The Douglas Adams Edition

Well, 2021 has come and gone for all practical purposes. The year has not been without its challenges. It is the nature of the beast.

The schools are about to close. Any parent’s nightmare until mid-January 2022. No wonder Douglas Adams’ jinnentonix (and maybe a variety of other interesting refreshments) are served from about midday throughout this period. Countrywide. Probably worldwide. Probably throughout the galaxy.

On 31 December 2020 the JSE Allshare Index closed at 59409. Yesterday it closed at 71021, producing a return of 19.5%, plus a dividend of around 3%. It was a very good year. A Frank Sinatra tune eddies through my mind.

 

Inflation in the good old US of A

The United States of America remains the main manufacturer of worldwide equity sentiment. During the last few months two fear factors raised their ugly heads in the US. One is the fear of rising interest rates during the coming months, and the other is a steadily increasing post-Covid rate of inflation. The two normally go hand in hand anyway.

Early in November US CPI data was released and revealed that consumer prices in the US continued to soar, with the headline CPI measure for October reaching a staggering 6.2%. This is the most rapid annual rate of increase since November 1990. This was a little stronger than the consensus estimates of a 5.8% increase, and a strong increase relative to September’s 5.4% reading.

Our previous Some Notes expounded some upon the spike in energy prices across the world. It is therefore not surprising that energy was a large contributor to the growth in US inflation. All the major energy component price indices rose: Gasoline: +6.0%, fuel: +12.3%, utility gas: +6.6%. The overall energy index increased at an annual rate of 30.0%.

Manheim Auctions Incorporated is an automobile auction company and the world’s largest wholesale auto auction based on trade volume. It has 145 auctions located in North America, Europe, Asia and Australia. Their price data index, after a brief respite, showed that second-hand car prices have once again started to tick up, rising by 2.5% on the month. The worldwide shortage of semiconductors was and remains the root cause for the increase in motorcar prices all over the world.

Food prices also added upward pressure on the index, increasing by 5.3% on the year. Overall, there are signs of a broadening in price pressures, with most sectors reporting robust increases in prices – airline fares and alcoholic beverages are among the few exceptions to this tend.

With the annual rate of consumer price inflation at a level not seen in over 30 years, attention must turn to the Federal Reserve’s reaction to this strong inflation report. In recent days, FOMC members have made it clear that the focus is on the tapering of the Fed’s $120bn per month QE programme. This was announced at the start of November.

However, speculations are mounting regarding the timing of a potential rate hike. With the spike in inflation broadening out across sectors and showing no signs of abating, it is likely that pressure will be on the Fed to move sooner rather than later to maintain price stability.

(Source 1 and 2)

Inflation in Europe

On Tuesday 30 November, the Euro Zone published very similar inflation numbers. Consumer price growth in the 19 countries sharing the euro accelerated to 4.9% in November, by far the highest level in the 25 years since the figure has been compiled. It is up from 4.1% a month earlier and well ahead of expectations for 4.5%.

Energy prices were up 27% compared with a year earlier as oil prices soared, but inflation in services and non-energy industrial goods, a drag on price growth in past years, were both above 2%, suggesting a rapid rise in underlying price pressures.

Although inflation is now more than twice the European Central Bank’s 2% target, it is unlikely to trigger any policy action, even if the data makes for uncomfortable reading, and may trigger political pressure on the ECB to rein in price growth. The ECB has long argued that the inflation surge is temporary, caused by a range of one-off factors, and will subside over time. Policy action now would thus be counterproductive, as it would thwart economic growth just when inflation eases on their own.

While some policymakers have warned that high inflation, even if temporary, could trigger a surge in wages, ECB President Christine Lagarde and chief economist Philip Lane have dismissed this argument, saying that wage growth remains anaemic and there is no sign that firms are permanently altering their remuneration behaviour.

Indeed, the ECB has promised continued stimulus with bond buys and record low rates throughout 2022, even as a long list of central banks around the world are already tightening policy. The USA is of course one that will begin the tightening process soon, as mentioned above.

The potential headache is that inflation will now take months to drop and could stay above the ECB’s target until the second half of 2022 – a communication challenge for a bank that has struggled with low inflation for a decade and has little experience with price growth above its set target.

(Source 1 and 3)

Company earnings in the US

During the last few months, US companies charmed investors with strong third-quarter earnings. A strong earnings season has powered Wall Street stocks to new record highs. Of the more than 400 companies on the blue-chip S&P 500 index that had reported their results by the end of October, 81% posted higher earnings than consensus estimates.

Overall, profits among S&P 500 constituents are up about 40% in the third quarter compared with the same period the previous year. Sales are up by about 20%. Earnings growth is lower than the record-breaking first two quarters of the year (when earnings were boosted by economic reopening and flattering comparisons with early 2020), but still on track to be one of the top five quarters on record since 2008.

