Weekly Market Report

12 December 2023

The Bottom Line

South Africa’s Third Quarter GDP Contracts More than Expected

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Global and Local Indicators.

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Global Report:

By Carel la Cock

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.

The Bottom Line: South Africa's Third Quarter GDP Contracts More than Expected

By Gielie Fourie

The South African economy pulled back from two consecutive quarters of positive growth, to shrink by -0.2% quarter on quarter (QoQ) in Q3 2023, the three months to end-September, after a downwardly revised rise in Q2 from 0.6% to 0.5%. The median estimate of economists in a Bloomberg survey was for a contraction of -0.3% QoQ. Year-on-year (YoY), the Gross Domestic Product (GDP) decreased by -0.7% in Q3 2023. The weaker GDP is not surprising given SA’s structural constraints of electricity supply and logistical constraints as well as the challenging global environment. Transnet, whose long-standing rail infrastructure woes have been compounded by the bottlenecks at ports, which have prevented companies from timeously getting their goods in and out of the country. Businesses are also grappling with cost pressures of higher stages of load-shedding.

The contraction in GDP is a political headache for President Cyril Ramaphosa, who has been accused by business leaders of being too slow in pushing through structural reforms that economists say are crucial to reinvigorating the economy. “The big picture is that SA’s recovery from the pandemic has been among the worst in the emerging world, with GDP just 0.3% above its pre-pandemic peak,” said Jason Tuvey, the deputy chief emerging-markets economist at Capital Economics. The rand briefly weakened through R19/$ in late trade on Tuesday 5 December after the release of the GDP data.

CLASSIFICATION OF ECONOMIC ACTIVITIES: GDP is calculated from data gathered from ten industries. The ten industries are subdivided into three sectors. The three-sector model consists of the Primary Sector, the Secondary Sector, and the Tertiary Sector. Five of the ten economic activities posted declines. The winners were utilities, transport, finance, government, and personal services. Half the sectors are still below their pre-pandemic GDP levels. To remove the effect of inflation, GDP is measured at constant 2015 prices. Quarterly figures are seasonally adjusted.

THE PRIMARY SECTOR: The Primary sector engages in the extraction of raw materials/natural resources such as mining, agriculture, and fishing. These activities are divided into two industries namely agriculture and mining. The output of the Primary sector becomes the input of the Secondary sector. (1) Agriculture, forestry, and fishing – QoQ growth declined by -9.6%, hurt by an unexpectedly sharp agricultural contraction that surprised even agricultural economists. The non-agricultural sectors (jointly) performed marginally better than expected. Agriculture was affected by lower output in field crops, animal products, and horticulture products. (2) Mining – QoQ growth declined by -1.1%. Decreased economic activities were reported for platinum group metals (PGMs), gold, other metallic minerals, and manganese ore.

THE SECONDARY SECTOR: The Secondary sector engages in manufacturing and construction. It takes the inputs from the Primary sector and its outputs become the inputs for the Tertiary (the third) sector. Secondary sector producers are worse affected by severe infrastructure constraints than businesses in the Tertiary sector. The divergence between goods-producing sectors and services continues. (3) Manufacturing – QoQ growth declined by -1.3%. Eight of the ten manufacturing divisions reported negative growth rates in the third quarter. The food, beverages, and tobacco division made the largest contribution to the decrease in the third quarter. The petroleum, chemical products, rubber, and plastic products division and the basic iron and steel, non-ferrous metal products, metal products, and machinery division also made significant contributions to the contraction of this industry. (4) Utilities – QoQ growth increased by 0.2%. (5) Construction – QoQ growth declined by -2.8%. The construction sector is vital for economic growth, yet it is the smallest industry in our economy. The militant construction mafia has brought many construction businesses to its knees. This is one of the reasons why this industry is struggling.

THE TERTIARY (THIRD) SECTOR: This sector receives its inputs from the Secondary sector and provides services and end products to consumers. It is by far the largest of the three sectors. (6) Trade, catering, and accommodation – QoQ growth declined by -0.2%. (7) Transport and communication – QoQ growth increased by 0.9%. (8) Finance and business services – QoQ growth increased by 0.5%. (9) Government services – QoQ growth increased by 0.1%. (10) Personal services – QoQ growth increased by 0.6%.

BOTTOM LINE: The economy lost momentum in the third quarter, raising the risk of slipping into a technical recession during the fourth quarter and putting heavy pressure on Transnet to fix its dysfunctional logistical infrastructure. Low economic growth implies less tax revenue for the government to fulfil its public mandate of providing essential services — and has the potential to throw the government’s fiscal consolidation efforts off track. The disappointment in 3Q 2023, weighs on the growth that can be achieved this year. Economic growth of less than 1% is likely in 2023. A modest improvement in 2024 is still expected.

Source: SA STATS

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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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