Weekly Market Report

5 September 2023

Global Report

10-Year Treasury Yield Threat.

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Local Report

A Look at Three Global Power Blocs – G7, G20 and BRICS.

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Market Indicators

Global and Local Indicators.

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Global Report: 10-Year Treasury Yield Threat

By Nick Downing

US equity markets surged on 31st August, with global markets joining the rally. The S&P 500 index enjoyed its biggest one-day gain in 3 months, capping three successive daily gains. The catalyst for the rally was weaker than expected economic activity data, notably falling new job openings, and fading consumer confidence. It was a case of bad news being good news, at least for Treasury bonds and equity markets. A weaker economy suggests inflation will keep decelerating, removing the need for further Federal Reserve monetary tightening. The prospect of lower inflation and lower short-term interest rates helps push treasury bond yields lower. Bond prices rise as yields drop. End August markets provide a foretaste of what may be in store for Treasury bond markets and equity markets in 2024 and 2025.

Rising bond yields are bad for equity valuations. Equity valuations essentially have two moving parts: Earnings and the Price-to-Earnings ratio. The Price-Earnings ratio comes under pressure when bond yields rise, in particular the 10-year Treasury bond yield, which is the benchmark in global financial markets against which all asset prices are priced. The equity risk premium is the forward earnings yield minus the 10-year Treasury bond yield. The US equity risk premium has dropped sharply this year indicating less value for shareholders. It has dropped to its lowest level since 2002, partly due to rising equity markets but mainly due to the sharp increase in the 10-year Treasury bond yield. The yield has increased from 3.19% to 4.21% over the past 12 months. From current elevated levels, given the compacted equity risk premium, a further sharp rise in the 10-year Treasury yield poses the biggest threat to US and global equity markets.

Some renowned economists including former Treasury Secretary Larry Summers believe the 10-year yield will move higher, premised on persistently strong economic growth, which would require further Fed monetary tightening to quell inflation. These economists believe that the current Fed funds rate, despite rising by 525 basis points since 2022, is not yet in restrictive territory. They believe continued economic strength will prevent inflation from returning to the 2% G7 central bank targets.

Others feel a US recession is just around the corner. The lag between the current interest rate hiking cycle and recession has been longer than usual due to massive pandemic handouts, amounting to some $5 trillion. By swelling household savings, the extraordinary pandemic fiscal relief made consumers less susceptible than normal to rising interest rates. Nonetheless, a recession is expected to arrive as excess savings are being depleted while consumers and businesses will eventually have to refinance at higher prevailing interest rates. The Conference Board’s Leading Economic Indicator (LEI) has dropped for 13 consecutive months. According to independent research firm Alpine Macro, the US economy has never avoided recession after such a long string of LEI declines and the current annual rate of LEI contraction.

Alpine Macro also believes inflation is coming down. Excluding shelter, core CPI has already fallen from a peak of 7.6% year-on-year to 2.6%. According to the San Franciso Federal Reserve Bank, shelter inflation is moving sharply lower and could turn negative in the second half of 2024. If core CPI excluding shelter remains unchanged at 2.6%, this means overall core CPI might fall to as low as 0.3% by late 2024. Alpine Macro believes 10-year Treasury bond yields are close to their cyclical top and likely to head lower.

Capital Economics, another independent research firm, shares the view on bond yields. It believes a mild recession is in the offing but also that inflation and bond yields will come down regardless of the strength of economic activity. Over the past eight Fed monetary tightening cycles, the 10-year yield fell by an average 130 basis points in the six months following the last interest rate hike. Futures markets are discounting only a small chance of a further rate hike at the upcoming Fed policy meeting on 19-20 September. The greater likelihood is that the July rate hike was the last in the current tightening cycle. Capital Economics forecasts falling inflation, a mild recession and the 10-year yield dropping to 3.25% by the end of this year and 3.0% by end 2024.

Provided the recession is mild, a sharply lower 10-year yield should be very positive for balanced investment portfolios. As yields fall bond prices rise. Equity markets will also rally, as the lower bond yield will create more attractive equity risk premia and the potential for higher Price-to-Earnings multiples. Capital Economics forecasts global equity markets will drop between now and the end of the year by 10% due to mild recession but following that a substantial 30% return in 2024 and a further 30% in 2025, in line with falling bond yields and a gradual economic recovery.

Nothing is certain in financial markets. Other analysts, although in the minority, believe that instead of retreating to 3.0% by end 2024, the 10-year yield could go in the other direction, potentially hitting 5.0%. A combination of other factors besides inflation and the Fed funds rate could contribute to a yield spike including the downgrading of US sovereign credit risk by Fitch rating agency, the deteriorating US budget deficit, and the unusually large sovereign debt issuance schedule. Moreover, the Bank of Japan has abandoned its cap on 10-year Japanese Government Bond (JGB) yields. Rising JGB yields will cause Japanese institutions to sell US Treasuries in favour of JGBs which for the first time in over a decade are offering reasonable yields.

Overberg Asset Management takes the view that the 10-year yield is close to peak levels and that the next two years will be good for financial markets, although nothing is certain. In the event of a bond yield spike or a deeper than anticipated recession, some risk mitigation needs to be in place through protective asset class weightings and effective portfolio diversification.

