Weekly Market Report

3 October 2023

Global Report

Global Market Prospects.

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Local Report

The Medium-Term Budget Policy Statement (MTBPS) 1 November 2023.

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Market Indicators

Global and Local Indicators.

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Global Report: Global Market Prospects

By Nick Downing

Economic growth across the world’s economies was stronger than expected in the third quarter (Q3), despite continued monetary tightening by the world’s major central banks. In July, the US Federal Reserve lifted its benchmark fed funds rate by a further 25 basis points to a range of 5.25-5.50%, a cumulative increase of 525 basis points since March 2022. The ECB, which had a benchmark interest rate of 0% in July 2022, implemented two additional rate hikes of 25 basis points each in August and September, lifting its policy rate to 4.0%. The Bank of England began hiking in December 2021, from a base rate of 0.1%, hiking from 4.5% to 5.0% in July and to 5.25% in August. Economic data came in stronger than expected, confounding the forecasts of recession published at the start of the year. In the US, the latest GDP data shows 2.1% quarter-on-quarter annualised growth in Q2. The eurozone, UK and Japan posted growth of 1.2%, 0.8% and 4.8%.

Despite reasonable economic growth, global equity markets lost ground in Q3 due to the impact of rising bond yields. Rising bond yields tend to result in a derating of equity market price-to-earnings multiples. The US 10-year Treasury yield broke out to new cycle highs, rising over the quarter from 3.82% to 4.59%. Sovereign bond yields increased across the world’s main economies. As yields rise bond prices drop. The S&P G7 Sovereign Bond index lost 3.89% in Q3, resulting in a year-to-date loss of 2.56%. The global equity risk premium, which is the forward earnings yield minus the G7 10-year government bond yield, has declined to its lowest since before the 2008/09 Global Financial Crisis (GFC). Rising bond yields have forced the US equity risk premium to its lowest since 2002, leaving little compensation for the extra risk of investing in equities versus bonds.

The UK FTSE 100 was the only index to record a gain in Q3, rising by 1.02% adding to its slender YTD return of 2.1%. Elsewhere losses over the quarter were consistent across equity markets. The US S&P 500 was down by 3.65%, China’s Shanghai & Shenzhen 300 index by 3.98%, Japan’s Nikkei 225 index by 4.01% and the German Dax by 4.71%. However, YTD returns showed greater divergence. The Nikkei led with a gain of 22.08%, followed by the S&P 500 with a gain of 11.68% and the Dax with a gain of 10.51%. The CSI 300 lagged with a loss of 4.7%. The MSCI All Country World index lost 3.81% in Q3, trimming its YTD gain to 8.5%, while the MSCI Emerging Market index lost 3.71% in Q3 and due to China’s outsized impact suffered a YTD loss of 0.38%. The benchmark performances mask significant differences across markets. In US dollar terms, global markets excluding the US have traded sideways over the year showing very little YTD appreciation. Within the US most of the YTD gains are attributed to the communication services, consumer discretionary and technology sectors, represented by the seven mega-cap stocks that have fuelled markets. These mega cap shares have gained collectively by 53% YTD, while the rest of the US market is up only 1%.

Financial markets are anxious that policy interest rates are still not restrictive enough and that continued economic growth will prevent inflation from returning to central bank targets. However, monetary tightening operates with a lag, historically of around 12-18 months before economic activity slows down. In this cycle, the lag between interest rate hikes and economic slowdown has been lengthened by the unusual build-up of excess household savings from Covid relief transfers. Yet, excess savings are close to being depleted. An economic slowdown is inevitable, as households and businesses increasingly refinance at higher interest rates and declining inflation mechanically increases the real rate of interest over coming quarters. The impact of earlier monetary tightening can only increase with time, lifting the likelihood of recession, however mild or short-lived.