Profit warnings in late summer and early autumn meant that some negative news found its way into analysts’ estimates and very probably priced into stocks at the time. However, while rising costs were a common refrain in earnings reports during the last months, many companies reported that they were able to pass on increasing costs without suffering a reduction in the demand for their products. Hence the increase in inflation reported above.

Strong results helped the S&P 500 to set 10 record highs since late October, and gains have not been limited to a small number of mega-cap stocks; the Russell 2000 index of small companies also hit a record high last week for the first time since March. The upbeat performance comes after a more subdued end to the third quarter, with the S&P 500 in September notching its second monthly loss of the year. It also marks a stark contrast to fixed income markets, where many investors have been wrongfooted by bad bets on central bank policy in recent weeks.

The graph above is that of the S&P500 for the two years from early December 2019 to the present time. The strength of the market over this period is clear. On 20 March 2020, at the bottom of the original Covid dip, the S&P500 closed at an index value of 2304. On 1 December 2021 the index closed at 4513, a little down from its recent high of 4704. This is an increase of 96% since the bottom of the dip that can be seen clearly in the graph above. All in US dollars of course.

An interesting note is that over the same period, our own All Share Index closed at 37963 on 20 March 2020. On 1 December 2021 the index closed at 71198, scoring a new all-time high. This is an increase of 88%. All in ZAR of course. In US dollar terms this is a return of 107%.

Doomsayers have been calling the end of this current bull market for months for a variety of reasons, ranging from concerns about the quality of earnings, the effect of interest rate increases (and a diminishing level of quantitative easing), and the possible effect of high inflation on the value of equities.

The economic relationship between interest rate levels and stock prices is complex. No rule can be applied to predict the effect of a change in interest rates and stock prices. Intuitively, it seems elegant to argue that the cost of borrowings would have a direct effect on profitability, and therefore on the share price of an equity. In addition, higher interest rates may probably decrease discretionary spending by the public. The relationship between the level of interest rates and equity prices are not always clear cut and predictable. For one instance, following a 0.25% increase in December 2017, the S&P500 increased by 6% in January 2028.

Similarly, the economic relationship between inflation levels and stock prices is complex too. In much the same fashion, it is enticing to argue that increasing inflation may reduce the sales or profitability of a company. But this relationship between the level of inflation and equity prices are not always clear cut and predictable. We would argue that higher inflation may probably support equity prices. This relationship is accepted as normal.

(Source 1 and 4)

So, Quo Vadis equity markets?

One thing is for certain: No one can tell the future. This is nothing new of course, and has been the case for a long time. Regarding the uncertainty and mystery of the future, Douglas Adams (in Mostly Harmless written in 1992) has to say: “Anything that happens, happens. Anything that, in happening, causes something else to happen, causes something else to happen. Anything that, in happening, causes itself to happen again, happens again. It doesn’t necessarily do it in chronological order, though.” We may add, anything that does not, does not.

History shows that the S&P500 index has historically generated an average 12-month return of 8% in environments of positive, but slowing economic activity, and rising interest rates. The US is probably entering just such a period at the present time.

Goldman Sachs expects the S&P500 to rise to about 5100 during 2022. This will be a gain of about 11% from the close on 2 December 2021 of 4577. If the US produces a positive equity sentiment and environment, it is highly likely that world markets will follow suit.

The following factors will support the US markets through 2022:

• Firm earnings by the S&P500 companies. Goldman Sachs estimate earnings will grow by 8% in 2022 and sales to grow by 9%.
• In addition, they are able to pass on inflationary pressures to their customers.
• The average annual US GDP growth from 1947 to 2021 is 3.2%. The growth rate expected for 2022 is just a little over 2%.
• Corporate tax rates will probably remain unchanged next year and remain a tailwind to
• Households own half of the $28 trillion in S. cash assets, an increase of $3 trillion since before the pandemic. Expect households to move some of this capital into equities over time during 2022.

(All sources)

At the current time, our investment portfolios are very well diversified and consist of quality companies with international exposure listed here and elsewhere. We avoid exposure to companies that do business in SA only as much as possible. The latter exposure in our portfolios is currently at levels of around 10%. Even less in many instances. This has been our approach for the last three years or so.

We enter 2022 with optimism, but with the usual caution. Well-diversified portfolios of quality equities with world-wide revenue exposure across many economic sectors will remain key. As usual.

Sources

Source 1: FAL7Shores Research

Source 2: Investec PLC. Various economic reports throughout November 2021 Source 3: Yahoo Finance. Various economic reports throughout November 2021

Source 4: The Financial Times Limited 2021. US companies charm investors with strong third-quarter earnings. Nicolas Megaw. 8 November 2021 Source 5: The bull market will continue in 2022. Goldman Sachs. Brian Sozzi. 16 November 2021