June 2022 Update
US labour market remains strong with total unemployment at c.3.5%, just 0.5% below its pre-pandemic level. Relative to its 50-year history, unemployment is significantly below its 6.2% average while wage growth is significantly above its 4% average. This indicates conflicting views towards the recessionary narrative currently dominating headlines abroad. Against this backdrop, US inflation unexpectedly rose to 8.6% y-o-y in May, the highest rate since 1981, which resulted in the Fed hiking rates by 75 basis points to slow down demand within the economy.
Inflation elsewhere in the developed world continued to rise with the Eurozone reaching 8.1% and the UK at 9.1%. As a result, the ECB is looking to be more aggressive with interest rate hikes on a quarterly basis while the BoE keeps to policy path of 25 basis points, despite UK inflation accelerating further. The hawkish tone ignited a sell-off in riskier assets across the globe, with the US dollar benefitting.
Furthermore, PMIs for June added to growing concerns about a sharp growth slowdown, and potentially a recession, in the US and Europe. Although only estimated, the S&P Global flash EZ composite PMI output fell to a 16-month low of 51.9 in June, well below expectations of a drop to 54.
The unemployment rate decreased to 34.5% in 2022Q1 (down from 35.3%) and GDP expanded by 1.9% q-o-q in 2022Q1 (better than expected). The local economy is under pressure in Q2 given that key indicators such as mining and manufacturing production declined by -14.9% and -7.8%, respectively, coupled with business confidence decreasing to 42% (from 46% in the first quarter).
SA Inflation surged to a five-year high as it increased notably more than expected to 6.5% y-o-y in May. It increases the chances of a further 50 basis point rate hike in July.
US 10-year bond yields, factoring in both a higher risk environment as well as higher inflation rose to 2.96% at period end. The first six months of 2022 rank as the worst performing six-month period in over 40 years for the Bloomberg US Treasury Index, reflecting a year-to-date negative return on “risk-free” US sovereign debt of -9.1%. Local currency weakness in the month supported the return of global bonds given that the Barclays Global Aggregate index was up +1.8% in Rands but -3.2% down in dollar terms.
The environment has been a tough one for the South African bond market. Yields on the 10-year bond yield rose over 73bps (from 10.25% to 10.98%) and the FTSE/JSE All-Bond Index returned -3.1%. SA yields were impacted by the negative global fixed income environment, but also in response to the rising domestic inflation backdrop, and uncertainty over how forcefully the SARB MPC will need to respond to contain inflation expectations. Eskom loadshedding also intensified significantly towards the end of June as striking workers impaired the ability to provide secure electricity supply to the country.
The rapid rise in the risk-free “price of money” put strong downward pressure on valuations of longer term cashflows and assets in all currencies. Equity valuations fell with the MSCI ACWI Index one year forward PE ratio falling to 13.8x from over 20x a year ago. The MSCI ACWI Index itself fell by -8.4% in June and -20% for the half year to end June (in USD). The decline marks this as a bear market, albeit not quite as extreme as the more than -50% peak-to-trough decline of 2008 nor the more than -30% decline of March 2020.
In South African Equity markets, the FTSE/JSE All Share Index delivered a total return of -8% for the month. Year to date the South African market has fared relatively well, down -8.3% in ZAR terms against global equity markets which are down in the region of -15% to -18% in ZAR. For the month of June, value underperformed growth by -7.2% but has delivered outperformance of +25.1% over the last year.
In a month where value underperformed growth, the CWM models underperformed peers (excl. Defensive) given the value bias incorporated in the portfolios. It is understandable as sectors such as basic materials (-16.6%) and financials (-13.3%), for instance, lost value whereas technology (+34.4%) gained value. The CWM models generally apply an overweight to the former while underweighting the latter.
Over the longer-term however, the CWM models maintain their outperformance as having a preference to value type shares ‘paid dividends’ both for the prior twelve months as well as since inception of the models above.
For the month of June, the asset allocation positioning of the global USD models contributed positively to relative performance (overweight Cash and underweight Commodities). Within Equities, the models benefitted from regional exposure to Developed and Emerging Asia, with the equity markets of both regions up strongly (+6.4% and +12%, respectively). However, an overweight to EM Bonds relative to peers detracted in the prevailing risk-off environment. Additionally, specific managers like Baillie Gifford, Orbis and PIMCO delivered bottom quartile performance. Despite a poor month in relative terms, we remain positive about the long-term outlook for the managers in question. For instance, the underperformance of the Orbis Global Equity fund can largely be explained by an underweight to Asia EM (up +12%) and an overweight to Latin America (down -12.7%). The extreme variation in performance between the regions is not structural in nature and is not expected to persist into the future, and therefore Orbis’ allocation doesn’t raise concerns. In fact, the Orbis Global Equity fund’s performance over the most recent quarter lands itself a top 9 percentile ranking within its broader peer group – despite the relative underperformance in June.
Looking back over the last year, underperformance was largely a function of higher EM exposure – both equities and bonds – with EM markets coming under significant pressure following the regulatory clampdown in China and invasion of Ukraine. For both asset classes, however, the long-term return outlook remains more attractive compared to developed market peers, given current valuations.
The global consensus is that the UK and Europe will enter a period of recession in the second half of 2022, given their energy crisis. While the UK is far less reliant on Russian gas than the European Union, the impact of curtailed supply on the price of natural gas still indirectly affects electricity prices in the UK and contributes to the overall cost of living crisis.
In terms of the US economy, a slowdown is expected to occur next year even though US consumers and corporate balance sheets are in good shape and the job market is strong. Existing home sales in the US trending downwards coupled with consumer sentiment reaching levels in line with the 2008 crisis are indicators that point towards a possible recession at year end or early 2023.
China has emerged out of their Covid induced lockdowns and are showing signs of improvement (i.e., higher PMI numbers, equity market rally, etc.). Unlike other countries, China is not struggling with inflation (currently at 2.1% Y/Y) and has a lot of scope to further stimulate the economy by cutting interest rates and improving infrastructure. We therefore expect the second half of 2022 to be strong for Chinese assets, but the longer-term outlook is highly dependent on regulatory policy, which remains uncertain.
The boom in commodity prices has turned in June and the outlook is now less optimistic. Base metals such as copper have come under pressure in June (down -12.6%) as recessionary fears cause prices to decline. Despite headwinds for the remaining year, copper remains attractive given their use in the pivot to green energy, which has become more urgent post the war in Ukraine. A lack of copper supply growth two years down the line should buoy prices in the medium term
Financial markets have gone through a tough six months since the start of the year with Covid barely behind us, and a myriad of other negative factors dominating headlines. We have always mentioned that in times like these it is crucial to remain focused on the long-term as it is easy to destroy wealth by acting out of impulse in the short-term.
At Core Wealth, we remain focused on our investment process, which has been tested since inception of the CWM models (>5 years), and we base our decisions on thorough research rather than being swayed by the popular narrative at the time. The managers included in our models are assessed monthly and have performed relatively well when measured at an aggregate level over the year so far. Individually, the managers are constantly evaluating the current market backdrop to assess whether their asset/security allocation is optimal and whether their fund can generate inflation beating returns over its investment horizon.
The CWM models remain well diversified, with exposure to commodities and all regions mentioned in the outlook above, particularly our USD and GBP models. South African assets (equities and bonds) remain attractively valued relative to global peers and therefore hold the majority weight in our local models.