Economic activity is already showing signs of slowing. New US housing starts dropped in August to their lowest level since June 2020. The US Conference Board Leading Economic Indicator (LEI) fell in September for a 17th consecutive month. The economy has never avoided a recession from the LEI’s current level and after such a long string of declines. The eurozone’s Economic Sentiment Indicator fell in August for the fourth consecutive month, weakening across all sectors and signalling a growing risk of recession. The UK economy is riskier than most as households have not deleveraged or mended their balance sheets in the same way the US and eurozone have done since the GFC. Its residential property market has risen to bubble proportions and in danger of protracted decline due to the sharp rise in mortgage interest rates. In Q2, Buy-to-Let mortgages in early arrears increased by 41% quarter-on-quarter. The bulk of homeowners are still at fixed mortgages of below 3% but they will increasingly need to refinance at higher mortgage rates.

The slowdown in economic activity is having the desired effect on inflation. The latest inflation data is encouraging, showing continued moderation in the US in response to improved supply chains, an easing in labour markets and the effect of lower shelter costs. Year-on-year core CPI excluding shelter has eased back from a peak of 7.6% to 2.6%. Shelter inflation is expected to turn negative in the second half of 2024, which means if core CPI excluding shelter remains constant at current levels, core CPI should return to sub 2% target levels by late 2024. These assumptions are reasonable given the incremental slowdown in demand. A similar downward path in inflation is expected in the eurozone and the UK, albeit with a slight delay compared with the US.

The inflation sceptics flag the recent spike in the oil price. The Brent crude price increased in Q3 from $73 to $95 per barrel, driven by drawdowns in US inventories and OPEC+ production cuts. However, oil is rapidly approaching peak demand as the world moves to alternative energy sources. Meanwhile increased energy efficiency means households are spending a steadily declining portion of their disposable income on fuel, thereby reducing the inflationary impulse of rising oil prices.

Some market forecasters are concerned by the potential for a hard landing in China and what it may entail for the global economy. China’s post-Covid economic recovery has been disappointing. Its GDP slowed from 8.8% quarter-on-quarter annualised in Q1 to 3.2% in Q2. However, economic momentum seemed to turn a corner in August amid improving consumer confidence with retail sales growth accelerating from 2.5% to 4.6% year-on-year. There was a pick-up in the Citigroup Economic Surprise Index and in manufacturing and services purchasing managers’ indices. China is experiencing strong growth in demand for goods that are higher up the value chain, including vehicles, vehicle parts, and electronic goods. Contrary to the deepening negative press coverage China’s GDP growth is tracking at its trend rate of 5% for 2023, in line with the government’s target.

The global equity market weakness experienced in Q3 may run into Q4 amid mounting evidence of economic slowdown and the threat of recession. At the same time, bond yields may rise further despite stable inflation expectations and the strongest signals yet that central bank policy rates have peaked. Yields may continue to respond negatively to the US sovereign credit rating downgrade by Fitch, the widening US budget deficit, and the surge in Japan’s government bond yields after the Bank of Japan raised its 10-year yield target from 0.5% to 1.0%.

However, the headwinds to financial markets felt in the second half of the year, notably recession risks and rising bond yields, should become tailwinds in 2024 and 2025. There are few structural economic imbalances, with the US and eurozone benefitting from strong private sector balance sheets across households and businesses. In the absence of structural imbalances, recessions will likely be, at worst, cyclical run of the mill and therefore mild and short-lived. Meanwhile, inflation is expected to return to central bank target levels, even in the absence of recession, which will allow monetary policy to pivot from interest rate hikes to interest rate cuts. Monetary policy easing, declining bond yields and the transformative benefits of AI, should lend support to equity market earnings as well as higher price-earnings multiples.

Local Report: The Medium-Term Budget Policy Statement (MTBPS) 1 November 2023

By Gielie Fourie

INTRODUCTION: The Medium-Term Budget Policy Statement (MTBPS) on 1 November 2023 will be interesting. The MTBPS is also referred to as the “mini budget”. It allows government departments to apply for adjustments to their budgets, apply for rollovers, and request additional funds for unforeseeable and unavoidable expenditures. Finally, it indicates how the government intends to allocate the upcoming national budget.

