December 2022 Update

Making The News

December brought little relief for investors as some of the factors that have led to a weakening global economy throughout 2022 continued during the final month. The prominent factors that affected the economy and financial markets during the year were:

1. The geopolitical tensions between Russia and Ukraine,
2. Elevated and persistent levels of consumer/producer price inflation,
3. Hawkish monetary policy and the expectation for short rates to remain higher for longer,
4. Ongoing uncertainty regarding the zero Covid policy in China,
5. And energy prices spiking post the Ukraine invasion but rolling over midway through the year.

News on the local bourse was dominated by political uncertainty and intensified loadshedding. Following the release of the Phala Phala panel findings, President Ramaphosa was rumoured to resign from office. Fortunately, this never came to fruition leading up to the ANC elective conference, but markets felt the pinch in the short-run as SA-centric financial asset prices (the Rand, bonds, and domestically focused equities) lost value.

Market Commentary

Despite the political upheaval in December, the Rand managed to remain stable against the US dollar (0.1% depreciation) during the month as Ramaphosa’s re-election as ANC president brought late-quarter relief.

The FTSE/JSE All Share Index returned -2.3% for the month and finished +3.6% in the green for the year of 2022. Resources (-3.6%) and financial (-5.2%) shares lost ground in December versus the Industrial index which was down only -0.07%. The industrial sector benefitted from Naspers/Prosus shares which both returned around +7% for the month on the back of improved sentiment towards Chinese regulations and ongoing buyback actions initiated by management. In addition, local listed property was the best asset class in December (up +1.1%) but its return over the year 2022 proved to be mediocre at +0.5%.

Globally, the MSCI World index and S&P500 lost -4.1% and –5.8% respectively in December, reflecting the ongoing uncertainty in the macroeconomic backdrop whereas emerging markets outperformed, returning -1.3%. Returns over the last year are largely negative for global equity indices [MSCI World (-12.7%) and MSCI EM (-14.8%)], as higher interest rates throughout the year caused asset prices to fall substantially.

Despite some respite in the last quarter, 2022 will be remembered as an extremely tough year for the global bond market. Yields rose rapidly, and significantly, during the year, delivering capital losses. In addition, given that starting bond yields were at incredibly low levels, the usual cushion to total returns that bond investors typically enjoy from earning an interest yield was unusually meagre in the current cycle. These dynamics resulted in an outsized negative return from global markets this year: -10.7% return for the Bloomberg Global Aggregate Bond Index was the worst in decades. Local bonds on the other hand also struggled but ended the year up +4.3%.

While the CWM model portfolios were mostly down in December, they performed well relative to peers, with an average outperformance of c.0.40%.

On the local side, the CWM Balanced portfolio was the strongest performer, beating the ASISA MA High Equity peer group by c.0.60%. The top contributor within the model was the Foord Balanced fund, benefitting from its relative overweight (+5%) to Naspers (up +7% for the month) and China Equities (the region, as measured by the MSCI China Index, was up +5.3%, bucking the general trend of falling equity markets).

The standout performer among the USD models was the CWM Global Defensive portfolio, outpacing the USD Defensive peer group by +1.5% (USD). Key to its success was its large relative underweight to US equities (down –5.8% in USD as measured by the Russel 1000 index) and overweight to emerging market local currency debt (up +2.2% in USD as measured by the JPM GBI-EM index). Exposure to the latter market is obtained through the PIMCO EM Debt fund (up +2% in USD after all fees) – the top performing fund within the model.

The CWM Global Growth (GBP) portfolio underperformed the GBP Aggressive peer group by c.0.4% (GBP). While the portfolio has similar overall equity exposure to peers, the passive allocation to the iShares MSCI Word ESG Enhanced ETF fully participated in the general equity drawdown, landing in the bottom quartile of its peer group (i.e. Global Large-Cap Blend Equity). An overweight to Financial Services stocks was also detrimental to the performance of the Dodge & Cox Worldwide US Stock fund (down –5.5% in GBP).

