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Global Report: Global Market Prospects
By Nick Downing
Q1 Global Market Review
Resilient growth, improving earnings and the prospect of interest rate cuts, continued to power global equity markets higher, maintaining the trend started in the fourth quarter (Q4) last year. The S&P 500 index gained 10.18% in Q1 boosted by strong earnings and Germany’s Dax by a similar 10.4%, helped by compelling valuations and a recovery in global export demand. Japan’s Nikkei was the outlier with a gain of 20.63%, helped by an official end to the country’s struggle with deflation. The Bank of Japan lifted its benchmark interest rate for the first time in 17 years, announcing that the “price stability target of 2% would be achieved in a sustainable and stable manner”. Japan’s economy is showing broad-based improvement and rising business and consumer confidence with wages increasing at a historically rapid pace. Companies are enjoying high returns on equity and strong profit growth. By contrast, China’s business and consumer confidence remains depressed due to real estate market woes and a lack of confidence in government’s economic policy, causing the CSI 300 index to return a subdued 3.1% in Q1.
The UK’s FTSE 100 index only delivered 2.84% due to weak economic performance relative to other G7 economies. GDP contracted for the 2nd straight quarter, meeting the official definition of a recession, by -0.3% quarter-on-quarter in Q4 and -0.1% in Q3. The MSCI Emerging Market index increased in Q1 by 1.90%, held back by China’s underperformance while the MSCI All Country World index increased by a solid 7.78%. Government bonds fared less well, with yields under rising pressure from recovering global trade and higher than expected inflation data from the US. As bond yields rise, prices drop. The US 10-year Treasury bond yield, the world’s de facto risk-free rate used for valuing financial assets, increased between end December 2023 and end March 2024 from 3.86% to 4.20%. The S&P G7 Sovereign Bond index lost 2.30% in the quarter.
Financial market concerns have shifted since the end of last year from there being too little to too much growth, which has again raised the spectre of undesirable inflation. US GDP grew at an annualised rate of 3.4% in Q4. Three successive strong inflation reports from the US for January and February together with continued economic resilience have forced the forward market to trim its expectations for interest rate cuts this year. Fed funds futures are now pricing in one or two 25 basis point rate cuts compared with six at the start of the year. The adjustment has occurred without any fallout to equity markets as earnings growth has been solid.
At its latest policy meeting concluded on 20th March, the Federal Reserve left its benchmark interest rate unchanged as expected but signalled 75 basis points of easing this year, despite a stronger growth and inflation outlook. Compared with its previous policy meeting held at the end of January, the Fed lifted its GDP growth forecast for 2024 from 1.4% to 2.1% and its core PCE inflation forecast for 2024 from 2.4% to 2.6%. The Fed has effectively lowered the bar for its planned policy easing, firm in its conviction that a recession is not necessary for inflation to return to its 2% target. The Congressional Budget Office meanwhile raised its estimate of 10-year potential real GDP growth from 1.8% to 2.1%, to account for higher immigration flows.
The combination of resilient growth and an easing in interest rates is a powerful cocktail for further equity market gains, although the positive outlook depends on inflation dropping to central bank targets. In the US, job creation is losing momentum, which should trim wage cost pressures. The labour market is cooling, businesses are replacing full-time jobs with temporary jobs and the unemployment rate has risen from a recent cyclical low of 3.4% to 3.9%. Small businesses, which account for 50% of the country’s employment, have reported a sharp decline in job openings. Meanwhile, unit labour cost growth should benefit over coming quarters from rising productivity with an acceleration in adoption of artificial intelligence (AI) applications. Disinflation is broadening, evidenced by the increasing fraction of items and expenditures showing price declines. Pipeline inflation pressures are also easing. Headline and core producer price inflation have returned to their pre-pandemic levels.
Inflation elsewhere is already at or rapidly closing in on central bank target ranges. Inflation in Canada plunged in February pushing core consumer price inflation to a 2.06% annual rate, already in line with the Bank of Canada’s target. In the UK, the official measure of inflation surprised to the downside in February with a decline from 4% to 3.4%. Further steep declines are in prospect after shop price annual inflation eased to 1.3% in March, down from 2.5% in February. In Switzerland, inflation is already below the Swiss National Bank’s target, prompting a 25-basis point rate cut on 21st March to 1.50%. Downside surprises in inflation could be replicated in the US amid the lagged response to monetary tightening.
