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Weekly Market Report
10 January 2023
Global market review and strategy outlook.
Business outlook 2023.
Global and local indicators.
By Nick Downing
All financial asset prices suffered in 2022, 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 surged, and equity prices plummeted. However, equity markets staged a recovery in the fourth quarter (Q4) amid signs that the world may have passed the point of peak inflation, peak central bank hawkishness and peak bond yields. The all-important 10-year US Treasury bond yield, against which all financial assets are priced, reached a peak of 4.23% in October compared with 1.49% at the start of the year but by the end of December had stabilised at 3.88%, helped by lower inflation readings and hints that the Federal Reserve is nearing the end of its rate hiking cycle. The Fed’s less hawkish policy outlook took some shine off the US dollar. The US dollar index fell 7.7% in Q4, reducing its year’s gain to 8.2%. A weaker dollar helped to shore-up global liquidity, to the benefit of global financial markets.
European markets were at the vanguard of the Q4 recovery, helped by a sharp drop in European natural gas prices. The benchmark price fell by 61.2% in Q4 ending the year 7.5% lower than its end 2021 level at €60/MWh compared with a peak of €341/MWh reached on 26th August. The Brent oil price also benefitted economic sentiment by falling 2.3% in Q4 trimming its gain for the year to 9.3%, priced at end December at $85.9 per barrel compared with a peak of $128 per barrel in March. The German Dax gained 14.9% in Q4, trimming its 2022 loss to 12.3%. The UK’s FTSE 100 index was an outlier, gaining 0.9% on the year after rising 8.1% in Q4, helped by a weak pound, and heavy index weighting in oil and commodity stocks as well as financials, which benefit from rising interest rates. The Nikkei also fared relatively well, losing just 4.9% on the year, helped by the Bank of Japan’s commitment to monetary easing and a weakening yen. In the US, the benchmark S&P 500 index gained 7.1% in Q4 but suffered a 19.4% loss on the year, while in China the Shanghai & Shenzhen CSI 300 index gained 1.7% and lost 21.6%, respectively. The MSCI World index lost 19.8% on the year despite gaining a hefty 9.4% in the last quarter. The MSCI Emerging Market index was hit hardest due to China’s effect, with a loss for the year of 22.4%, despite recovering 9.2% in Q4.
Will equity and bond markets maintain their positive momentum in 2023? This largely depends on inflation, interest rates and whether economies dip into recession. Inflation appears to be rolling over. In November, US consumer price inflation (CPI) rose by just 0.1% after rising 0.4% in October. Year-on-year CPI increased 7.1%, the smallest increase since December 2021, marking a steady downtrend since peaking at 9.1% in June. Falling rents, which comprise 40% of US core CPI, and falling medical care prices, are expected to combine with near zero goods inflation to reduce core CPI as the year progresses. Wage growth should come under downward pressure from falling job vacancies. According to independent research firm Capital Economics, “The current post-pandemic surge in price and wage inflation is naturally framed in terms of what occurred in the 1970s, but the surges in wage and price inflation following both world wars were even bigger. Both of those surges faded within a couple of years, without the need for a severe recession or a large and sustained rise in unemployment.”
The Federal Reserve slowed the pace of its rate hikes from 75 basis point increments to 50 bps at its latest policy meeting in December. After its rapid increase the fed funds rate, currently at 4.25-4.5%, is now close to the Fed’s own projected terminal rate of 5.0%, suggesting only one or two rate hikes of 25-50 bps remain. Other central banks, including the Bank of Canada and Reserve Bank of Australia have already reduced the size of their rate hikes. The ECB and Bank of England are expected to adopt the Fed’s more cautious approach, which according to its press statement “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” 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, which appears to have shaken central banks. The Bank of England stepped in with unlimited purchases of UK gilts. While the Fed has continued lifting interest rates, it has dramatically slowed the shrinking of its balance sheet. Meanwhile, liquidity expansion has resumed in Europe and in China.
Declining inflation, an end in sight for monetary tightening and hints of an end to central bank asset sales, should stabilise bond yields. According to Bank of America strategist Michael Hartnett, the last time that the Treasury bond fared so badly was in 1788, over 200 years ago. 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 (yields rise when bond prices drop) are highly likely to come down in 2023, benefitting all financial asset classes, including equities.
Economic activity is expected to slow in 2023 but it should come as no surprise to financial markets. The slowdown has been well telegraphed. Recessions are anticipated across developed economies in the US and Europe, but they are likely to be shallow and short-lived, with forecasts for a mild fall in US GDP of just 0.5% and 1% in Europe. In the US and Europe, 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. Economies are well equipped to deal with a cyclical downturn, which means they are expected to begin recovering quickly, from as early as the second half of the year. The downturn may be greater at around 2% and slightly more prolonged in the UK and other economies suffering from property bubbles and high household debt levels including Canada, Australia, New Zealand, and Sweden. Meanwhile, China’s growth rate, having dropped in the first nine months of 2022 to a year-on-year rate of just 3.0%, should pick up momentum this year with the lifting of Covid restrictions and increased fiscal and monetary stimulus. As the world’s second largest economy, China’s improved outlook should provide a boost to global growth.
At the start of last year global equities were valued at two standard deviations above their long-term average price-earnings multiple and price-to-book. Necessary corrections in bond and equity markets have restored both the long-term risk-free rate (10-year US Treasury bond yield) and the global equity risk premium back to normal levels. Global equities have moved back from an estimated forward price-earnings multiple of 20x to 14.3x, below the long-term average of 15.8x. While US markets have realigned with their long-term average other markets are well below theirs, in some cases including Europe, the UK and China, by a considerable margin, indicating a good starting point for investors.
