November 2022 Update

Making The News

After months of brutal lockdowns, markets were repeatedly buoyed in November by rumours that China would be relaxing its zero-covid policy early next year. Unfortunately, Chinese officials confirmed that the incremental easing seen to date – including no more PCR tests for railway and domestic air travel – were only aimed at optimising implementation of the policy. In fact, protests broke out towards month-end against renewed mobility restrictions.

November saw the global ratings agencies Fitch and S&P Global comment on their SA credit rating. S&P Global maintained its positive outlook, which currently stands at three notches below investment grade. S&P said this was supported by a deep and liquid capital market that can accommodate the government’s borrowing requirement, as well as a better-than-expected fiscal and debt position. The agency did caution against the risks associated with electricity and infrastructure constraints and the ongoing public sector wage talks. Fitch kept their SA credit rating (BB-) unchanged and stuck by their stable ratings outlook.

Eskom’s System Status and Outlook Briefing confirmed that it would need to maintain load-shedding (at least stage 2) over the next 6 to 12 months due to planned capital investment projects and repairs. Notably, Unit 1 of Koeberg – which alone supplies electricity equivalent to one stage of load-shedding – will be shut down for maintenance from December to at least June 2023. In a positive turn, Petro SA provided Eskom a temporary diesel lifeline, enabling the return to service of the open-cycle gas turbines, which have often prevented higher stages of loadshedding in the past. Renewed budget for diesel will only become available in April 2023 when Eskom moves into the next financial year.

Market Commentary

November saw global equity markets rally strongly, with the MSCI All Country World Index returning +7.8% in USD (but -0.3% in Rands) on the back of strength in both developed and emerging markets equities. The month ended with the Fed signally slightly slower future rate hikes, news that excited the US market and the darling technology shares which were both up +5.6% in USD.

Earlier in the month, Chinese and Hong Kong equities had moved higher despite draconian Covid lockdown policies remaining in place. The market watched localised protest action with interest and built expectations of economic re-opening in early 2023 in China, which would bring a much-needed boost to the global growth outlook ahead. The MSCI China & Hong Kong indices were up over +10% for the month.

Locally, the domestic SA outlook took its lead from the supportive risk-on backdrop, with the ZAR strengthening across major currencies, most notably the USD at 7.5%. The FTSE/JSE All Share Index returned +9.6% for the month with notable gains from the Industrial shares [China tech-related such as Naspers (+38.7%) and Prosus (+36.7%)].

In fixed income markets, US bond yields fell as the anticipation for future interest rate increases changed to smaller increments. US 10-year bond yields reflected this sentiment shift by rallying from above 4.0% to close the month at 3.6%. Stronger US bond markets, as well as positive sentiment towards emerging markets, buoyed SA bonds in November, with yields rallying across the curve and the FTSE/JSE All Bond Index returning +3.9%.

Impact on CWM Model Portfolios

A common thread throughout the CWM local model range is higher equity exposure, particularly to local shares. This has held the models in good stead compared to peers given that the All Share Index outperformed the All Country World Index by +12.6% in Rands. Across the outperforming local models with equity exposure (i.e., all except for CWM Income) in November, the highest overweight was to Chinese equities, which during the month returned +20.0% at an index level. Along with China exposure benefitting the local models, so has the exposure to local listed property (up +5.8%), which forms a high overweight in the models such as CWM Retirement Growth and CWM RI-Defensive.

Despite having similar positioning to the outperforming models during the month, those model portfolio’s which underperformed were CWM Flexible and CWM RI-Growth, largely because of a higher overweight to small cap/value shares which underperformed their counterparts (i.e., Top 40 (-11.9%) and Growth (-12.2%) respectively].

For the Global USD models, growth asset exposure was broadly in-line with peers for Global Balanced and Global Growth whereas Global Defensive benefitted more from an overweight over the course of the month. Basic materials [top MSCI ACWI sector in November (+4.8%)] held an overweight across the USD model range and as a result buoyed performance in the model’s equity sleeve carve out. Furthermore, exposure to bonds favoured emerging markets and over the month, EM bonds outperformed DM bonds by 2.4%.

