Weekly Market Report

4 October 2022

Global Report

Q3 Global Market Review and Strategy Outlook.

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Global and local indicators.

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Global Report

By Nick Downing

According to Charlie Munger, Warren Buffett’s right-hand man at Berkshire Hathaway, “Inflation is the way democracies die. It’s the biggest long-run danger we have …. Apart from nuclear war.” The traditional way to beat inflation is by increasing interest rates, but Warren Buffett famously said that “Interest rates are to asset values what gravity is to apples.” Inflation maintained its surge to fresh 40-year peaks across the US, Europe and the UK, prompting central banks, led by the Federal Reserve, to continue ratcheting up interest rate expectations despite the growing threat of recession.

The falling real value of household disposable income coupled with rising interest rates, and the continued war in Ukraine, caused equity markets to reverse their temporary July rally. All major markets fell in the third quarter (Q3) widening their year-to-date (YTD) losses. The MSCI World index lost 6.6% in Q3 and 26.4% YTD. The MSCI Emerging Market index suffered respective losses of 12.5% and 28.9%, with its heavily weighted Shanghai and Shenzhen CSI 300 index dropping 15.2% in Q3 and 23.0% YTD due to property woes and continued Covid restrictions. Over Q3, the major developed markets: the S&P 500, German Dax, FTSE 100 and Nikkei 225 lost 5.3%, 5.2%, 3.8% and 1.7%, taking their YTD declines to 24.8%, 23.7%, 6.6% and 9.9%. The UK market was aided by its significant weighting to oil, commodity and financial shares, which tend to outperform in an inflationary environment, while Japan was helped by its continued bias towards monetary easing. The US 10-year Treasury bond yield surged again, rising over the quarter from 2.97% to 3.80%, compared with 1.51% at the end of 2021. Divergence in economic growth, interest rate differentials, capital flows and shrinking dollar liquidity, powered the US dollar index to 112.2 up 7.1% on the quarter and a massive 17.2% YTD. The Brent oil price slipped back to $87.9 per barrel, a 23.4% decline on the quarter but still up by 13.1% YTD.

Inflation is the biggest threat in today’s world economy and to global financial markets. US consumer inflation was 8.3% year-on-year in August, down slightly from its recent peak of 9.1% in June, but core CPI, excluding food and energy prices, increased by 0.6% month-on-month, larger than the prior month’s 0.3% increase. UK consumer inflation retreated from its July peak of 10.1% in August but only slightly to 9.9%, while Eurozone inflation marched to a new record of 10% in September. Central banks have altogether abandoned their belief that the inflation spike is transitory and are fighting to get back ahead of the curve. The Bank of England has hiked 7 times since December 2021, lifting its base rate from 0.1% to 2.25%. The last rate hike was 50 rather than the standard 25 basis points. The ECB has only hiked twice, but in leaps, from -0.5% to 0.75%. The Fed has been the most aggressive, lifting its fed funds rate from 0.0 – 0.25% last December to 3.0 – 3.25% in September, including 3 consecutive rate hikes of 75 basis points.

The annual Jackson Hole central bankers’ symposium in August set the scene for more interest rate hikes. The severity of Fed chair Jay Powell’s message unnerved financial markets. He said the “overarching focus right now is to bring inflation back down to our 2% goal”, that the Fed “will keep at it until we are confident the job is done.” He cautioned that interest rate increases will “bring some pain to households and businesses” and a “sustained period of below-trend growth” but “these are the unfortunate costs of reducing inflation… a failure to restore price stability would mean far greater pain.” As well as signalling more rate hikes, the Fed is scaling up the sale of bonds from its balance sheet. Its “quantitative tightening” programme is expected to reduce its balance sheet from $9 trillion to $6.5 trillion, which will accelerate the withdrawal of dollar liquidity from global financial markets. US money supply fell at an annualised 1.6% over the 3 months to end September, which along with two data points in July, was the sharpest decline since 1938. Surges in the dollar and in energy prices are also contributing to shrinking liquidity.

