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Weekly Market Report
1 November 2022
Reallocating cash to equity markets.
Medium-Term Budget Policy Statement.
Global and local indicators.
By Nick Downing
All financial asset prices have suffered this year, rattled by the highest inflation and the sharpest increase in interest rates in over 40 years, strict Covid restrictions in the world’s second largest economy, the biggest war in Europe since WW2 and an energy supply shock that rivals 1973. Bond yields and the US dollar have surged, and equity prices have plummeted. Further volatility and downside risk probably lies ahead, but valuations are once again looking attractive. Bond yields, the dollar and equity valuations are over 2 standard deviations from their long-term means, which suggests good trading levels for long-term investors. The combination of falling share prices at the same time as continued solid earnings growth has resulted in a sharp derating in global equity valuations. The trailing price-earnings multiple of global equities now lies at 15.2x comfortably below its long-term average of 19.1x.
The bears are waiting for the traditional market capitulation marked by a sharp rise in the VIX volatility index. Equity market volatility has been noticeably absent in this bear market, perhaps because there has been such a strong consensus among investment institutions that markets would drop from mid-2021 onwards. The inflation shock was bound to result in a dramatic tightening in monetary policy. The consensus means very few market participants have been caught unawares and on the wrong side of the market decline. A “blood on the streets” moment might therefore not occur.
Failing to reallocate cash raised over the past 15 months runs the risk of missing out on the best profit-making opportunities. Markets always run hardest at cycle turning points. Current valuations and early signals that the market may be turning offer the opportunity to buy shares that have long been on the radar but were always too expensive. There are several signals that equity markets are getting close to the bottom. It is unclear how quickly inflation will return to target levels but there is growing evidence that inflation is at least turning lower. Gas prices have dropped around 70% from their highs reached in August, due to mild weather and plentiful inventories. Inventories stand at 93% of capacity in Europe. Monetary policy appears to be at peak hawkishness. The Bank of Canada and Reserve Bank of Australia both delivered smaller than expected interest rate hikes in their October policy meetings. The ECB stuck to its 75 basis-point rate hike but adopted a dovish tone in its policy statement. The Federal Reserve is due to follow through with a 75 basis-point increase on 2nd November, but this will likely mark the last of its jumbo rate hikes, to be followed by a 50 basis-point hike in December. By then the fed funds rate will be 4.5%, close to the neutral level and the rate discounted by fed funds futures.
The last rate hikes are always the most painful. There is a growing chorus from economists and even members of the Fed that monetary policy is in danger of over-tightening and creating a financial accident. The riot in the UK gilt market in October, when the 10-year gilt yield gained by 150 basis points in a matter of days, was an early warning signal. According to Macro Strategy Partnership, the US real interest rate is at its highest point since the early 1980s. The research company calculates it by subtracting the 3-month annualised rate of monetary growth from the fed funds rate (currently 3.25%). US monetary supply fell at an annualised rate of 5.02% over the last 3 months. Hence the real US interest rate is 3.25 less minus 5.02 which equals 8.27%. In the context of such rapidly shrinking liquidity and fractures starting to appear in bond markets, it is only a matter of time before the Fed pivots towards a more cautious “wait and see” approach. Quantitative tightening will likely make way for yield curve control, whereby the Fed targets yield levels at the long end of the bond market. This way, the 10-year Treasury yield can be brought lower through intent without necessarily having to commit to actual asset purchases. The result is less inflationary as yields can be brought lower without increasing money supply but at the same time brings borrowing costs lower.
The 10-year Treasury bond yield has jumped from 1.5% to 4.0% since the start of the year. This follows a jump from 0.90% to 1.5% in 2021. As bond yields rise prices fall. According to Bank of America strategist Michael Hartnett, the last time that the Treasury bond fared so badly was in 1788. The last time bond prices dropped two years in a row was in 1959. Apparently three years in a row has never happened, which suggests bond yields are highly likely to come down in 2023, benefitting all financial asset classes, including equities.
OAM has been raising cash in our client portfolios over the past 15 months by selling the weaker share holdings. We have started gradually putting the cash back to work with the initial purchase of JPMorgan American Investment Trust Plc. The share has long been on the radar and now provides an opportune entry level. The US economy has retraced from its excessive valuations earlier this year and once again trades in line with its long-term average price-earnings multiple. The US market is admittedly expensive versus other world markets, but this is largely explained by the heavy weighting of technology and healthcare stocks, which tend to trade at higher multiples. The US private sector, after the decade of deleveraging that followed the Global Financial Crisis, is in rude health. Balance sheets are solid, banks are well capitalised, there are no structural imbalances in the economy. The US is energy self-sufficient and is far removed from the Ukraine war. Third quarter company earnings were stronger than expected. The delayed impact of monetary and fiscal tightening will cause an economic slowdown in 2023 but the expected recession is likely to be shallow and short-lived.
The managers of JPMorgan American say that the market pullback has created opportunities to acquire attractive, high growth companies at more reasonable prices. Managers split their allocation to large-cap stocks equally between growth and value shares so that the balance does not deviate more than 60:40 in either direction. Performance has been boosted over the past year with exposure to material and energy stocks, which still comprise 10% of the portfolio despite some profit taking. Its largest exposure is to information technology at 23% although this is underweight compared with its benchmark, the S&P 500 index. The share has an excellent track record versus its benchmark and its investment company peers. The share is very liquid with a market capitalisation of close to £1.5 billion.