US company earnings strengthened for the second consecutive quarter, confirming that the overall profit cycle is improving. Aggregate earnings of the S&P 500 index grew in Q4 by 10% year-on-year on a 4% increase in revenue, up from the previous quarter’s earnings and revenue growth of 7.5% and 2%, respectively. Most of the earnings growth is in the communication services, consumer discretionary and technology sectors, which reported year-on-year earnings growth of 36.6%, 24.2% and 53.4%, respectively. These sectors are home to the high-flying mega-cap technology shares. Earnings performance is expected to broaden out over time as improving manufacturing and trade activity enhance the earnings outlook of more cyclical sectors.
The US ISM manufacturing purchasing managers’ index exceeded the neutral 50-level in March, jumping into expansionary territory for the first time since September 2022. The global economy is also gaining momentum, with manufacturing activity and global trade both firming, which bodes well for an expansion in economic growth and earnings outside the US. However, US markets are expected to outperform on a 2-year view due to stronger earnings growth and the likelihood of a bubble forming on the back of enthusiasm around AI.
US mega-cap technology shares are expensive, trading at an estimated forward price: earnings multiple (PE) of 29x, although this is well below peak dot.com levels. Unlike then, earnings are rising rather than falling and interest rates are close to being cut rather than being hiked. The S&P 500 index excluding the mega-cap tech shares is trading on a 19x forward PE, which is close to the long-term average of 17x. According to the Fed Stock Valuation Model, which calculates fair value for the S&P 500 index by dividing the current aggregate forward earnings per share ($250) by the 10-year bond yield (4.6%), the implied fair value for the equity index is around 5435 compared with its Q1 closing level of 5255. Other equity markets are far cheaper, with most trading at their long-term averages despite the positive outlook of improving earnings and interest rate cuts. China is the valuation outlier, trading on a forward PE multiple of 9x compared with its cyclical peak of 17x in 2021.
Local Report: Local Market Prospects
By Nick Downing
Q1 Local Market Review
The JSE All Share index lost ground in the first quarter (Q1), decoupling from strong global equity markets over the period. After their strong year-end finish in 2023 some pullback was perhaps to be expected, given the contraction in aggregate earnings. The earnings decline is illustrated by the rise in the All-Share index price: earnings multiple between the end of December and the end of March from 10.9x to 13.2x despite the index falling in Q1 by 3.1%. Although the mining sector suffered sharp earnings declines the Resources 10 index only lost 0.5% as the profit downgrade had been largely discounted. The Financial 15 index fared worst due to weakening credit extension and concern over rising loan loss provisions. Industrials eked out a modest positive return of 0.2% helped by the dual listed rand hedge companies, which were assisted by firmer global markets. The rand also lent a hand by weakening 3.6% versus the US dollar from R/$ 18.30 to 18.95. In line with rising sovereign bond yields and the likelihood of the SA Reserve Bank (SARB) keeping its policy rate higher for longer, the 10-year RSA bond yield increased over the quarter from 9.77% to 10.88%. The dollar gold price gained by a solid 9.79% in Q1, due to strong central bank buying, providing a boost to the SARB’s gold and foreign currency reserves.
Weak equity market returns belie slight improvement in the macro-economic and policy outlook. The economy managed to avoid two successive quarters of contraction with GDP growing in Q4 2023 by 0.1% quarter-on-quarter and 1.2% year-on-year, up from -0.2% and -0.7%, respectively in Q3. A reduction in the severity of electricity loadshedding, port and rail delays should keep the improvement on track. The SARB estimates loadshedding will subtract 0.6% from GDP this year and 0.2% in 2025 compared with 1.5% in 2023. Research from RMB Morgan Stanley notes that the average stage of loadshedding was 1.8 for the first two months of this year versus 3.8 for the same period last year. Installed rooftop solar capacity has more than doubled over the past 12 months from 2.4GW to 5.4GW, comprising over 10% of Eskom’s energy capacity. The Treasury forecasts GDP growth will nudge higher to 1.3% this year, rise to 1.6% in 2025 and 1.8% in 2026.