Looking across our model range over the last year, we are pleased with the average outperformance over peers of c.3%. All models are also in positive outperformance territory since inception.

Outlook

As we enter 2023, we expect global markets to remain volatile but to deliver better performance than that experienced in 2022, barring any significant black swan event(s). While it is always difficult to forecast such events, we highlight below a few challenges and opportunities worth considering in the new year:

1.Corporate profits expected to deteriorate

If central banks continue to hike rates, it increases the risk of a global recession. Corporate profits typically fall during recessions and the graphs below show the historic trend of profits falling throughout periods of US recessions. Since the year 2000, one-year earnings estimates (bottom left) and net margins (bottom right) fell precipitously during 2002, 2008 and 2020 (yellow shaded bars).

It is largely a consensus view that global economic growth will in fact slow in 2023 making the chances of corporate profits deteriorating higher. As such, we have reduced equity exposure within the CWM USD models to below that of their respective peer groups. While an unfavourable earnings reporting season will impact all equity allocations negatively, by having less exposure compared to peers, the models would benefit on a relative basis.

2.Tight US labour markets

The Fed still faces challenges with their labour market as demand exceeds available supply. The resultant effect of this is wage inflation (bottom right graph) which spiked throughout 2022 and remains at elevated levels. In the FOMC minutes for December, members expressed their concerns towards unemployment being at historical low levels, payroll gains being robust and job vacancies being high.

As we expect demand to erode and corporate profit margins to deteriorate, we expect more companies to stop hiring or potentially lay off workers to cut costs. COVID-19 winners (e.g., Amazon, Meta, etc.) have already cut costs in such a manner and we expect this to increase the unemployment rate in 2023 and hopefully bring down inflation further.

3.Softer energy & food prices

Perhaps more encouraging news for markets in the longer term is the evident fall in oil prices to lower levels than the start of the year (bottom left), despite the war in Ukraine. Brent Crude oil is now roughly c.$78/barrel and Russian crude oil is at a significant discount around $42/barrel from a peak of c.$100/barrel at the height of the invasion. The discount is a result of the price cap pressure that the Europeans and the Americans have put on Russian energy. Furthermore, natural gas in Germany and the UK (bottom right graph) are down sharply from its peak in early 2022. This reflects the warm winter weather but also very good energy conservation and Liquified Natural Gas (LNG) imports across the region.

Additionally, global food prices have come down during 2022 with reference to the FAO Food Price Index (FFPI – bottom left graph red line) averaged 132.4 points in December, down 1.9% from its November reading and, importantly, the ninth consecutive monthly decline. In terms of the components that make up the FFPI, vegetable oils and cereals (bottom right graph) largely drove the decline in December.

In 2022, high food prices were one of the main drivers of inflation, so lower food prices will naturally be welcomed. However, the prospects for 2023 hinge on beneficial weather to boost strained crop supplies and ease supply chain pressures.

4.A potentially weaker US dollar

The US dollar is likely to trend weaker in 2023 after hitting record highs against every major currency in 2022, as emerging markets recover and inflation eases. From mid-2022, the dollar began correcting and this could continue as the dollar currently is overvalued and we expect there to be fewer rate hikes in 2023. The result over the past year was emerging market underperformance but this could turn in 2023 as the dollar weakens.

5.Re-opening of China’s economy

After a year of domestic economic volatility and international turmoil, China is expected to focus on economic growth this year, which means the country will further deepen reform and expand opening-up. As such, fiscal support will be targeted and focused, whereas monetary policy will likely remain cautious and neutral until the end of the US Fed’s tightening. In turn, sectoral success is predicated on three critical areas: COVID-19, the technology sector, and the property market.

For the rest of the global economy, normalising the Chinese economy could significantly ease supply chain disruptions that have contributed to rapidly rising goods inflation. However, it is worth bearing in mind that a rebound in growth in China could also boost demand for global commodities, thus contributing to inflationary pressures and proving to be a double-edged sword for global inflation.