Of Wars and of Prices

Because of the uncertainty brought along by the Russian invasion of the Ukraine in late February 2022, we have been reluctant to put pen to paper. Reticent we were, but the time has come. 

Thus far, this good year of Our Lord 2022, has been anything but calm and placid: it’s been volatile, with market-moving news seemingly coming out every few days from all corners of the globe. While this news flow has mostly been on the negative side, it is encouraging to note that the underlying bullishness of equity markets tends to resurface in the absence of fresh challenging events or comments. Since the highs of December 2021, two leading themes have had a major impact on market behaviour: 

One, the inflation genie is well and truly out of the bottle, continuing to run at the highest levels in decades all over the globe. Consensus is that, while base effects are due to kick in, inflation is set to remain elevated for a considerable amount of time, possibly well into 2023. As a result, interest rate increases have been implemented by most central banks the developed world over, in concert with the withdrawal of quantitative easing (asset buying by central banks). The notable outlier here has been the European Central Bank, who were on the same path but have understandably become extra cautious with the Ukrainian war erupting on their doorstep (more of that anon). 

Interest rates are in several respects the most important variable in the investment world: not only do they determine the amount of yield received from bond or cash investments, but significant changes in the level and trajectory of rates have the potential to move all asset markets. While our more detailed market commentary elsewhere expands on this, the critical issue now is that the era of extremely low interest rates, and the massive monetary stimulus that has provided to markets, is coming to an end. 

However – and this reflects strongly in our fund positioning below – even the highest projections of where rates are likely to go in the next two years still leave interest rates at stimulatory levels historically. In the developed (“first world”) countries, real rates, which are what interest rates come to after being adjusted for inflation, are very likely to remain negative and significantly so. This implies that investing money into bonds or cash is still far less attractive than investing capital into businesses and assets that can grow, with the result that monetary stimulus – although diminished – will probably remain strong for years yet, supporting stock and other asset markets. 

Of further note is a growing concern about the yield curve “inverting”. This happens when near dated interest rates priced into bonds start trading at higher levels than longer dated rates, for example say the 3y US rate were to become 2.8% while the 10y rate trade at 2.5%. An inverted yield curve implies interest rates rising or staying high in the near term, while eventually dropping later. Why is this important, other than for fixed income managers optimizing their portfolios? Well, a yield curve inversion has historically been quite accurate in predicting a recession, particularly in the USA (and where the US leads, the world follows). 

Such recessions have followed 6 to 18 months after the yield curve “flipped”. However, and perhaps counterintuitively, these pre-recession periods have historically been very good for equity markets. 

Should we see a US recession in the next two years – and the yield curve still has some way to go to invert – it is quite understandable considering the red-hot economic growth experienced there recently (unlike in poor South Africa…). There is currently little to suggest that such a potential recession would be other than mild and short-lived. 

Secondly, and grimly, our concerns about the possible repercussions of the Russian military build-up on the Ukrainian borders have come to pass, with a near worst case scenario having rapidly developed there following the Russian invasion in late February. We say “near worst case”, as a full-blown military conflict between NATO and Russia (and potential allies) has thankfully not come to pass. This is not to denigrate the immense pain, suffering, loss and damage this senseless aggression has wreaked on the Ukrainian people, once again the unwilling victims of their eastern neighbour’s ambitions. 

The spectre of nuclear war also remains, although the apparent poor showing of the Russian military begs the question as to what their capabilities truly are. Nevertheless, it is a development that doesn’t bear thinking about, and one can but only pray that it shall never come to pass. 

As anticipated, the ostracization of Russia has led to large market moves, particularly in oil, natural gas and other commodities where Russian supplies are important on a global level. Ever-tightening sanctions are sure to have a material impact on the Russian economy, although it would be naïve to think that these, even were they to include a full-scale ban on Russian oil and natural gas imports, would completely cut off Russia from global trade. There remain plenty of buyers outside of the Western sphere of influence willing and able to buy Russian commodities, most notably the vast markets of China and India. As a result, it may very well be possible for Russia to sustain its war effort for a significant period, which would keep on supporting commodity prices and per extension, keep pressure on inflation globally. 

According to remarks made by senior US military officers, absent a political solution, the war could very well end up being measured in years and not months or weeks. A “new normal” for the global economy to adjust to, and as ever in the extremely intricate web of the modern global economy, there are certain to be unanticipated consequences. These are not all necessarily negative either: with great disruption often comes great opportunity. 

Perhaps dazzled by the bright spotlight on the above two themes, Covid has steadily faded into the background globally. With the odd exception of events like the Shanghai lockdown, most nations have eliminated or severely cut back Covid restriction. The mantra of “zero Covid” has in most cases been completely abandoned and is more and more being judged to have been a massively damaging and failed policy. The generational impact these policies have had on inflation is starting to bite, with political repercussions looking likely in several countries. 

