Weekly Market Report

25 July 2023

Global Report

The Federal Reserve in 2024.

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Local Report

The Impact of Inflation on Investments: Strategies for Preserving Wealth.

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Market Indicators

Global and Local Indicators.

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Global Report - The Federal Reserve in 2024

By Nick Downing

The Federal Reserve concludes its policy meeting tomorrow on 26th July. The consensus forecast is that the Fed will hike the fed funds rate by 25 basis points to a range of 5.25-5.50%. It has been raised in almost record time from 0% in March 2022. Will tomorrow’s rate hike be the last? A lot depends on where the equilibrium or neutral rate lies, defined as the real fed funds rate (after subtracting inflation) that neither stimulates not restricts the economy.

The level of the neutral fed funds rate is objective and open to fierce debate, especially now after such a rapid and substantial tightening in monetary policy. Economists are divided in two camps. One believes that the fed funds rate is already in restrictive territory and a recession is on the horizon due to the lagged impact of rate hikes so far. The other believes that rates are not yet restrictive, that a recession is not on the horizon and that the Fed will need to tighten more in order to beat inflation.

Independent global investment research firm, Alpine Macro, makes a compelling argument that the fed funds rate is already well above the neutral rate and macro trends are likely to keep the neutral rate low over the long-term. Alpine Macro cites the Federal Bank of New York’s equilibrium rate model, which captures the effect of the Covid shock. According to the model the neutral rate has dropped to 0.6% which is below the pre-pandemic level, suggesting the fed funds rate is already around 2% above the neutral rate. Alpine Macro cautions that the Fed has no need to tighten further as real interest rates are already restrictive and inflation is coming down sharply. Headline US CPI has fallen from a peak of 9.1% in June 2022 to 3% in June 2023. Core CPI, which excludes food and energy prices, has dropped from a peak of 6.6% to 4.8%, a more modest reduction but if shelter is excluded core CPI would be 2.8%, close to the Fed’s 2% inflation target. The shelter component of CPI lags the actual housing market which has already dropped.

If the fed funds rate is already restrictive and inflation keeps coming down, it is likely that the Fed will be cutting interest rates over the next two years. Independent economic research company, Capital Economics forecasts the fed funds rate will peak at 5.25-5.50% and drop to 3.25-3.50% by end 2024, dropping further to 2.50-2.75% by the end of 2025. The prospect of sharply declining interest rates will be welcomed by financial markets.

Alpine Macro argues that the neutral policy rate will remain compressed globally over coming decades across the world due to long-term demographic and productivity trends and rising global inequality, which are all reducing the trend economic growth rate and therefore dictate a lower neutral interest rate. As the world’s population ages, the workforce is shrinking which reduces the potential economic growth rate. Productivity growth has been steadily tracking lower, which also reduces the potential economic growth rate and therefore commands a lower neutral interest rate. As global inequality rises, a larger proportion of wealth flows to the rich who are inclined to save more, having a similarly depressing effect on economic potential. The IMF forecasts that equilibrium real interest rates are likely to stay close to pre-pandemic levels in advanced economies in the coming years.

There are caveats to this view. The steady productivity decline may reverse course with the advent of artificial intelligence. Many research organisations are predicting an annual AI productivity boost of 1% or more over coming years, which would lift economic growth potential and the equilibrium interest rate. Consumers in the US and across Europe spent the decade following the 2008/09 Global Financial Crisis (GFC) deleveraging their balance sheets, creating space for a new credit boom. A new credit boom would also lift economic growth potential and the equilibrium interest rate. The energy transition will come with higher energy costs which would depress economic growth potential, but the need for bigger government budgets would provide a counterbalance.

A compressed equilibrium interest rate bodes well for lower interest rates in 2024 and 2025 and for financial markets. The proviso is that we avoid a painful recession. The pessimists warn that rising interest rates take anywhere between 12-24 months to work through the economy and since the Fed started raising interest rates 16 months ago, much of the impact is yet to be felt. However, others cite the greatly improved household, company and bank balance sheets due to the decade of post GFC deleveraging and accumulated excess savings from Covid-era handouts, which make the private sector impervious to increased interest rates.