By Gielie Fourie
INTRODUCTION: On Wednesday, 26 October, finance minister Enoch Godongwana delivered his second Medium-Term Budget Policy Statement (MTBPS). “Medium-Term” refers to a period of three years. The minister painted a positive story. The income side surprised to the upside. Revenue collection was adjusted upwards to R1.68 trillion. SARS Commissioner Edward Kieswetter says SARS compliance efforts have contributed 12% to net revenues collected. On the expenses side billions of rand have been allocated to bail out mismanaged and plundered State-Owned Enterprises (SOEs). The billions allocated to bailouts, could have been allocated to build new infrastructure projects – however, no funds have been allocated for new infrastructure projects.
THE INCOME SIDE: Gross tax revenues are expected to be around R83.5 billion (bn) higher in FY22/FY23 than forecasted in the February 2022 budget. The minister could revise estimated revenue income upwards by R83 bn in the current year, R95 bn the year after, and almost R100 bn in the final year of the medium-term period (2024/25). As mentioned, revenue collection was revised upwards to R1.68 trillion. Total revenues could optimistically be R106bn higher – higher than even the most optimistic forecasts. Financial markets reacted positively to the MTBPS. SA’s fiscal position remains relatively sound, largely thanks to the recent surge in global commodity prices. Despite higher commodity prices, export volumes increased. This allowed government to narrow the projected budget deficit from 4.9% of GDP in 2022/23 to 3.2% in 2025/6. It will also defray some of the risks from higher interest costs.
The key positive fiscal story remains a continued downward trend in South Africa’s debt trajectory. Government is using the windfall tax receipts to stabilise debt. Since 2007/8, public debt has risen seven-fold, from R577 bn to over R4 trillion in 2021/22. Looking back at the forecasts of government debt in the MTBPS of 2020 and 2021 and this year’s budget speech, we see a significant downward trend in the debt forecasts as a percentage of GDP. MTBPS 2020 forecasted that in 2024/25, government debt would be 90.4% of GDP. This has since been adjusted significantly lower every year. The latest projections from the 2022 MTBPS now forecasts 2024/25 government debt at 70.4% – a material downward revision of 20 percentage points.
Investors will be encouraged by the many reasonable steps and realistic decisions taken on the part of the National Treasury (NT). Unfortunately, higher interest rates have pushed the costs of debt higher – the cost of repaying this debt will be almost R6 bn higher than was expected in February. As a result, payments on the interest for this debt now exceed spending on essential services like health and security. Interest payments will rise to 4.8% of GDP by 2025.
THE EXPENSES SIDE: A R30 bn bailout was allocated to DENEL, SANRAL, TRANSNET AND KWAZULU-NATAL (KZN): DENEL: Denel is to be allocated R3.4 bn which, together with the sale of non-core assets worth R1.8 bn, will help stabilise the company and unlock a committed order book of R12 bn. SANRAL: R23.7 bn was allocated to Sanral. Government will take over 70% of Sanral’s debt and the Gauteng provincial government 30%. Gauteng will henceforth be responsible for the maintenance of the 201 km Gauteng Freeway Improvement Project. TRANSNET: R5.8 bn was allocated to Transnet, half of which is allocated to repair flood-damaged infrastructure. The other half was allocated to bring out-of-service locomotives back into service and improve rail capacity. SA AIRWAYS: It is a godsend that SAA has been sold and did not need a bailout again. More State SOEs should follow that route. The minister said government continues to review the value created by SOEs as part of evaluating whether they can operate sustainably. KZN FLOOD DAMAGE: A further R2.9 bn has been allocated to deal with flood damage in KZN.
COVID AND ESKOM: The Covid-19 social relief of distress grant, introduced in May 2020 as a temporary measure to support low-income households during the pandemic lockdowns, will be extended until March 2024. The minister said 7.4 million people currently receive this grant. ESKOM: National Treasury is to take over a portion of Eskom’s R400 bn debt burden. The minister said, “The quantum is expected to be between one-third and two-thirds of Eskom’s current debt.” This is a wide margin. The exact amount was not specified in the budget – this omission makes the budget unrealistic. However, these are only proposals. The minister added, “The debt takeover, once finalised, together with other reforms, will ensure that Eskom is financially sustainable. Debt relief alone will not solve Eskom’s problems and this measure is part of a comprehensive approach.”
FIGHTING FINANCIAL CRIME: There is an additional allocation of R8.7 bn for the police, with further amounts earmarked for other crime-fighting agencies. With the threat of grey listing by the Financial Action Task Force (FATF) looming large, government is ramping up its monitoring and prosecution of sophisticated crimes. To prevent grey listing, two bills have been tabled in parliament to address compliance with the FATF 40 recommendations. Two bills might not be enough to convince the FATF that our compliance is world class. A FATF investigation found that SA is compliant with only three of its 40 recommendations.
BOTTOM LINE: Despite all the positive news around the budget, there are risks. A substantial risk is our lack of growth. Godongwana promised growth-enhancing economic reforms, but growth is likely to limp along at a low 1.6% a year over the next three years. Treasury has lowered its 2022 economic growth expectations to 1.9% – however, the IMF expects a growth rate of 1.1%. Yet, in a sea of mediocrity, there are still pockets of growth in our economy. Last week Dis-Chem announced that it expects headline earnings per share (HEPS) for the six months to August to rise by between 43.1% and 45.4%. MTN reported that its six months HEPS is up 46.5%. Motus reported that its HEPS for the year to June 2022 was up 72%. We hold all three of these companies in our portfolios. Price will always follow earnings. Contact one of our experienced consultants if you are interested in investing.
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.