Eventually though, these effects should peter out, leading to the many severely disrupted global supply chains normalizing to fully functional status, which should help bring inflation back under control and stimulate general economic activity. Estimates on the timing of this vary, but it seems likely that recovery will still be needed well into 2023, and possibly even 2024 in some sectors. The tail risk of further Ukraine-type conflicts, or new and more dangerous Covid variants, could delay this further. 

The FAL and Seven Shores Position

Our fund or investment positioning, to benefit from the opportunities provided by these trends, while guarding against the risks posed, can be summed up as follows: 

• Our investments maintain their exposure to international companies and equity markets, as the rebound in economic activity post Covid creates a lot of potential for economic growth and by extension, growth in share prices. Furthermore, the “Great Risk Event” of the post-global financial crisis era, namely a lift-off in interest rates, has now been digested by the markets. The latter have been remarkably resilient all things considered. 

As we have pointed out before, the relationship between the level of interest rates and equity prices is unpredictable and has a mixed history. But we do know that inflation is good for equity prices. 

The weakness of the South African economy, stemming from structural issues that are likely to persist, leads us to prefer foreign equity investments to local ones. 

• The FAL funds (collective investment schemes) have for several years had the maximum exposure to offshore investments allowed by regulations, which has been handsomely rewarded in terms of the returns offshore equity funds have contributed. These limits have in the past month been raised from 30% to 45%, which is great news for investors, and will going forward enable us additional freedom to construct robust, rewarding portfolios. As mentioned above, the weakness of the South African economy, stemming from structural issues that are likely to persist, leads us to prefer foreign equity investments to local ones. 

• However, high commodity prices are supporting both JSE-listed resources companies, as well as the rand. This, in combination with the sharp pullback in the heavily weighted information technology sector, suggest a tactical repositioning for the current environment. The FAL Balanced Fund of Funds has thus increased its holdings of JSE equities, with a strong focus on shares of companies that are not reliant on the struggling SA economy for their revenues, profits, and growth. Exactly as we do for most of our investment products. 

These include companies like Richemont, British American Tobacco, Naspers/Prosus and others who earn very little of their revenue in SA, as well as commodities producers (Anglo American, Billiton, Sasol and many of the mining companies) that make profits from the global demand for their outputs. Over the past couple of years, the Balanced Fund of Funds has been conservatively positioned relative to its peers, as we have been waiting for the risks from Covid and the inevitable start of interest rate hiking to dissipate. This approach served the fund very well through the large Covid-induced selloffs in 2020, while is has unfortunately not yet participated in the subsequent rebound as much as it could. With our major risk concerns now becoming less of a worry, and the global economy recovering from the damage of the past two years, it makes sense to increase exposure and benefit from this growth. 

• The Stable Fund of Funds and the FAL Balanced Fund have, due to their mandates and the appropriate fund regulations, had a relatively larger allocation to JSE equities, which has helped fuel their excellent recent performance, with especially the Balanced Fund being one of the best performing funds in its category. Their asset allocations are thus largely unchanged from the recent past, while the detailed selection of underlying investments reflect our views expressed here. 

• On the fixed income side, which by regulation needs to make up a minimum of 25% or more of each of the funds, we maintain our preference for shorter-term instruments (for example 3-year bank notes) over longer term bonds. Rising interest rates have the potential to create significant drops in the value of longer-term bonds. Furthermore, the higher rates paid by longer bonds do not in our estimation compensate for the risks posed by the heavy indebtedness and weak credit ratings of especially the South African government, which is by far the largest issuer of these bonds (i.e. borrower of money) in the country. 

While the future remains as difficult to predict as ever, we are confident that these allocations are likely to be effective at growing the value of investor capital, and at the same time are sensible enough to sidestep the worst risks posed by potential future events. We are keeping a very close watch on events and trends that may significantly change the picture and balance of risks and rewards in a world that is changing ever faster. The FAL team and funds are well positioned to react rapidly if need be. 

So, Quo Vadis Equity Markets?

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 very probably entering just such a period at the present time. 

Earlier this year Goldman Sachs expected the S&P500 to rise to about 5100 at the end of 2022. This would be a gain of about 13% from the then prevailing level of just below 4500. Such expectations have been reduced because of the many uncertainties caused by the war in Ukraine. The prices of oil, gas, and a whole range of agricultural products are probably set to rise during the months ahead. It is probably conservative to expect the average 8% annual growth in the S&P500 from the current of 4400 to the end of 2022. 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 S&P500 companies: Goldman Sachs estimate earnings will grow by 8% in 2022 and sales by 9%. 
• In addition, companies can 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 profits. 
• Households own half of the $28 trillion in U.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. 

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. 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 continue 2022 with optimism, though with the usual caution. Well-diversified portfolios of quality equities, with worldwide revenue exposure across many economic sectors, will remain key. As usual. 

Do not be shy. Give us a call. Amanda Witherspoon	amanda@7sc.co.za and 072 658 4481
Andre Greeff	info@7sc.co.za and 072 797 1797
Charles Snyman	cns@fal.co.za and 082 377 9335
Ian Lane	info@7sc.co.za and 076 165 5166
Jacobus Strauss	info@7sc.co.za and 082 818 2044