September 2021 Update

Making the News

The month kicked off with disappointing US jobs figures for August (+235k) amid a surge in the Delta variant. Despite the weak number, average monthly job growth for 2021 stands at 586 000 and average hourly earnings growth continues to accelerate (0.6% m-o-m in September vs. 0.3% expected). Coupled with persistently high inflation prints (+5.3% August), the Federal Reserve re-affirmed that tapering of bond purchases might “soon be warranted”. Nine out of the 18 FOMC members now also expect short-term rates to be hiked as early as 2022.

Developments in the ongoing saga of embattled Chinese property developer Evergrande dominated news flow. The company is the country’s 2nd largest developer by sales and has the dubious honour of being the most indebted firm in the world (+$300bn). A combination of depressed sales and more stringent rules for obtaining debt financing has resulted in severe cash flow problems and two missed coupon payments during the month (total: $129m). Besides the 254 banks and non-financial institutions exposed to Evergrande’s debt, $6.5bn of high-yield wealth management products has been sold to 80k retail investors. Potential contagion effects could deal a massive blow to China’s growth, as 25% of its GDP is related to the property sector.

For the fourth quarter in a row, SA GDP surprised to the upside in 2Q21 (+1.2% q-o-q). Commentators believe that, even with a contraction in 3Q21 GDP (which includes the supply shock from the July lootings), full-year GDP growth could be more than +5%. The figure would be a welcome reprieve, as local GDP is currently still 1.3% below the 4Q19 level (pre-COVID). Encouragingly, SA COVID case numbers have dropped off sufficiently for the country to move down to adjusted level 2 mid-September (subsequently level 1). It will be a boon for the hospitality and tourism sector, which have been a drag on GDP.

Market Commentary

The US dollar strengthened against the Rand by 3.4% in September. Fears of contagion risk from China and tapering concerns weighed on sentiment, pushing investors towards the safety of the dollar. Although the dollar strengthened materially within the month, it remains -11.2% weaker over the last year.

Despite benefitting from dollar strength, global equity markets struggled in the month [MSCI World (-0.3%) and MSCI EM (-0.1%)]. SA equities fell in tandem but to a greater degree in Rand terms, ending the month down -3.1%. Resources, measured by the broad Basic Materials basket, lost -9.8% during the month as the US dollar strengthened and commodity prices retraced. Small (+5.6%) and mid-cap (+0.5%) stocks remained resilient but could not cushion the fall of the top 40 JSE listed shares which has a 32.4% allocation to Resource companies. Nevertheless, equities, both local and global, have delivered inflation beating returns over the last year of +18.3% and +11.3% respectively in Rand terms.

In the fixed income space, US 10-year treasuries rose in anticipation of the Federal Reserve expected to start withdrawing policy support just as global growth slows. This along with the Evergrande default concerns in China caused SA bonds to sell off by -2.1% during the month.

Impact on Our Portfolios

The small/mid-cap bias within the CWM models paid off during September. This bias is accessed through the allocation to PSG within several of the CWM local models. PSG Balanced and Flexible outperformed their peers by +3.7% and +3.8% respectively. A performance table of the local models versus their peers is shown below, referring to returns over the month, one year and since inception.

As one can see from the table above, the local models performed well over the last month, year and since their respective inception dates. A standout model has been CWM Flexible, which has consistently outperformed its peers by more than +2% over the periods shown above. Additionally, it is worth mentioning that in the previous monthly wrap up, readers would have seen an -0.1% underperformance of CWM RI-Growth since its inception. This however has turned the corner and the model is +0.1% ahead of its peers to the end of September 2021.

On an arithmetic average basis, outperformance of the local funds has been +1% over the month, +4.4% over the last year, and +0.8% since inception after fees.

Moving over to the global side, September has not been a good month as the higher tilt to emerging markets hurt performance. Despite a difficult last month, the one year and since inception returns shows the strong outperformance investors would have experienced. The standout model here would be CWM Global Balanced which outperformed its peers after fees by +5.5% and +2.2% over the last year and since inception respectively.

As the road to recovery continues, one would notice the upgrades to the five year returns above, particularly that of the local models. As a note to clients, the CWM global models started in December 2016 and are on their way to a five-year track record at the end of November 2021. In the bar graph above, the CWM Foreign house views are used as a proxy for the actual global models because of their strong asset allocation alignment and longer track records. Going forward, the CWM global models (defensive, balanced and growth) will be incorporated and shown above.