FISCAL CLIFF: According to media reports South Africa is facing a fiscal cliff – a perfect storm of lower receipts and increased expenses by the fiscus. For finance minister, Enoch Godongwana, the MTBPS will be a tough balancing act. He undertook to focus on the critical tasks of revitalising our economy and protecting the fiscus. Unfortunately, several economic factors are having a combined effect of limiting his options of balancing expenses and revenue. We look at some of these obstacles that are growth-negative and are inhibiting economic growth.

1 – LOWER REVENUE COLLECTIONS: Since the Covid lockdown in 2020 the fiscus has benefited from higher commodity prices, peaking in March 2022. Thereafter commodity prices dramatically collapsed reaching a low in June 2023. The major cause for the drop was interest rate increases as governments fought high inflation. Inflation was driven by high oil prices, not by commodities. The prices of our main export commodities collapsed. Year-on-Year (Y0Y) coal is down 63.34%, palladium is down 42.24%, rhodium is down 70.71%, platinum is down 1%, wheat prices are down 40%, and corn is down 30%. This is not good for the fiscus, and for farmers. Loadshedding, Transnet and SA Harbours contributed to lower mining output and less tonnage being exported, triggering a consequential collapse in the windfall revenue national treasury has been receiving post the Covid lockdown.

2 – SOCIAL RELIEF OF DISTRESS (SRD) GRANT: The SRD grant has grown into a major hot potato. It would be better if we never had the SRD grant in the first place. In February the government budgeted R36.1 billion (bn) up to March 2024 for the SRD grant, a R350 per month grant given to all unemployed people since the Covid lockdown. When the grant was first introduced as a temporary lockdown measure, government was advised that it would not be able to get rid of it once it was introduced. It would simply not be politically possible to take away money from 10 million unemployed people once they started receiving it, but government knew better. Government is now actually looking for a way to make the grant permanent. There are calls from labour unions to increase the SRD grant to R420.00 per month and to “convert” it into a Basic Income Grant (BIG) – an increased grant parading under a new name (BIG), now made permanent. That was never the intention.

National Treasury (NT) is clear that the grant is effective in reducing poverty (and also marginally effective in increasing employment). NT has not proposed that it be removed. The unintended consequence is that the SRD Grant is already (in effect) a permanent new social welfare grant. With the general elections planned for 2024, there is no likelihood that the grant will be scrapped. In a presentation, NT outlined the cost for a gradual increase in the SRD grant to ensure that its allocation is close to the food poverty line (FPL). In this scenario, the cost of the grant increases to R129.8bn by 2030/31. NT has been clear that the grant will need to be funded by cutting expenditure or raising taxes. NT has proposed three options: (1) close select government programmes to raise the funds required to extend the SRD grant in 2024/25; (2) raise VAT by 2 percentage points; or (3) extend the grant for one more year, coupled with an announcement by the president that the extension would be accompanied by a wholesale review of the social grant system.

4 – MANAGING THE PUBLIC SECTOR WAGE BILL: In addition to the SRD grant, the government has also had to fund an unexpected wage increase for public sector employees. The government had initially budgeted for a 1.6% increase and ended up having to fund a 7.5% increase. Government continuously has to fund higher wage increases than budgeted for. One of the unintended consequences of this is where the government needs to hire more employees, as in the police service due to the massive increases in crime, they end up hiring less because more of the budget is devoted to current employees.

5 – RECONFIGURATION OF THE STATE: In this year’s State of the Nation Address (SONA) President Ramaphosa stated that he had instructed NT and the Presidency to “work together to rationalise government departments, entities and programmes over the next three years”. The NT estimates that “we could achieve a potential saving of R27bn in the medium term if we deal with overlapping mandates, close ineffective programmes and consolidate entities where appropriate”. These austerity plans, and min Godongwana, were slammed by the SA Communist Party yesterday.

BOTTOM LINE: The above are just some of the challenges that min Godongwana must address. The lower commodity prices were outside government’s control. All the other issues were under government’s control. Min Godongwana owns 30 fedora hats, one for each day of the month. For his own safety he should add a hard hat to his collection before 1 November. Our advice to the minister: “A budget should reflect the values and priorities of our nation, not only that of one political party”.

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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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