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Weekly Market Report
28 February 2023
Investing in a higher inflation world.
2023 Budget. A decent one.
Global and local indicators.
By Nick Downing
Even the inflation doves, those most convinced that inflation will come back down, admit that inflation will not return to the sub-2% target levels achieved in the decade post the 2008/09 Global Financial Crisis. Independent research firm Capital Economics does not believe we are heading towards a repeat of the 1970s, which is a good thing. At least we will avoid stagflation, a lethal combination of high inflation and prolonged recession. In fact, trend growth in the US and Europe is expected to be higher than in the decade prior to the pandemic, but inflation will also be higher than it was in that period. Its long-range US CPI forecasts for the periods 2026-2030 and 2031-2050 are 2.3% and 2.3%, and for the Eurozone, 2.2% and 2.0% respectively. This is a very different setting to the decade prior to the pandemic when the world feared deflation rather than inflation, when the Federal Reserve and ECB had interest rates at zero percent and several trillion dollars’ worth of sovereign bonds were generating negative yields.
Where should one invest in a higher inflation world? A balanced portfolio comprising equities, bonds and cash should continue to fare well, producing decent real returns. Bonds now offer positive yields, in contrast to two years ago when negative yields guaranteed long-term losses if held to maturity. Equities will remain the top performing asset class, but which sectors and which regions of the world are likely to be the most rewarding? Growth-style sectors including information, communication, and technology companies, many with unproven business models, were richly valued in the past decade. However, the discount rate used to value these long-duration stocks, has climbed with rising interest rates and bond yields. Yields are likely to remain high and possibly climb further in a higher inflation world. These shares, promising returns many years in advance will be especially susceptible to higher discount rates.
Sectors with high short-term profitability, but less exciting long-term opportunities, the typical “value” sectors of the market, will be relatively immune to the rising discount rate, and should outperform. These include energy and commodities, also sectors that have regulated inflation-linked pricing such as utilities, real estate and healthcare, and sectors that hold a substantial amount of physical assets on their balance sheets such as industrial conglomerates. Banks and financials should be the biggest winners of all. Not only are banks and financials typical value investments they are also leveraged to rising interest rates. Their net interest margins increase in a rising rate environment.
US equities trade at an incredible 50% premium to the global non-US aggregate, at an estimated forward price earnings multiple of 18x versus 12x. This is largely explained by the technology sector’s substantial weighting in US indices. In contrast with the US, markets across Europe, the UK, Japan, China and emerging markets have far lower technology weightings but far higher weightings in the traditional value sectors that are expected to outperform in a more inflationary environment. Many investment analysts have downgraded their US outlook in favour of the more value-biased regions.
As value shares re-rate the distinction between value and growth shares will become less clearly defined. Inflation winners may eventually come from either camp but are likely to share the following attributes. Good quality, cash generative companies with strong balance sheets and pricing power. Companies with high gross margins generated by strong competitive positions. Companies with low capital requirements. Low debt is not necessarily a good thing in a higher inflation environment. Provided the balance sheet is robust, inflation will erode the value of the debt pile in real terms, benefitting shareholders.
Many richly valued “growth” shares will continue to do well. For instance, branded consumer goods. Many are represented in Finsbury Growth and Income Trust PLC, listed on the London Stock Exchange under the ticker FGT.L and which has been held for several years in OAM’s global portfolios. Its manager. Nick Train cites its portfolio brands Johnnie Walker whisky and Remy Martin cognac, which since 1933 have increased in price in the US 21x compared with US inflation that has increased 11x. Burberry is another of its holdings, making up 8% of the FGT portfolio. In 1916, a Burberry trench coat cost three guineas compared with the current price of £1,790, a price appreciation far exceeding UK inflation.
It may not be such a bad thing if inflation settles slightly above current central bank target levels. Higher inflation will erode the real value of elevated sovereign debt piles. Japan, which suffers from a 250% government debt-to-GDP ratio and has battled with decades of deflation, will be an obvious beneficiary of higher inflation.
While outperformance may come from different regions and from different sectors of the market than it has over the past 15 years, equities will continue to be the best performing asset class. Edison Research in a recent report on Finsbury Growth & Income dated 27th January 2023, summarises Nick Train’s outlook: “Over the 70 years of Queen Elizabeth 2’s reign, he says, the value of UK equities increased by 2500x versus inflation at just 20x, which the manager finds deeply reassuring. Despite the current pessimism around the UK economy and stock market, Train believes that sound UK companies can continue to protect savers’ capital against inflation and generate wealth for investors.”
By Gielie Fourie
INTRODUCTION: Economists have described the budget as “decent, reasonably neutral, good and boring”. Finance Minister, Enoch Godongwana, delivered his second budget on Wednesday 22 February 2023 under challenging circumstances, like loadshedding and the anticipation of SA being greylisted by the Financial Action Task Force. On the positive side, tax revenue collections exceeded the 2023 Budget by R93.7 billion. This was not enough to announce major tax proposals in this budget. The improvements to revenue collection are due to higher collection of personal and company taxes. We look at a few highlights of the budget – first the things that directly affect all of us, and lastly, we look at the bigger picture.
