One of our preferred global managers (Terry Smith – Fundsmith Equity Fund), wrote in an update this week on how inflation, rising interest rates and an increasingly likely recession have two obvious effects on equity investments – fundamental effects and valuation effects.
He admitted that he has no insight as to the extent interest rates will need to rise to quell inflation, “but that the rate hikes will do nothing to correct the continuing supply problems in commodities, semiconductors and just about everything else”.
It is unquestionable that, in a period of rising interest rates, long dated assets will fare worse than short-dated ones. This applies to equities as well as bonds. These impacts (or investment returns), caused by macro profiles, are what can be construed as valuation effects, and tend to unpredictable, both in extent as well as in duration.
We, at Dynasty, prefer to focus on fundamental effects of the macro profiles on the equities within our clients’ portfolios. Our favoured funds comprise resilient companies with high gross margins within specific sectors, which can be considered the best defence against collapsing earnings in a high inflationary environment. This approach has held up well year-to-date in that the revenue growth of such companies in the past six months has remained strong – circa 8% annualised – although their share price performances will no doubt be of cold comfort to our clients at this time.
Our investors should take more comfort that although the next few quarterly earnings seasons are unlikely to be exciting, the companies within our quality-style funds will probably fare better in a higher inflation or recessionary environment than other sectors in which demand may be more cyclical.
That is why we believe longer term investors should not be deterred by valuation/ market effects on their equity investments in the short-term. We conclude that, by having assessed the fundamental effects of macro factors such as high inflation on our clients’ portfolios, we are sanguine that the underlying companies in our selected funds will survive and prosper relatively well in the current environment, and that this will drive long-term outperformance over full economic cycles going forward.
“We believe quality companies can deliver consistent long-term outperformance and growth irrespective of the macro picture. In times like these, the opportunity to generate long-term growth is often the greatest. Focus on quality at a reasonable price, rather than growth at any price”
– Clyde Roussouw, Co-Head of Quality at Ninety One
Global News
- US inflation to the end of June 2022 again increased by the highest level in 40 years as the year-on-year increase in consumer prices was 9.1%, versus an expectation of 8.8%. The market digested the figure reasonably well, falling 0.45% on Wednesday, whereas in June the S&P experienced an intra-month decline of more than 10% either side of the May CPI publication, which was 8.6%.
- This week the dollar rose to a 20-year high against its trade-weighted peers, reaching parity against the Euro for the first time in two decades. On this measure, the dollar has gained 13.5% in 2022 and 17% over the last year as the US leads the rate hiking cycle, and the safe-haven status of the Greenback has come once again to the fore.
- A global squeeze on energy supply that’s triggered crippling shortages and sent power and fuel prices surging may get worse, according to the head of the International Energy Agency. The whole energy system is in turmoil following the February invasion of Ukraine by Russia, at the time the biggest oil and natural gas exporter and a major player in commodities. The soaring prices are lifting the cost of filling fuel tanks, heating homes and powering industry across the globe, adding to inflationary pressures and leading to deadly protests from Africa to Sri Lanka.
- This has come just as the globe was getting serious about green fuel, with the energy shock causing surging inflation as well as political headaches across the globe. There is currently no end in sight to the conflict that is, to a large extent, responsible for this issue.
- Meanwhile, copper is down 35% to below $7,000 a ton, a 20-month low from a record high set just four months ago when metals were soaring on concerns about supply in the wake of Russia’s invasion of Ukraine at a time when consumption remained hot. Oil is also losing value and is set to end the week at around the $102 per barrel level. Markets are worried that Europe will slip into recession due to punishing energy prices, while some of China’s biggest cities continue to be locked down due to the country’s Covid-zero policy. Should commodity prices remain even at these levels, recent price declines will place downward pressure on inflation over the next year.
- In the UK, more people visiting doctors and holiday bookings drove an unexpected jump in UK economic growth in May, rising 0.5% after the previous month’s 0.2% decline. This is offsetting continued weakness on spending at the shops, as retail sales are falling at a rate “not seen since the depths of the pandemic”, as price rises hit household budgets. Economists had forecast growth of 0.1%.
- Following Boris Johnson vacating the position, Britain’s new prime minister will be announced on September 5. First votes will begin eliminating some of the 11 candidates in a crowded and increasingly unpredictable and divisive contest to replace Boris Johnson this coming week.
- Across the English Channel, the European Central Bank has to date been much more dovish than in other countries, showing a reluctance to trim its balance sheet or raising rates. That policy has now changed, and it is likely that target overnight rates would be back above zero in September. That represents a big shift. The move in European fixed-income markets has already been seismic. The rise in 10-year German bund yields over the last six months has been the largest this century.