Finance Minister Godongwana avoided the temptation of populist spending measures in the 2024 Budget ahead of the General Election. His budget mirrored the message of fiscal prudence and utility structural reform delivered by President Ramaphosa in his State of the Nation Address. The budget deficit widened as expected to 4.9% of GDP from 3.6% last year but is projected to reduce over the next three years to 4.5%, 3.7% and 3.3%. For the first time since 2009, a primary surplus was recorded at 0.4% of GDP. The primary surplus is income minus expenditure before interest. This should allow the Treasury to start chipping away at the country’s debt pile, which has risen to 70.9% of GDP and costs more than R1 billion per day to service. To ease the debt burden, the Treasury took the unusual step of tapping into the country’s Gold and Foreign Exchange Contingency Reserve Account (GFECRA) to the tune of R150 billion, causing some concern that this may set a dangerous precedent and leave the currency vulnerable to future shocks. Godongwana signalled his support for structural reforms by announcing that Eskom would lose R2 billion a year in bailout funding for every year the utility delays in selling a non-core asset while Transnet’s R47 billion guarantee is contingent on allowing outside parties into its railway network.
Business and consumer survey data were relatively downbeat over the quarter with both the Absa manufacturing purchasing managers’ index (PMI) and the S&P Global economy-wide PMI hovering just below the neutral 50-level at 49.2 and 48.4, respectively. The FNB/BER quarterly consumer and business confidence indices declined from -17 to -16 and from 31 to 30, respectively. Private sector confidence should recover from the easing in loadshedding, but high interest rates are taking their toll compounding the effect of weak real wage growth and high unemployment. Private sector credit extension growth remained depressed at just 3.3% year-on-year indicating little appetite for credit-fueled spending or investment. The SARB has kept its benchmark repo rate at a historically high 8.25% since last May which is high compared to other emerging markets in nominal terms and especially in real terms after subtracting the inflation rate.
However, the SARB will not be hurried into cutting the repo rate. At its most recent policy meeting on 27th March the policy committee decided unanimously to keep rates on hold citing upside risk to inflation, in particular food prices and imported inflation stemming from potential rand weakness. In February headline consumer price inflation (CPI) re-accelerated from 5.3% to 5.6% year-on-year and core CPI excluding food and energy from 4.6% to 5.0%, moving away from the midpoint of SARB’s 3-6% target. On a month-on-month basis CPI and core CPI gained by a substantial 1.0% and 1.2%, respectively. In his policy statement SARB Governor Lesetja Kganyago said “Given extra inflation pressure, headline now reaches the target midpoint only at the end of 2025, later than previously expected. As a result, the policy rate in our baseline forecast also starts normalizing later.”
Uncertainty ahead of the General Election on 29th May is also likely to dent domestic demand. Polls indicate the ANC’s support will drop below 50%, which means it will need to find coalition partners at a national level. The newly formed MK party may force the ANC’s vote closer to 40%, which could be good news for the Multi-Party Charter but also raises the risk of President Ramaphosa coming under pressure from Deputy President Paul Mashatile, which could ultimately open up the prospect of a national coalition between the ANC and EFF. Even in the more moderate scenario of a coalition between the ANC and one or more of the Multi-Party Charter parties, coalition politics are messy at the best of times, especially in South Africa where they remain untested at national level. For instance, the Constitution requires that parliament must meet to elect a new president within 14 days after the election result has been certified. Uncertainty may build even after the election has run.
South Africa’s equity market valuation is depressed compared to its own long-term average and relative to other emerging markets. The disparity is explained by slower economic growth. Local growth is hamstrung by continued high borrowing rates and a lack of confidence in government policy. While an easing in loadshedding and some progress in tackling road and rail backlogs offers a glimmer of hope, far more progress is needed. Interest rates will decrease in time, which will boost confidence over the short term, but a more sustainable equity market re-rating requires a decisive shift in economic policy.
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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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