The outlook for global markets is greatly improved compared to this time last year. A year ago, inflation and interest rates were surging, and economic momentum was falling, while valuations were extremely demanding. A year later, inflation is declining, central banks are close to ending their tightening cycles and while recession is around the corner it is likely to be mild and short-lived, with China’s improved outlook boosting prospects for an early global recovery. Earnings will inevitably succumb to the expected recession, although markets may look through the slump given undemanding valuations and expectations that economic recovery will commence as early as the second half of the year. Equity markets typically strengthen before recessions end, usually by around four months. The US mid-term elections also bode well for markets. Since 1930, US markets have typically performed strongly in the year following the midterm election. There have only been two years of negative returns and even then, not by much: In 1947 and 1978, US markets dropped by 0.5% and 2.4% under presidents F. Roosevelt and J. Carter, respectively. Good news out of Ukraine in terms of a negotiated settlement could add further to the positive sentiment.
By Gielie Fourie
INTRODUCTION: This week, on Friday the 13th, the tone will be set for what we can expect in 2023. South Africa is to meet the FATF, the global finance watchdog, in Barat, Morocco. We will have to prove to the FATF that we should not be grey listed. Our delegation will be led by the National Treasury’s acting director general, Ismail Momoniat. The SA Reserve Bank (SARB) has warned that grey listing will cause reputational damage and could trigger capital outflows. Mr Momoniat is the right man to lead the team. He holds master’s degrees in science and in mathematics. He was a mathematics lecturer at the University of the Witwatersrand. He has served the National Treasury for 27 years where he has served as deputy director general for 22 years. He has a clean record. The problem lies with our leaders – it is difficult to find even one with a clean record.
2023 FINANCIAL OUTLOOK: First pain, then gain. Herman van Papendorp, head of investment research at Momentum Investments, said people should prepare for more pain, and then gains, in 2023. Van Papendorp said the interplay between inflation, interest rates, and economic growth is likely to determine global asset class returns in 2023. A slowdown in global economic activity in 2023 seems almost inevitable. However, the magnitude of the growth slowdown remains uncertain. A mild slowdown, or so-called soft landing, is still possible, but more indicators, particularly inverted yield curves, are pointing to the increased probability of a global recession, also called a hard landing. However, there could be some relief for equities towards the latter part of the year as markets start looking beyond the downward growth cycle and begin discounting an eventual pivot to lower interest rates by the US Federal Reserve (the FED).
ASSET CLASSES: Van Papendorp said South African equities have an attractive valuation underpin, both within the global universe and against its own history. This should stand the JSE in good stead during potential global equity drawdowns, but particularly during subsequent recoveries when global risk appetite rises. South Africa’s real bond yields are also attractive against their own history and relative to those in global markets. Part of the high real yield differential is due to a fiscal and country risk premium. He expects falling inflation in the coming year to become less supportive for inflation-linked bonds. Although South Africa’s listed property operational metrics are improving, they remain worse than in the pre-COVID era. The potential for meaningful listed property returns upside from undervalued levels needs to be weighed against some remaining negative fundamental factors.
LOWER GROWTH UNTIL 2024: The Organisation for Economic Co-operation (OECD) says that South Africa’s fiscal and monetary policy are now turning contractionary – limiting the level of money supply for less spending and investment to slow the economy. The latest OECD Economic Outlook for November of 2022 reported that growth for South Africa is projected to be 1.7% in 2022, 1.1% in 2023, and 1.6% in 2024. The commodity boom boosted the country’s tax revenues. These windfall revenues have allowed the government to prolong the Social Relief Distress Grant until March 2024 and introduce temporary measures to cushion the impact of inflation without adding pressure on public finances.
DEBT: The OECD pointed out that debt remains above 70% of GDP, and rising debt-service costs already represent 15% of government spending. The fiscal policy is expected to be contractionary in 2023 and 2024 to consolidate public finances, achieved mostly by containing the public sector wage bill. Monetary policy is expected to continue tightening, with the repo rate expected to reach 7.25% in early 2023 and staying at that level until core inflation falls close to 5%, anchoring inflation expectations and limiting pressures on the exchange rate. Efforts to rein in the public sector wage bill and to address weaknesses in the management of public procurement and state-owned enterprises should continue.
RAISING TAXES TO RAISE LIVING STANDARDS: This sounds like an absurdity. We have a shrinking tax base. In the 2022 tax year three million people paid 97% of all personal taxes. President Cyril Ramaphosa confirmed that 29 million people in South Africa receive monthly grants, which economists warn is unsustainable with the country’s small tax base. The ANC wants to increase taxes, which may include a wealth tax, to fund a basic income grant (BIG). The OECD said that broadening the base of corporate and personal income taxes by redesigning (read phasing out) tax exemptions and raising property and environmental taxes would create fiscal capacity to finance growth-enhancing reforms while also improving the efficiency and equity of the tax system. The fiscal capacity should be used to improve the quality of energy, transport, and telecommunications infrastructure, which would boost productivity growth and living standards.
ELECTRICITY: Electricity shortages and more persistent inflationary pressures than expected will potentially delay the reduction of interest rates and create risks to growth. The planned split of Eskom will proceed to allow other producers to compete and complement capacity while also bringing prices down. Allowing private providers of renewable energy to feed power into the grid would help reduce electricity shortages while creating incentives for private investors to develop clean and cost-effective electricity.
BOTTOM LINE As stated above, the 2023 financial outlook will be, first pain, then gain. A lot depends on what happens in Morocco on Friday the 13th. At the January 8 celebrations in Bloemfontein the past weekend, the ANC made more promises of financial help to its members and to political parties. There was again talk of extending the mandate of the SARB. We cannot weather any more financial storms. There is a lovely Moroccan proverb that says: “Drop by drop the river rises.” We wish Mr Momoniat and his team all the best for their crucial meeting in Morocco.
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.