- In company news, Russian gold miner Petropavlovsk plans to file for administration after sanctions on Gazprombank, its main lender and the sole buyer of its product, meant it was unable to repay loans and placed it among the first listed companies to face collapse because of the Ukraine war.
- This comes as Lego terminates its contract with the operator of its 81 stores in Russia, according to franchisee Inventive Retail Group (IRG). This could spell an end to the Danish toymaker’s operations in Russia.
- Social media giant Twitter has sued billionaire Elon Musk over his abandoned $44 billion takeover bid, asking a judge to force him to follow through on his offer. Its lawyers argued that he failed to honour his agreement to pay $54.20 a share for the San Francisco-based social-media platform. Musk abandoned the deal last week, citing in part concerns about the number of fake accounts among users.
- At the time of writing, the S&P500 was down 2.8% for the week based on Thursday’s close.
Local News
- The Rand breached R17/USD earlier this week, a level which was last seen in October 2020.This means the currency has weakened by 7.8% against the US dollar year-to-date, largely in line with a range of emerging market currencies. However, since 24 June 2022 the Rand has depreciated by a substantial 8.77% against the US Dollar. Interestingly, the Rand has weakened less (versus the US dollar), by only 3.5% against the Euro since 24 June and by 4.6% against the British Pound.
- Domestic inflation climbed seven basis points to 6.9%, data showed on Tuesday. This has led to expectations of more aggressive rate hikes. However, simultaneous worries about growth prevented traders from wagering on a 75-basis point hike at the central bank’s next meeting. The rate is now the highest since September 2016.
- Although manufacturing activity improved in May from the 7.6% decline recorded in April, it remained in negative territory because of continued power outages that limited the recovery in the sector after Eskom implemented power cuts for 27 days in the month. Manufacturing production decreased 2.3% year-on-year in May.
- Eskom continues to implement loadshedding, although promises have been made that it could come to an end in the next few days. Among other issues, caused by a lack of maintenance, Eskom’s chief nuclear officer, is the latest and most senior staffer to depart the Koeberg nuclear facility. He leaves at the end of July to join a Canadian plant.
- The seemingly good news is that South Africa is set to tackle “mafia” groups that have compromised power utility Eskom Holdings. Eskom has called for more arrests to apprehend people suspected of corruption involving the state-owned company. Police have apprehended two former employees of Swiss industrial firm ABB and their wives for alleged graft linked to more than $29 million of contracts with Eskom.
- Anthony Butler has stated that a total collapse of the grid would leave South Africa “a few meals away from chaos”. “The implications of total grid failure are alarming. Key parts of national infrastructure, including hospitals, telecommunications systems, mines, sewage treatment plants and water pumping stations, have generator or battery backup that can sustain them through intermittent power cuts, but not for extended periods. Transport, logistics, security, financial services and payments systems cannot continue for long with the grid down. Televisions and radios will go off, cellphones will die, sewage plants will overflow, and petrol stations will run out of fuel. Pretty soon food supply chains will freeze.”
- May’s retail sales were hammered, growing way below expectations, showing that consumer confidence and households have come under severe pressure. The pressure mainly stems from rising prices, especially of food and fuel — as well as the rising cost of servicing debt. There were also delays in the government’s payment of the Social Relief of Distress Grant in May.
- As a result, economists have downgraded their 2022 GDP expectations and will potentially heap pressure on the government to come up with extraordinary measures to boost growth. The downward revisions follow a slew of negative economic data, including elevated production and input costs, infrastructure bottlenecks, and persistent electricity supply disruptions.
- In fact, according to Ed Stoddard, recession is all anyone in the corridors of power can currently talk about. Recession and stagflation are looming on the horizon in the face of intensified load shedding, cooling commodity prices, a rand that is on the ropes and ongoing state failure.
- Meanwhile, more than 50% of South Africa’s 257 municipalities are bankrupt or insolvent and unable to pay creditors or even service workers’ pensions, according to finance minister Enoch Godongwana. The situation is compounded by the political dysfunction in many municipalities, he added.
- The ruling ANC’s acting secretary-general Paul Mashatile is blocking anyone facing serious criminal charges from participating or being nominated by branches to contest any leadership positions at the national conference in December. This could be an advantage for ANC president Cyril Ramaphosa, although he, himself, is in trouble over stolen forex that should have been converted to rands as per the country’s regulations.
- At the time of writing the JSE All Share was down 5.7% for the week, with the Rand having declined by 1.8% against the US dollar.
Sources: Dynasty, Bloomberg, BusinessLIVE, Daily Maverick, Reuters, etc.