RELIABLE ELECTRICITY: The importance of reliable electricity was emphasised. A continued focus on the matter (along with other infrastructure investments) will be supportive of economic growth, the general equity market, and energy players locally. This has been a recurring theme over the last few years, but it seems as if we are moving in the right direction in terms of actual implementation.
TAX INCENTIVES AND TAX REBATES FOR SOLAR INSTALLATIONS: Businesses will receive a tax incentive of 125% of the cost of renewable energy assets used for electricity generation from 1 March 2023. For individuals there is a tax rebate of 25% on the cost of solar panels capped at R15,000.00 per individual. (Inverters and batteries are excluded). The tax incentives and tax rebates for solar installations (excluding inverters and batteries) will be positive for companies with exposure in this space such as Reunert, along with SA Inc. companies generally – who will enjoy a tax break on installations and cost savings on energy following these installations. We may also see an indirect benefit for the banks in terms of financing.
BRACKET CREEP: Adjustments to prevent bracket creep will put more money in your pocket. For example, people earning R1 million per year will have their effective tax rate reduced from 29.8% to 29.2%. The absence of additional fuel levies (see below), and new social grant increases will also put more money in some peoples’ pockets. This will be partially offset by higher “sin taxes”, and a below inflation state wage bill increase. The net effect is expected to be positive for SA Inc. stocks, banks, and retailers.
COMPANY TAX: Lowering the corporate/company tax rate, from 28% to 27% will be positive for SA Inc. profitability and is a step in the right direction in making South Africa a more attractive market to invest in. This will be effective from next month – 1 March 2023
SUGAR TAX: Following intense lobbying from the sugar industry, government has decided to not increase the sugar tax in the 2023/24 and 2024/25 financial years. This will be welcomed by the Food Producers – particularly those with a large contribution from “snacks and treats” like AVI and Tiger Brands.
SIN TAXES: After the damage done by the Covid lockdowns, government did at least offer a little relief by raising sin taxes by consumer price index (CPI) linked increases. In the past it was not linked to CPI. Excise tax is to rise in-line with CPI on a blended basis. This will be neutral for Tobacco and Alcoholic Beverage Producers (although British American Tobacco’s and Anheuser-Busch’s exposure to South Africa is small on a relative basis, and Distell is under offer).
FUEL LEVY AND ROAD ACCIDENT FUND: Godongwana said the National Treasury will not increase the General fuel levy and RAF levy for 2023. The General Fuel Levy is currently pegged at R3.94 per litre, and the RAF levy is at R2.18 per litre of 95 petrol (inland pricing). Combined, they add R6.12 to every litre of petrol and diesel sold in the country. The absence of a fuel levy increase will be positive for logistics companies although many operate on a pass-through basis. The diesel fuel levy refund will be extended to manufacturers of foodstuffs for two years beginning 1 April 2023 – this will be positive for the SA Food Producers and may result in an ultimate saving for consumers.
CAPITAL GAINS TAX (CGT): No change here. Individuals must still include 40% of capital gains in their income while companies and trusts still must include 80% of their gains in their income. The overall maximum effective tax rates for individuals remains unchanged from last year at 18% and for companies and trusts it is 21.6% and 36% respectively. SA trusts cannot distribute capital gains to non-resident beneficiaries. Government intends to apply this principle to other types of incomes correspondingly.
RETIREMENT WITHDRAWALS: Lump sums withdrawn before and at retirement will be adjusted upwards by 10%, meaning the tax-free amount that can be withdrawn at retirement increases to R550,000.00.
ESTATE DUTY/TAX AND DONATIONS TAX: Donations Tax remains unchanged – it is levied on donations over R100 000 in total per year at 20%. The tax rate increases to 25% on the part of the donation exceeding R30m per year. Donations between spouses are tax free. Estates will pay estate duty at a rate of 20% on estates bigger than R3.5m, and then at a rate of 25% for the part above R30m. For practical reasons Donations and Estates have similar tax regimes.
INTEREST RECEIVED EXEMPTION: No change here. The annual exemption for interest did not increase. The tax rules for interest received from a SA source remain unchanged. If you are under 65 years of age, the first R23,800.00 is exempt. If you are over 65 years of age, the exemption goes up to R34,500.00. The amounts are odd indeed, but it provides a very handy tax relief. The likelihood that it will ever increase is slim. They have been replaced by Tax-Free Investments. The Tax-Free Investments amounts remained unchanged.
BOTTOM LINE: Despite this being a “decent” budget, execution on the expenditure side must likewise be “decent”. At the same time the efficacy of growth enhancing initiatives, efforts to stabilise network industries and SARS’ ability to continue improving its efficiency in revenue collection must be managed by professionals. We have junk status, Eskom, greylisting and corrupt officials to contend with. We still have a tough road ahead of us.
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Reference: Datastream. GDP and debt to GDP – ECR Research.
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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