The track record of the GBP global models is now just over one year and since inception, these models have outperformed peers significantly. The last month has been mixed with the global defensive and balanced models slightly underperforming whereas the growth model outperforming. Asset allocation is broadly in line with peers for the Defensive and Balanced models, however Global Growth has a larger overweight to Bonds which favours emerging markets.

A return measured in one month is usually volatile with some models outperforming and some underperforming. While we keep a close eye on performance each month, we focus our attention to performance over longer market cycles. Therefore, the model range (local and global) has outperformed across the board over the last year and since their respective inception dates. This is testament to good asset allocation calls, top performing underlying managers selected and a preference to the value style of investing over the track record periods of each model.

Outlook

Equities

We believe there is a high probability of the global economy slipping into recession in 2023. The evidence of a slowdown is most stark in rate-sensitive sectors such as housing, where surging mortgage rates have cratered the sales of new homes (Figure 2).

We believe market expectations for equity earnings do not yet reflect even a mild recession. Until such time as valuations adjust to reflect the economic reality, we remain underweight equities in our portfolios.

Bonds

The US T-bill yield has surged by +4.4% YTD. As a benchmark for interest rates globally, it has shaken-up the ‘zero-yield’ landscape across the developed world for the first time in over a decade.

It has also reduced the need to take risk by looking for income further along the yield curve. We remain cautious on long-duration government bonds for the following reasons:

• A lack of policy easing in the unfolding slowdown (due to persistent inflation) flips the traditional negative correlation between stocks and long-duration bonds (Figure 3).
• The private sector must absorb an increased supply of bonds as governments continue to run deficits at a time when central banks trim their bond holdings.
• Continued upside surprises from structurally higher inflation pose headwinds.

Living with inflation

We do see inflation cooling over the next year, but not sufficiently to drop below the 2% policy target. Part of the reason for this, in the short-term, is a pause in rate hikes by Central Banks as the damage of aggressive monetary tightening becomes more evident.

Over the longer-term, we see three structural constraints keeping inflation above pre-pandemic levels:

• Ageing populations
• Global Fragmentation
• Net-Zero Carbon Transition

Ageing Populations

The proportion of the US adult population that is older than 65 is increasing. Figure 1 shows that the trend is expected to continue. An older population does not necessarily lead to significantly lower demand – especially if you factor in increased healthcare needs. A relatively smaller workforce could struggle to meet demand and result in persistent inflation pressure.

Global Fragmentation

Globalization fostered the creation of cross-border, cost-efficient supply chains and has been a major driver of moderating inflation for the past 4 decades. The pandemic and war in Ukraine, however, have countries reconsidering the merits of self-sufficiency. A transition to localized supply chains could result in fresh mismatches of supply and demand, and ultimately prove to be inflationary.

Transition to Net Zero Carbon

We believe the global transition to net-zero carbon emissions could accelerate, boosted by significant climate policy action (Figure 4) and technological progress reducing the cost of renewable energy. Societal preferences should also shift, as the negative impact of climate change becomes more evident.

The process of moving to net-zero, however, involves a huge reallocation of resources. If high carbon production (Oil & Gas) falls faster than low carbon alternatives are phased in, shortages could result, driving up prices and disrupting economic activity.

Conclusion

The expectation of persistently higher inflation relative to market pricing, suggests that portfolios stand to benefit from an overweight to inflation-linked bonds, and continued exposure to real assets like commodities and infrastructure. Once equity markets adjust sufficiently to price in the economic damage caused by central banks, the asset class can be upweighted again – at proper valuations, it remains one of the best inflation-hedges over time. Finally, long-duration government bonds look unattractive relative to their higher-yielding, lower-risk, shorter-duration counterparts.