Despite the common themes of rising inflation and tightening global liquidity, regional outlooks differ markedly. The US economy is already in technical recession following two straight quarters of contraction in the first half of the year. However, as in Europe, households, businesses and banks enjoy robust balance sheets due to the decade of deleveraging that followed the 2008/09 Global Financial Crisis. The lack of structural imbalances means any recession is likely to be shallow and short-lived. However, inflation is likely to be stickier in the US, due to a larger accumulation of pandemic-era savings that have largely been depleted in Europe. In the US, which is energy self-sufficient, energy costs comprise around 6% of GDP but in Europe including the UK, energy costs are as high as 20% of GDP. The energy crisis, if sustained, will rapidly absorb savings and destroy household discretionary spending, creating the conditions for deflation. Europe, including the UK, is more in need of quantitative easing than quantitative tightening. It has already begun. The BOE has pledged unlimited purchases of the 30-year gilt to shore up its sovereign bond market. The ECB has launched the Transmission Protection Instrument (TPI) to buy unlimited quantities of sovereign and private sector debt from eurozone countries that are suffering from abnormally high government bond yields. Japan is well positioned, households enjoy excess savings, companies have sound balance sheets, and the central bank is maintaining its zero-interest rate policy and asset purchase programme. China is hamstrung by the implosion of its property bubble but will benefit from the eventual relaxation of its zero-Covid policy and a ramping up in fiscal and monetary policy.

The US economy is the most robust but the outlook for continued strengthening of the US dollar may not be good news for its equity markets. The US will lose export competitiveness and overseas earnings will be worth less in dollar terms, whereas equity markets in the UK and Europe and Japan, already at their biggest discounts to US markets in decades, will receive a substantial boost from their more competitive currency valuations. A strong dollar will be a handbrake on US equity markets, but it will assist in lowering imported inflation, which for the time being is the Fed’s overarching priority.

Financial markets are likely already three-quarters of the way through the current bear market. Valuations are at bargain levels across Europe, the UK, Japan, China and other emerging markets. Both trailing and forward estimated price-earnings multiples, price-to-book and enterprise value-EBITDA ratios all at substantial discounts to their long-term averages. The US is an outlier, with valuations still close to the long-term average and therefore not yet in bargain territory like other markets, which combined with the Fed’s policy outlook and strong dollar may constrain the market’s relative performance over coming months.

The bottom in global markets may not be far away, either in months or in point terms. The bears, such as past US Treasury secretary Larry Summers, who warned the Fed of its policy error in early 2021, believe the US will need to undergo a significant increase in unemployment to bring inflation back to its 2% target. Others believe the market is too fixated on demand-side factors such as monetary and fiscal policy, business and consumer spending. The shocks of the pandemic and the Ukraine war suggest supply-side economics hold the key. Capital Economics chief economist Paul Ashworth feels the answer might lie in the impact the supply shock has had on the supply curve. According to his framework, when there is a supply shock and output moves uncomfortably close to potential, shifts in demand may create small changes in output but potentially large changes in price. The good news is that it could similarly take only a modest fall in demand to produce a large drop in inflation. The easing of supply chains, as evidenced by the sharp decline in shipping container rates adds credibility to this more favourable outlook.

In its latest asset allocation report, independent research firm Capital Economics forecasts further declines across world equity markets before year-end, but these are minor compared with the substantial positive annual returns predicted in 2023 and 2024. It is likely that the Fed is close to “peak hawkishness”. The Fed has progressively lifted interest rate expectations with each subsequent policy meeting, so that committee members now project a peak fed funds rate of 4.6%. This is the level inflation could conceivably drop to within coming months and likely therefore to be the terminal rate. A 4.6% terminal rate suggests that only two additional hikes remain, of 75 and 50 basis points, in November and December. Beyond that point, the Fed’s withdrawal of dollar liquidity from global markets will probably pivot to renewed quantitative easing, creating the conditions for a sustained recovery in global equities.

Local Report

By Gielie Fourie

INTRODUCTION: October is Transport Month in South Africa. The Transport Month campaign is an annual feature on the calendar of the Department of Transport and is one of the platforms through which the department engages directly with its stakeholders. During October, the Department of Transport will focus on transport infrastructure services in aviation; maritime; public transport and roads. Unfortunately, these infrastructure services have been so neglected that there is not much to be proud of.

