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Weekly Market Report
14 February 2023
Inverted yield curves and recessions.
Global and local indicators.
By Nick Downing
Whether a recession occurs in the US ultimately depends on how much more the Federal Reserve hikes interest rates and that depends on how inflation behaves. January’s nonfarm payroll report, although good news for short-term growth, with unemployment falling to a new long-term low of 3.4%, caused alarm among inflation watchers. Although strong payrolls are good for growth, they are less good for inflation and so the Fed may be more inclined to lift the fed funds rate by another 50 rather than 25 basis points. The last 2-3 rate hikes are always the most painful, as by then the fed funds rate is closer to the neutral level, and in danger of moving into restrictive territory.
As things stand, the yield curve is telling us that the Fed has already pushed the fed funds rate into restrictive territory and that a recession is inevitable. Curve inversions tend to occur when central banks lift interest rates, which push up short-dated (2-year) bond yields while supressing longer-dated (10-year) bond yields, as markets project declining inflation and growth. Recessions typically occur around 12 months after a yield curve inverts. The yield curve has been inverted since July, with the 2-year yield trading at one stage last week at an 86 basis-point premium to the 10-year Treasury yield. This is the biggest inversion since 1981 when US CPI was above 10% and the fed funds rate under Fed Chair Paul Volcker was around 19%.
Should we be alarmed? When predicting recessions, yield curve inversion has a good track record, but it is not infallible. As the saying goes, yield curve inversions have predicted 12 of the last 10 recessions. A false alarm was sounded in 1994. Many economists believe there is no imminent US recession on the horizon.
One reason is that bond yields have been heavily distorted by the exceptional central bank quantitative easing unleashed during 2020 and 2021 to save the world economy from the Covid pandemic. Record levels of central bank asset purchases have reduced the amount of bonds that are available for trading. Moreover, asset purchases were concentrated at the long end of the bond yield curve. The Fed owns around 30% of all outstanding Treasury debt. Studies show that in the absence of the Fed’s QE purchases, the 2-10-year yield curve would be 100 basis points more positive. At the same time, increased regulatory requirements demand ever greater collateral, which drives buying of longer-dated Treasury bonds and exacerbates the shortage.
Economic fundamentals are far more robust than the inverted yield curve would suggest. Households in the US are still sitting on over $1 trillion of excess savings accumulated during the pandemic-era handouts. Even before the handouts, household balance sheets were in rude health after a more than decadelong period of deleveraging post the 2008/09 Global Financial Crisis. Companies and banks also deleveraged. Private sector balance sheets can cope with raised interest rates. Other economic tailwinds include full employment and strong wage growth, which boost household disposable income, that is further benefited by falling inflation.
There is also a powerful global effect. China, the world’s second largest economy, is reaccelerating after abruptly abandoning its Covid restrictions. China’s GDP is expected to grow by 5% this year compared with 3% last year. In Europe, plunging energy prices are reigniting growth momentum. Independent research firm, Cross Border Capital, highlights two of its daily data series. The first monitors economic surprises versus consensus expectations. The second uses an algorithm to assess GDP implications from movements in trade-sensitive currencies, commodity prices and corporate credits. “Both concur that there has been a recent acceleration in world economic growth, even back to the 3% level last recorded in 2020.”
Despite evidence to the contrary, other economists feel that a recession is inevitable. They cite the lagged impact of interest rate increases. With a lag of 6-12 months, interest rates will take time to reverberate through the economy. They also point out that pandemic-era excess savings will soon be depleted. Yet even these economists have been surprised by the strength of economic activity so far and admit that although a recession is inevitable, it will also be mild and short-lived. It may last as little as 6 months, in which case, since share prices discount events in advance, equity markets will probably look straight through the recession to the expected recovery on the other side.
The current yield curve inversion may correctly predict an upcoming recession but supply and demand distortions to the US Treasury bond market mean that the scale of the recession is unlikely to mirror the biggest curve inversion since 1981.
By Gielie Fourie
INTRODUCTION: On the Johannesburg Stock Exchange (JSE) the number of listed companies is shrinking slowly, while at the same time the market capitalisation of the JSE is growing fast. In short, less is more – we are left with less companies, but with more value. It has been happening in slow motion — so slow you may not even have noticed. In 2003 the JSE had an estimated 473 listed companies – now we have around 325 companies left – 148 companies (31.2%) have delisted. See the graph below. During the same period, the market capitalisation of listed companies increased from US$182.6 billion to US$1.36 trillion in March 2022. An increase of 645%.