Local Report: A Look at Three Global Power Blocs – G7, G20 and BRICS

By Gielie Fourie

INTRODUCTION: The G7, G20, and BRICS are three international groupings of countries that play significant roles in global trade. The rationale for forming these groupings is to advance trade between its members. They are first and foremost economic blocs, with a smidgin of politics included in the mix. The formation of BRICS, and now BRICS+, has brought about a profound shift in the global economic and political landscape as the influence of the BRICS bloc grows among developing nations.

BRIC, an acronym for Brazil, Russia, India, and China, was formed in September 2006 under the initiative of Brazil. The term was coined by Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK treasury minister. In his 2001 paper, “Building Better Global Economic BRICs” he argued that by 2050 the four BRIC economies would come to dominate the global economy. Critics of his paper mentioned that the countries were too disparate and diverse to form a successful economic group. When South Africa became the next “BRIC in the wall” in 2010, the name was changed to BRICS. The 15th BRICS summit in August 2023 in Johannesburg, chaired by President Ramaphosa, was a historic occasion for BRICS. It was attended by 50 countries. Six countries, Argentina, Egypt, Ethiopia, Iran, Saudi Arabia, and the United Arab Emirates were invited to become members of BRICS. The name will change again, this time to BRICS+. At least another 14 countries have applied for BRICS+ membership. If approved, it will lift its membership to 25. Jim O’Neill had foresight in creating the acronym “BRIC”, rather than the monicker “G5”. BRICS+ is headquartered in BRICS Tower, Shanghai, China.

BRICS INFLUENCE: BRICS was initially formed to foster economic cooperation among its members and to enhance their collective influence on global affairs. Importantly, it also seeks to increase the group’s political standing in the world. BRICS countries collectively represent a significant share of the world’s population and economic output – see table below. Although they have made strides in enhancing cooperation, their impact depends on their ability to find common ground among its diverse member states – for example, right now the relations between India and China are at an all-time low.

BRICS BANK: The New Development Bank (NDB), formerly referred to as the BRICS Bank, is a development bank established in 2014 by the BRICS countries with the purpose of providing resources for infrastructure as an alternative to the World Bank. BRICS was frustrated with the World Bank and the IMFs austerity measures. For years, BRICS has lobbied for a greater say in the affairs of the World Bank and the IMF, but its combined votes at the World Bank directors’ meetings stands at 11%. World Bank and the IMF conditions to their loans are a strict “one size fits all” model, rather than custom-tailored loans to focus on the unique needs of each individual borrower. BRICS considered the strict conditions as an infringement on national sovereignty. The NDP represents a first step by the BRICS nations in challenging the global financial order of the Bretton Woods institutions, like the World Bank and the IMF, which are dominated by the United States and other high-income countries.

A BRICS CURRENCY: The New Development Bank does not have any plans for the group to create a common currency, like the Euro. Likewise, there is no meaningful discussion concerning the creation of an Eastern version of the EU – partially because there is already one in the form of ASEAN, a trading group of ten Southeastern Asian countries, namely Brunei, Burma, Cambodia, Indonesia, Laos, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

THE FUTURE OF BRICS: BRICS countries are a voice for a non-Western world – a rival to the wealthy G7 countries. BRICS countries are seeking to liberate themselves from Western (particularly the G7) standards and regulations. For example, there is no discussion amongst BRICS members about human rights, corruption, or democracy. For many countries the absence of strict rules and regulations is where the appeal of BRICS lies. Seventy-seven countries – and not insignificant ones – have been invited to join BRICS. There are concerns that BRICS will become a “club” where politics is more important than trade – mutual trade between BRICS members amounts to a mere 6% of their total trade. South Africa has a negative trade balance with every single BRICS country. Six BRICS+ countries are major oil producers – BRICS+ countries will control more than 80% of the global oil trade and 40% of global GDP. South Africa will be assured of a secure oil supply. BRICS countries are aligning themselves as an alternative to the G7 and the G20. Who are the G7 and the G20?

THE G7: The Group of Seven, formed in 1975, is an informal bloc of advanced industrialized democracies – the United States, Canada, France, Germany, Italy, Japan, the United Kingdom, and the European Union (EU). It became the G8 when Russia joined in 1998. It reverted back to the G7 in March 2014 when Russia was suspended indefinitely following the annexation of Crimea. BRICS, however, is pro-Russia. It has never supported sanctions against Russia following Russia’s invasion of Ukraine. Since the war BRICS has drifted further apart from the West. Both a formal constitution and a permanent headquarters are absent from the G7. All the G7 countries are members of the G20. No country is a member of all three groups.

THE G20: The Group of Twenty, formed in 1999, comprises 19 countries, not all of them democracies. The G20 includes all the G7 countries, plus Argentina, Australia, Brazil, China, India, Indonesia, Republic of Korea, Mexico, Russia (despite being suspended by the G7), Saudi Arabia, Türkiye, South Africa, and the EU. Spain is not a member but is invited as a permanent guest. South Africa will hold the G20 presidency in 2025. Like the G7, the G20 does not have a permanent secretariat or headquarters. The G20 represents 85% of global GDP and two-thirds of the world’s population.

BOTTOM LINE: In summary, the G7, G20, and BRICS+ are international groupings that play roles in shaping global governance and cooperation. Economically BRICS+ will grow bigger, while growth in the G7 and G20 is slowing down. Below is a comparison of the three power blocs.

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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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