July 2022 Update

Global News

The US economy added 372 000 jobs in June. This was much higher than the consensus of 273 000. The US reached a 40-year high headline inflation of 9.1% y-o-y in June. The FOMC (Federal Open Market Committee) signalled that a 50bps or 75bps rate hike is on the table for July which eventually materialized into a 75bps rate hike. Wrapping up the US, parity with the Euro was broken for the first time in 20 years after a sharp rise in the US Dollar.

In the Eurozone (EZ), consumer inflation accelerated to an all-time high of 8.6% in June, above market expectations of 8.4%. The European Central Bank (ECB) raised its key policy rate by 50bps to 0.5%, marking the first increase in 11 years as an attempt to curb inflation.

In commodity markets, concerns about fresh lockdowns in China amid COVID flare-ups in Shanghai led to a slump in the iron ore price, while also contributing to the dip in global oil prices.

Local News

The SARB’s MPC raised the policy interest rate by 75bps, pushing the repo rate to 5.5% and the prime lending rate to 9%. This was done as an attempt to curb consumer inflation that accelerated to 7.4% in June, from 6.5% in May. This is the highest reading since May 2009.

On top of high inflation, SA experienced its worst loadshedding on record, predominantly fuelled by the strike of Eskom employees and the high usage of electricity during the winter months. More pressure was put on the electricity producer with wage increases of 7% costing them an additional R1 billion per year.

On a more positive note, the SARB expects the economy to expand by 2% in 2022, revised up from 1.7%.

Market Commentary

With fears mounting regarding a recession, it is no surprise that appetite the towards safe-haven dollar remained elevated, causing the rand to lose 1.7% against the greenback in July. Furthermore, the rand also lost 1.9% against the pound, however, gained 0.8% against the euro.

After a difficult first half of 2022, July returns were up strongly from recent lows. The MSCI World Index returned +9.8%, leading the way globally while the MSCI EM Index returned +1.4%, with the Hang Seng Index down -7.8% (USD) for the month despite some improvement in Covid lockdowns in China. On the local front, SA equities enjoyed a positive month, up +4.2% and still relatively strong versus global peers YTD. Returns were boosted by rand weakness during the month.

SA bonds rallied along with the rally in global yields, the ALBI returning +2.4% for the month. This return masks a highly volatile month with a sharp sell-off seen across emerging market bond markets. SA bonds also sold off sharply into the middle of the month and then recovered back again towards month end as global risk appetite stabilised.

Lastly, after a three-month losing streak, SA listed property posted a positive gain, ending the month up +8.8%.

Relative performance during July was mixed across the local models. CWM Income performed well given its preference to local bonds (+2.4%) over cash (+0.4%). CWM Defensive, on the other hand, struggled during July (underperforming peers by -0.1%) as exposure to China through the Nedgroup Stable fund dampened performance.

CWM Balanced and RI-Growth had similar factors that caused underperformance during the month. The lower allocation to US equities as well as Growth as a style relative to their peer group detracted from performance.  The underweights were most pronounced in Allan Gray Balanced and Foord Balanced, both of which achieved bottom-quartile performance for the month. CWM RI-Defensive managed to buck the trend, benefitting from a strong overweight to listed property and small cap shares, and as a result outperformed peers by +0.4% in July.

CWM Retirement Growth outperformed its peers during July as a higher weight to local equities and listed property benefitted the model. Despite CWM Flexible having a high allocation to equities, in a risk-on environment, the underweight to the US and overweight to value shares caused the model to underperform its peers by -1%.

One year and since inception relative returns remain robust across the models. CWM Flexible remains the standout performer, besting peers by +4.2% and +2.7% over 1-year and since inception, respectively.

The USD models performed relatively well over the past month. CWM Global Defensive marginally underperformed peers due to the model’s underweight to developed market equities, particularly the US, which was up +9% in dollars. CWM Global Growth, on the other hand, outperformed peers by +0.3%, benefitting from higher growth asset exposure in a month where markets reverted to a “risk-on” stance.

Longer-term returns remain robust as the models all outperformed their peers by over +0.5% since inception.

Looking Forward

The toxic combination of risk factors impacting markets YTD – ranging from soaring inflation, war, renewed lockdowns (China), and quantitative tightening – has at least had one positive outcome: improved valuation multiples in equities and higher yields on developed market bonds.

The graph below shows the % change in the PE valuation ratio for prominent regional equity indices YTD. On average, stocks are 12.1% cheaper now than they were at the beginning of the year. Notable regions of improvement include: China (20% improvement); Germany (25% improvement) and US Large Caps (22% improvement).

However, many developed nations are still trading at expensive levels relative to history, given high starting PE multiples at the beginning of the year. The chart below compares regional equity valuations as at 31 July 2022 (NOTE: green indicates valuations below long-term averages; red indicates valuations above long-term averages).

Despite the sell-off YTD, US Large and Small Caps are still trading at elevated levels. However, if one looks at the overall US index through a Value Style lens (US Large Value), the opportunities become more attractively priced. Besides the UK and Japan (which have been trading at affordable levels for  some time), further developed market opportunities are emerging in countries like Germany, Italy and Spain.

That leads us into the second ingredient (besides valuations) necessary for a region to represent a solid investment case: growth expectations. The impact of developed-world inflation on consumers’ disposable income and businesses’ profit margins, is being felt on the ground according to purchasing managers in both the manufacturing and services industries. Below are the composite PMI’s of a selection of important developed market economies. A figure above 50 points to manufacturing and services sectors that are expanding (<50 contracting), while a decrease from a higher to a lower value above 50 points to a slowdown in growth momentum. Certain countries are already in contraction territory (i.e. USA, Germany, Italy), while all countries have lost growth momentum.

The chart below looks at the composite PMI breakdown for Emerging Markets (EM) taken as a whole and compares it to the same figures for Developed Markets (DM). Over the last 3 months, EM has been experiencing improving activity levels across all the underlying PMI components – notably in the forward-looking Output and New Orders subcomponents. In contrast, the subcomponents for DM are mostly deteriorating, with Output and New Orders subcomponents in contraction territory.

While the feedback on the ground suggests that demand is losing steam in DM’s, are the weak forward-looking growth signals confirmed elsewhere in the market? Well, under normal circumstances – where economic growth and inflation are expected to accelerate – lending money to the government for 10-years as opposed to 2-years (through Treasury Bonds), justifies additional compensation in the form of a higher yield.

However, when a recession is expected – implying slower growth and lower inflation – the opposite can be true: the 10-year bond can yield lower than the 2-year, as the market prices in future rate cuts.

The graph below explores the dynamics. Since the early 1990’s, a recession (shaded area) has followed every instance where the 10-year Treasury yielded less than the 2-year Treasury (negative figures in graph). The lag time between inversion and recession ranges between 1 quarter to 4 quarters. Currently, the yield curve inversion (-0.48%) is at levels last seen when the DotCom bubble burst (trough: -0.52%).

Conclusion

Our current outlook can be summarised as follows:

• While global equity valuations have improved YTD, the US and many other DM’s are still expensive in terms of their historical trading ranges;
  • However, within the US, Large Cap Value stocks are starting to look more attractive;
• Besides the UK and Japan, other DM’s that have become cheaper after the sell-off include Germany, Italy and Spain;
• On aggregate, EM’s remain attractively valued, including China, Brazil and SA;
• Growth momentum is slowing in DM’s and improving in EM’s;
• The market is expecting a DM economic slowdown in 2023 to the extent that interest rates will need to be cut;
• DM bond yields have improved and could potentially enjoy a tailwind if the expected slowdown materialises.