 12-month forward price/earnings ratio is 10.1x compared with the long-term average of 13.6x and the price/book ratio is 1.5x also well below the long-term average of 2.7x. For long-term investors, with a 10-year investment horizon, current valuations should guarantee superior returns, especially if there is compelling evidence that China’s structural economic imbalances are being corrected.

Local Report

By Gielie Fourie

INTRODUCTION: Crypto assets are now officially financial products in South Africa. The Financial Conduct Authority (FSCA) will regulate it. On Wednesday 19 October 2022, in Government Gazette No. 47334, the definition of a “financial product” was amended to “declare a crypto asset as a financial product for the purposes of that definition”. A crypto asset means a digital representation of value that; (a) is not issued by a central bank, but is capable of being traded, transferred, or stored electronically by natural and legal persons for the purpose of payment, investment, and other forms of utility; (b) applies cryptographic techniques; and (c) uses distributed ledger technology.

This is a watershed moment for cryptos in SA. New regulations will likely result in greater adoption of crypto assets by the South African investor market. Regulations will provide the level of trust the market needs. It will allow crypto to go mainstream. The South African Reserve Bank has been working with other regulators to recognize crypto assets as financial products to make them easier to monitor from a money-laundering and terrorist financing perspective. The declaration on Wednesday does not mean that they are legal tender, Eugene Du Toit, of the FSCA, said at a press conference.

REGULATIONS AND LICENSING: With crypto assets’ promotion in status as financial products it makes it easier for regulators to monitor the market and to safeguard consumers. The declaration on Wednesday, which took effect immediately, comes as governments around the world push to regulate cryptocurrencies to protect users from fraudsters. To operate legally, existing crypto asset service providers (Casps) will need to apply for a FSCA licence between June 1 and November 20, 2023. Casps will be subject to the reporting requirements and monitoring controls of the FSCA. Anyone planning to purchase cryptos will then be able to check whether they are dealing with a licensed and credible crypto provider.

Financial service providers, like banks and asset managers, will have to be licenced by the FSCA to legally trade in crypto assets. Financial advisors will have to upskill their crypto knowledge. They will have to study and pass examinations to obtain licences to give advice on crypto assets. Regulations that ensure that crypto asset providers operate in a more professional and responsible manner can only be a good thing for the industry and the public.

The licensing requirements will drive exacting standards in the industry, particularly in relation to consumer protection, with potential investors easily able to identify those providers that satisfy regulatory requirements, says Marius Reitz of crypto platform Luno. Another key benefit is that it should allow qualified financial advisers to better advise their clients on crypto investments. Until now, financial advisors could not provide advice on unregulated assets or products. Crypto scammers are subject to a variety of criminal laws, but that has proved almost impossible to enforce, in part because there was no clear definition of a crypto asset. Weeding out the scammers should become easier going forward. We have seen collapses in the industry with consumers losing billions of rand. The biggest failure was the demise of Mirror Trading International last year with losses totalling about R20 billion.

GREY LISTING: The FSCA was clearly moved to act fast by the threat of SA being grey listed by the Financial Action Task Force (FATF), which could lead to disinvestment from SA due to the perceived financial risks. South Africa must report back to the FATF during October 2022 on measures taken to combat money laundering and terrorist financing. During its inspections, the FATF found that South Africa was compliant with only three of the FATF 40 recommendations. Government is now setting the necessary legislation in place to prevent us from being grey listed. Casps must also provide the FSCA with any information that is requested on a particular customer. With the amendment to the definition of financial assets they are now legally obliged to hand that information over to the FSCA. The same rules are being applied elsewhere in the world. The FSCA’s intention is to protect the public from crypto scammers and exchanges that do not abide by the law.

BOTTOM LINE: The FSCA moved quickly and decisively on declaring crypto assets as a financial product. The threat of being grey listed motivated the FSCA to act swiftly. The FATF now has six months to review our new regulations and its implementation. The FATF will announce its findings, and decision, in April 2023. Overberg Asset Management welcomes the regulations. Although regulations are often seen as an irritation and administrative burden, we see it as a step in the right direction. We will study the new regulations and upskill our knowledge and services to best serve our clients. If you need more information, please contact one of our highly qualified consultants for a free consultation.

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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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