Weekly Market Report

31 October 2023

Global Report

IMF World Economic Outlook.

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Local Report

2023 Medium-term Budget Policy Statement – Preview of Tax Revenues.

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Market Indicators

Global and Local Indicators.

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Global: IMF World Economic Outlook

By Carel la Cock

The global economic landscape continues to grapple with the persistent aftermath of the COVID-19 pandemic and Russia’s invasion of Ukraine, while simultaneously navigating a host of other economic challenges. Despite displaying a remarkable degree of resilience earlier in the year, with economies gradually reopening and inflation gradually retreating from its peak, the path to a full recovery remains uneven, marred by the consequences of the pandemic, geopolitical tensions, and increasingly fragmented global economic relations.

Economic activity has not yet returned to pre-pandemic levels, especially in emerging markets and developing economies. The global economic recovery has been hindered by various factors, both cyclical and structural, including monetary policy tightening to combat inflation, reduced fiscal support amid high debt levels, and the impacts of extreme weather events.

Despite these headwinds, global gross domestic product (GDP) grew by 3.4% in the second quarter year on year, driven by strong consumer demand amid tight labour markets in the US and a return of tourism in countries such as Italy, Spain, and Mexico. However, pandemic era excess savings, which have supported developed economies this year amid rising interest rates, are being depleted while households are still contending with higher cost of living and lower access to credit extension. Furthermore, the boost to growth from international travel is also waning as tourism approach pre-pandemic levels. The global manufacturing sector has also shown signs of slowing down with knock-on effects on industrial production and global trade in goods as the effects of the interest tightening cycle is taking effect.

Global growth is projected to slow, with a forecast of 3.0% in 2023 and 2.9% in 2024, falling below the historical average of 3.8% achieved in the two decades preceding the pandemic and the 3.5% achieved in 2022. Growth for 2024 has also been downgraded by 0.1 percentage point since the July outlook. Advanced economies are expected to experience a slowdown from 2.6% in 2022 to 1.5% in 2023 and 1.4% in 2024 in line with expectation in July, however the contribution to growth has been revised.

In the United States, the economic growth forecast for 2023 stands at 2.1% and is expected to slow to 1.5% in 2024. This projection has been revised upward, with a 0.3 percentage point increase for 2023 and a 0.5 percentage point increase for 2024 compared to the July 2023 WEO Update. The upward revision is due to stronger business investment in the second quarter and resilient consumption growth, which reflects the still tight labour market. Moreover, the government’s fiscal stance is expected to be expansionary in 2023.

The euro area is expected to experience a decrease in economic growth, dropping from 3.3% in 2022 to 0.7% in 2023, but rebound to 1.2% in 2024. These forecasts have been revised downward by 0.2 percentage points for 2023 and by 0.3 percentage points for 2024 when compared to the July 2023 WEO Update.

Emerging market and developing economies are also expected to see a modest decline in growth. China’s economic growth, which had initially surged after the COVID-19 reopening in early 2023, is now showing signs of slowing down. Growth decreased from 8.9% in the first quarter of 2023 to 4.0% in the second quarter.

High-frequency indicators are pointing to further economic weakness, with a crisis in the property sector playing a significant role in hindering growth. Combined with uncertainty in the labour market, reflected in elevated youth unemployment rates exceeding 20% in June 2023, have had a dampening effect on consumption. Despite the reopening of the economy in the first quarter, consumer confidence remains subdued. Industrial production, business investment, and exports are also showing signs of weakness, influenced by a combination of declining foreign demand and geopolitical uncertainties. Commodity-exporting countries and nations integrated into the Asian industrial supply chain are particularly vulnerable to China’s loss of economic momentum.

Global headline inflation, which had surged to 11.6% in the second quarter of 2022, has since dropped to 5.3% in the second quarter of 2023, narrowing the gap between the 2022 peak and the pre-pandemic average of 3.5% (2017-19). Underlying (core) inflation, which excludes food and energy prices, has also decreased, although at a slower pace. It dropped from 8.5% in the first quarter of 2022 to 4.9% in the second quarter of 2023, approaching the pre-pandemic annual average of 2.8% (2017-19). In major economies, it ranged from 0.3% in China to 4.6% in the euro area and 4.7% in the United States in the second quarter of 2023.

In the United States, tight labour markets have been a significant driver of inflation, although recent data indicates some easing in labour market conditions. Wage growth has remained controlled, preventing wage-price spirals in advanced economies. At the same time, wages at the lower end of the income distribution have risen faster than the average, narrowing the wage gap.

Despite central banks’ decisive actions, inflation remains above target in most economies with inflation targets. Many central banks, including the Bank of Canada, the Bank of England, the European Central Bank, and the Federal Reserve, raised rates in July to address this issue. The Bank of Japan allowed more flexibility in yield curve control. An exception to this pattern is China, where inflation remains subdued, and the People’s Bank of China reduced interest rates in June and August.

Global inflation is expected to gradually decline from 8.7% in 2022 to 6.9% in 2023 and 5.8% in 2024. However, these projections have been revised upward, and most countries are not anticipated to reach their inflation targets until 2025.