The latest Wall Street Journal economists’ survey conducted from 7-12th July suggests the US economy will avoid a hard economic landing. The average forecast is for US GDP to have grown at a 1.5% annual rate in the second quarter (Q2) up from the 0.2% forecast in the previous survey. For Q3 they expect 0.6% growth compared to the 0.3% contraction projected in the previous survey. They only expect a mild 0.1% contraction in Q4 and for 2024 they forecast 1% growth, double the previous forecast of 0.5%. It seems a US recession, if it occurs at all will be mild and short-lived, the proverbial soft landing, which combined with disinflation and falling interest rates would be extremely positive for equity markets.

Local Report - The Impact of Inflation on Investments: Strategies for Preserving Wealth

By Werner Erasmus

Inflation is a silent financial force that can significantly affect our investments and overall financial well-being. As prices of goods and services rise over time, the purchasing power of our money diminishes. This erosion of value has a profound impact on various investment avenues, making it crucial for investors to understand and plan for inflation’s effects. Inflation has risen significantly in South Africa and globally since the Covid 19 pandemic on the back of constrained supply chains, government stimulus packages, low interest rates, rising oil prices and labour shortages. The trajectory of South Africa’s headline inflation rate has been shaped primarily by fuel, electricity, and food price inflation. Inflation in South Africa peaked in July 2022 at 7.8% well above the 4.5% target of the South African Reserve Bank (SARB). The above target inflation rates have resulted in the increase in interest rates in an effort by the SARB to bring inflation back down. Fortunately, inflation has been decreasing gradually since the peak in July 2022 with the latest figure for June 2023 CPI coming in at 5.4%. In this article, we explore the impact of inflation on investments and discuss strategies to preserve wealth in an inflationary environment.

1. Erosion of Purchasing Power: One of the most direct impacts of inflation on investments is the erosion of purchasing power. As inflation increases, the same amount of money will buy fewer goods and services. This means that even if your investment portfolio grows in nominal terms, its real value might decline when adjusted for inflation. For example, if your investments yield a 5% return, but inflation stands at 3%, your real return is only 2%.

2. Fixed-Income Investments: Fixed-income investments, such as bonds, are particularly vulnerable to inflation’s impact. When you invest in a fixed-income security, you are essentially lending money to an issuer in return for periodic interest payments. However, if inflation rises during the investment’s term, the purchasing power of those interest payments decreases. Additionally, when the investment matures, you might find that the principal amount can buy fewer goods and services than when you initially invested.

3. Equity: While equity is generally considered a hedge against inflation, its performance during inflationary periods can still be affected. Inflation can lead to higher production costs, reducing profit margins for companies. Moreover, companies may struggle to pass on these increased costs to consumers if their products or services face price sensitivity. As a result, a high and sustained inflation rate can negatively impact corporate earnings and, consequently, stock prices.

4. Property: Property is often considered a reliable hedge against inflation. During inflationary periods, the value of properties tends to rise, preserving the investment’s purchasing power. Additionally, property can provide a source of passive income through rent payments, which may also increase with inflation. However, it is essential to note that real estate’s performance can vary based on local market conditions and other economic factors.

Four Strategies to Preserve Wealth:

(a) Diversification: Diversifying your investment portfolio across different asset classes can help mitigate the impact of inflation. While some assets may suffer during inflationary periods, others may perform well, reducing overall risk.

(b) Inflation-Indexed Securities: Consider investing in inflation-indexed securities, like Treasury Inflation-Protected Securities (TIPS). These investments adjust their principal value based on changes in the Consumer Price Index (CPI), ensuring that your investment keeps pace with inflation.

(c) Equity Investments: Despite potential challenges, equities have historically outperformed inflation over the long term. Companies that can adapt to inflationary pressures are likely to maintain or increase their value over time.

(d) Property: Property, especially physical property, can function as a valuable hedge against inflation due to its tangible nature, appreciation potential, ability to generate rental income, and its relative low correlation to traditional assets. In addition to property, consider investing in tangible assets like precious metals, commodities, or infrastructure projects. These assets tend to retain value during inflationary periods.

Conclusion: Inflation is an erosive factor that negatively impacts the value of investments. Its eroding effect on purchasing power underscores the need for investors to plan and strategize accordingly. Diversification, inflation-indexed securities, equity investments, and real assets are all valuable tools for preserving wealth in an inflationary environment. By understanding inflation’s impact and implementing prudent investment strategies, investors can navigate inflationary periods and achieve long-term financial success. Remember, staying informed and seeking professional advice can make a substantial difference in safeguarding your investments against the ravages of inflation.

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Reference: Capital Economics – Historical bond and equity return data.

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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