Looking Forward

The graph below uses the IMF’s latest expected GDP growth numbers over the next two years to compare the size of the respective economies in 4Q22 to a 4Q19 baseline. The selection of countries represents 83% of global output and projections are as at 31 July 2021.

The average global growth numbers for 2021 and 2022 are 4.8% and 4.3%, respectively. Compared to 2019 (2%), relatively stronger growth is still expected as the world emerges from the Covid crisis and activity levels return to normal. Compared to their size before the pandemic, however, there is a wide divergence in countries’ expected outcomes: the clear frontrunner is China (+17% larger), with the US (+8%) leading the pack of DM countries. Interestingly, the EM average (+5.6%) is exactly double that of their DM counterparts (+2.8%).

The recent torrent of negative news coming from China, however, casts a shadow on its superior growth expectations. Regulatory clampdowns on the tech and private education sector, an energy shortage resulting in rolling blackouts, and the overly indebted property sector have all conspired to increase the risk premium required by investors in both the Chinese equity and bond markets.

Concerning the property sector, the situation with Evergrande has stolen most of the spotlight. With 1300+ residential projects in 280 cities, 200 000 employees and 1.6m clients who have prepaid for flats not yet delivered, the scrutiny is certainly justified. According to Bloomberg, the chances of a systemic event are slim. Total outstanding commercial bank loans to the property development sector (c. RNB10trn) are cushioned by balance sheet bad debt reserves to the tune of cRNB5.4trn. Unless an extraordinary default rate is assumed across the entire commercial and residential property book, a Lehman Brothers scenario is unlikely. Additionally, no derivative contracts are traded on Evergrande’s debt, greatly reducing the impact of a credit event.

The structural slowdown in the property sector does, however, have implications for China’s future growth, as the sector makes up c.25% of GDP. Interestingly, land sales by local municipalities account for a large portion of government revenue (between RNB8trn and RNB10trn). To safeguard future revenue, the CCP will have to adapt to the changing structure of the economy and mandate a comprehensive overview of their tax code.

All in all, we believe that long-term investors should stay the course and maintain their exposure to China within a diversified portfolio. In fact, as the graph below shows, the sell-off in Chinese equities have made valuations attractive compared to earlier in the year when the market was trading at elevated levels relative to historical averages.

Changing gears now to the US and monetary policy, we can expect a period of increased volatility leading up to the November Federal Reserve meeting, where the official tapering of the $120bn p.m. bond purchases is expected to be announced. How does it impact policy in SA? There are at least three reasons why the South African Reserve Bank is less tied to the US tightening cycle than it was in 2013:

• SA currently boasts a current account surplus of 5.6% of GDP (in 2013, SA was part of the “Fragile Five” – countries with large current account deficits making their currencies vulnerable to financial outflows)
• Inflation is lower (currently 4.9% vs. 5.8% in 2013)
• The real yield spread between SA government bonds and US Treasuries (c.7.9%) is sufficient to retain capital flows

Therefore, while the SARB has interest rate hikes in the pipeline for 2022 & 2023, it will be on account of a stronger local economy, and less reactionary to what is happening in the US than in previous cycles.

A final word on the outlook for SA Equities. As per the IMF projections above, SA’s economy is not yet expected to close the gap relative to its 4Q19 level by the end of next year, in real terms. Does that necessarily imply a bleak outlook for the JSE? Emerging markets typically show a lower correlation between GDP growth (which covers listed and non-listed business activity) and listed equity returns. The JSE proves to be no exception.The graph below compares SA nominal GDP (qoq growth) with JSE quarterly returns since 2003. The regression results indicate that GDP growth does not explain a significant portion of the JSE ALSI’s returns (R2 = 0.015). The implication is that other factors are more important drivers of performance.

Two factors that research has identified as vital ingredients for future JSE performance, are Valuations and Earnings Revisions. As such, the graph below looks at the JSE earnings cycle and the recent sharp uptick in JSE aggregate earnings (107% in September compared to a year ago).

While future growth figures will moderate as the 2020 numbers are washed out of the base, the current consensus forward PE multiple (9.2 versus a 10.2 historical average) indicates that the local bourse has not yet absorbed all the earnings revisions fully, and that there is still more room for PE expansion. In fact, on multiple valuation metrics (see table below), the JSE is trading at cheap levels. This, in combination with active stock picking that identifies companies with good management, diversified earnings bases, and durable competitive advantages, aligns a portfolio to participate maximally in the upside potential in SA equities.