While some extreme risks have diminished, such as banking instability, the overall balance of risks remains tilted to the downside. The possibility of a hard landing in China’s property sector poses a significant threat with potential global spillovers. Increasing inflation expectations and tight labour markets could lead to persistently high core inflation, necessitating higher policy rates. Climate and geopolitical shocks also loom large on the horizon, with the potential for additional spikes in food and energy prices.

Local: 2023 Medium-term Budget Policy Statement - Preview of Tax Revenues

By Gielie Fourie

INTRODUCTION: Finance Minister Enoch Godongwana will present the Medium-term Budget Policy Statement (MTBPS) in parliament tomorrow. The MTBPS outlines government policy objectives and priorities and presents a fiscal framework for the mid-term. It is a three-year rolling outlook, outlining revenue and spending estimates.

THE DEFICIT: In our Report of 3 October, we stressed the need to cut back on expenditure as revenue collections disappointed in a year of weak economic growth and poor exports. This report will focus on the revenue side of the budget. The current weak fiscal outlook originates mainly from a larger than expected decline in government tax collections and tighter financial conditions that have constrained government’s borrowing programme. Government has a revenue gap of R30 billion and turned to SARS Commissioner Edward Kieswetter to increase tax collections to make up the short fall.

It is indeed high time that the minister places greater responsibility on SARS, and provides it with resources, to improve compliance levels and tax collections. There is ample evidence in the media of tax evasion by criminal syndicates operating outside the tax net. Mr André de Ruyter, former Eskom CEO, detailed the modus operandi of a major fuel and coal syndicate operating at Eskom’s power plants. Recent improvements introduced by SARS in its efficacy are yielding material revenue gains, though this will only partly compensate for the general revenue underperformance. Recently SARS made a major breakthrough that did not receive enough media attention.

Three weeks ago, on 12 October SARS reported in a media statement: “A massive inter-governmental search and seizure operation across five provinces was carried out today to break the back of a sophisticated criminal syndicate of alleged coal-smugglers. SARS was the lead agency in today’s search and seizure operation because information became available regarding a host of tax crimes allegedly committed by members of the coal-smuggling syndicate. It is due to such hard work, often behind the scenes, that leads to these investigative breakthroughs and ensures that South Africans can return to a lifestyle without loadshedding. These targeted operations also help to prevent the loss of revenue to the fiscus, which in this case amounted to more than R500 million. The five provinces were Gauteng, Mpumalanga, KwaZulu-Natal, the Free State, and Limpopo.” SARS Commissioner Edward Kieswetter said, “it is because of such naked greed that the country has experienced unprecedented loadshedding ……”. We have money for everybody’s needs, but not for everybody’s greed. SARS took the lead role in the search and seizure operations, not SAPS, nor the Hawks, nor the Asset Forfeiture Unit.

EXPENSES OUTSTRIPS REVENUE: The treasury said total revenue growth was 8.7% year-on-year in August, while total expenditure grew at a stronger pace of 9.2%. South Africa’s budget deficit widened to R238.4bn in the first five months of the 2023/24 fiscal year, or R254.4bn, including Eskom debt relief. This is much bigger than the R160.7bn in the same period in 2022/23. It is expected that the deficit could grow to 5.5% of GDP this year, compared to a Budget 2023 projection of 4.0%, forcing min Godongwana to make tough decisions to plug the deficit. He has three main options to boost revenue – cut spending, borrow more money, or raise taxes. Each of these options has its drawbacks and risks.

REVENUES: Year-to-date (YTD) tax collections were below projections mainly due to a drop in exports and manufacturing. Exports were hit by lower commodity prices, reaching a low in June 2023, and the effect of loadshedding on operations. Logistical problems at Transnet and SA Harbours contributed to less tonnage being exported. Loadshedding also affected manufacturing and retail sales when retailers had to close their businesses and work shorter hours. The expected improvement in electricity supply should support economic activity and tax revenues next year. If the YTD growth in personal income tax revenues can be sustained, it would reach Treasury’s budget estimate, but these revenues have been losing momentum and may ultimately also undershoot, even if only slightly.

FUNDING, RATINGS AND BONDS: Funding is failing to keep pace with the public’s needs, service delivery demands, inflation, and other financial pressures. Expectations of what can be delivered will have to decrease. Funding would partly depend on the extent to which government plans to use funding sources such as government’s gold and foreign exchange contingency reserve account. We don’t expect any improvement in SA’s credit ratings, so government would try to limit any increase in bond issuance, given the poor appetite from foreign investors.

BOTTOM LINE – SARS IS THE ANSWER: The “tax gap” is the difference between taxes legally owed and taxes collected. The overall tax gap is estimated at 39% of the potential tax liability or 2.0% of GDP over the period 2015 to 2017. The biggest source of the tax gap is unreported income. PwC estimates the tax gap to be around R300bn. If SARS can reduce it by just 10% it would generate an additional R30bn in revenue – sufficient to fill the gap mentioned above. We have difficult choices to make. The easy choice is to give Commissioner Kieswetter additional resources to carry out search and seizure operations so that tax collections can increase.

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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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