For the first time in the history of the vehicle industry in South Africa, naamsa (the Automotive Business Council) will be bringing the world’s industry giants to South Africa for futuristic and ground-breaking discussions and potential business opportunities. The contribution of the Transport and Communication sector to our Gross Domestic Product (GDP) in 2021 was 8.19%. The sector is growing. In Q2 2022 the sector’s Quarter-on-Quarter seasonally adjusted growth was 2.4%. It was one of only two of the ten industry sectors in South Africa that managed to show growth. The industry accounts for 17.3% of the country’s manufacturing output. It exports vehicles and components to 152 international markets.

NEW VEHICLE SALES: According to naamsa, the new vehicle market remains resilient despite increasingly tough economic conditions via elevated inflation and the upward trend in interest rates which are eroding households’ spending power and present an affordability challenge to consumers. Annual consumer inflation increased to 7.6% Year-on-Year (YoY) in August 2022, while the prime interest rate increased to 9.75%. Further interest rate hikes are anticipated for the remainder of the year. However, the car rental business continued to support the new vehicle market as the tourism sector is starting to stabilise after the lifting of all COVID-19 lockdown restrictions.

According to the ABSA Purchasing Managers’ Index (PMI), domestic demand is continuing to benefit from the reopening effect after the COVID-19 lockdowns. The new vehicle market’s performance year-to-date (to 30 September 2022) is still 13.4% ahead compared to the corresponding period in 2021. The pace of steady growth is expected to slow down for the balance of the year. Total new vehicle sales in September 2022 were 47,786 vehicles. Vehicle exports are not far behind. A total of 43,474 new vehicles were exported in September 2022, a growth of 104.6% compared to September 2021.

NEW VEHICLE RETAILERS LISTED ON THE JSE: Motus, with a market capitalisation of R20 billion, is the biggest vehicle retailer listed on the JSE. It trades at a price earnings (PE) ratio of 5.6x, a dividend yield of 6% and a price to book (P:B) ratio of 1.4x. Based on these metrics Motus is not expensive. Headline earnings per share for the 2022 financial year were up 72%. The dividend was up 71%. Profit before tax was R4.4 billion; free cashflow was R4.8 billion. Debt is high at R4.1 billion, but the net debt to equity ratio was an acceptable 36%. Net debt to EBITDA was 0.8 times, well below the bank’s debt covenant requirement of 3 times.

The only other listed vehicle retailer is Combined Motor Holding (CMH). CMH has a market capitalisation of only R2 billion. It trades at a PE ratio of 5.6x, a dividend yield of 12% and a P:B ratio of 1.9x. CMH is not expensive. It is a well-managed company, but unfortunately the share is illiquid. CMH operates dealerships for 26 different vehicles brands – all the dealerships are in South Africa.

MOTUS*: Motus was spun out of Imperial Holdings in 2018. It is the exclusive South African importer of Hyundai, Kia, Renault, and Mitsubishi vehicles. Hyundai, Kia, and Renault offer popular entry level vehicles that retail for below R200,000.00. Their more expensive models retail for more than R1 million. These models have a collective market share of 24.5%, up from 22% a year ago. Only Toyota sells more vehicles than Motus in South Africa. Motus sold more vehicles than Toyota during May – July 2022 when Toyota’s manufacturing plant south of Durban, its biggest in KwaZulu-Natal, was closed after the heavy floods in April 2022.

Motus has a big advantage that differentiates it from its competitors – it imports all its products. Motus has no manufacturing facilities. It does not carry the risk of labour unrest and labour strikes that manufacturing plants often experience. Motus operates offshore with 114 dealerships in Britain and 36 dealerships in Australia. In addition, it operates two car rental companies in South Africa, Europcar and Tempest, which have a combined market share of 29% in the car rental business. Motus also owns exclusive distribution rights for Nissan in four East African countries. Motus is fully vertically integrated in the retail vehicle industry.

BOTTOM LINE: Motus is a growing company. Last week Motus signed a deal to acquire 100% of the issued share capital of Motor Parts Direct Holdings Ltd, an aftermarket parts business in the UK, for R3.64 billion. It will reduce the company’s dependency on vehicle sales. The business is cash generative and asset light. In an economy experiencing high inflation and high interest rates, Motus offers affordable vehicles to consumers. Motus will use the October Transport month to further increase the exposure of its products. Not everyone can afford an 8-litre luxury car, but a 1-litre Kia can also take you from point A to point B.

* Disclosure: We hold Motus in our client portfolios.

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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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