The number of firms listed in the world’s largest economy – the US – is shrinking as well and has been shrinking for some time. The total number of US listed companies has fallen by nearly 40% since 1997. The Wilshire 5,000 Index – one of the broadest representations of the US market – was established in 1974. It was named for the approximate number of companies included in the index, namely 5,000. As of March 31, 2022, the index contained only 3,660 companies, a drop of 1,240 companies. While the US markets are shrinking, the market capitalisation of US listed companies has been rising steadily.
We can postulate from this that the average market capitalisation of listed companies has increased. An ever-decreasing number of mega big firms dominate stock markets. It is not an ideal trend, as fewer larger firms lead to less corporate discipline and weaker shareholder democracy. Some refer to it as the “oligopolisation” of the economy, where few powerful companies exert undue control on the market. (Killik & Co Investment Management, London). The total number of companies listed globally has never been higher than today, thanks largely to the rapid expansion of stock exchanges in Emerging Markets.
Why is this happening, why are markets shrinking? The key factor is simply that fewer firms want to be listed. Some entrepreneurs fear the level of regulation and media scrutiny that comes with listing. With fewer companies to pick from, investors, and asset managers, struggle to achieve balanced, diversified portfolios that truly represent the underlying economy. What started as a trend in the world’s largest market – the US – will inevitably ripple out to other bourses, particularly the older, more established ones.
A first spinoff of this trend: Reliance on broad indices as a full representation of the underlying economy looks increasingly unwise, especially in the US. A second spinoff: This trend underscores the importance of international portfolio diversification to ensure that an investor is not inadvertently over-exposed to the listed firms that increasingly dominate Western bourses. The historical reason for listing a company on a stock exchange is the opportunity it offers to raise capital. However, there are now CEOs who simply do not see the point of listing when they can raise capital from private equity and venture capital firms instead, far away from public markets and away from the costs and regulations associated with listing.
ENTER PRIVATE EQUITY: In South Africa and the US combined, more than 3,800 companies have delisted over a period of 50 years. Many of them were profitable small or micro capitalisation companies. This universe of small unlisted companies is regulated by the companies act but escapes the regulations of stock exchanges. This puts them legally out of reach for asset managers. Asset managers need small companies in their portfolios – some have excellent growth potential. There is a way out for asset managers. Listed companies are allowed to invest in unlisted companies. Private equity refers to investment companies that buy and manage small unlisted companies.
ETHOS: On the JSE there is a successful specialist private equity company, EPE Capital Partners Ltd (“Ethos Capital”). Ethos is the largest private equity firm in sub-Saharan Africa. Ethos has investments in several companies. Companies that you may recognise are Twinsaver (toilet and tissue paper), Primedia (premium radio stations like 947, 702, Kfm 94.5, CapeTalk, and Eyewitness News), RTT (a courier company), and AutoZone (vehicle parts). They are all unlisted companies.
REINET: The Rupert family’s investment vehicle is operating as a private equity fund. Reinet’s largest unlisted investment, Pension Corp, has been a decent performer. €1.315bn invested over the years has more than doubled to €2.65bn. Pension Corp represents 50% of Reinet’s Net Asset Value (NAV). Reinet’s second biggest investment is in BATS, valued at around €1.8bn. BATS is Reinet’s cash cow. Besides the millions Reinet receives in dividends, Reinet also sells BATS shares when it needs cash. Smaller unlisted investments include Nano Dimension (the pioneer of 3D Printing), Soho China Property, GAM Real Estate (invests across Western Europe, especially in the United Kingdom). Smaller investments in private equity now account for about 18% of Reinet’s NAV. Johan Rupert has made excellent investments in the past. He is looking for the next big one. It will take time. Rupert knows: The day you plant the seed is not the day you eat the fruit.
BRAIT: Brait is an investment holding company focused on driving sustainable long-term growth and value creation in its investment portfolio of sizeable unlisted businesses operating in the broad consumer sector. The current investment portfolio includes New Look (ladies’ fashion brands), Virgin Active (health clubs), Premier (mainly packaged food) and Iceland Foods (frozen foods).
BOTTOM LINE: An unintended consequence of shrinking stock markets was the birth of Private Equity. Unlisted companies had a need for funding and leadership without the compliance intricacies of a stock exchange. Private equity allowed asset managers access to the pockets of excellence in the small capitalisation universe. All big companies were once small companies. Having exposure to small caps can be very profitable. Tencent, now the biggest company in China, was started in a small building. Ignore small companies to your peril. To find out more, contact one of our consultants for a gratis consultation.
The shrinking JSE. The number of listed companies on the JSE.
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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.
Spend some time with our team to find out which one of our portfolios is best for you!