September 2022 Update

Global News

Market turbulence continued in September as central banks continued to tighten monetary policy aggressively [Fed (up 0.75% to 3%), BoE (up 0.5% to 2.25%), BoC (up 0.75% to 3.25%), etc.] to rein in inflation. The resultant uncertainty regarding the severity of a recession has weighed on markets. This was exacerbated by the impact of energy shortages and rampant energy inflation, particularly in Europe.

The UK’s mini-budget set fiscal policy at odds with monetary policy and UK inflation objectives, and the effect on financial markets has been severe: unprecedented volatility in the gilt markets (10-year rising by 1.9% in September), record lows in sterling (USD per GBP reaching 1.07 from 1.16 since the start of September) and surging mortgage costs (the Halifax Standard Variable Rate jumping from 4.5% to 5.24%). To help prevent a potential crash in the gilt markets, the Bank of England (BoE) pledged to purchase unlimited long-dated bonds.

Local News

Domestically, loadshedding intensified with Stage 6 power cuts dragging down sentiment and confidence. Local headline inflation for August was in line with consensus at 7.6% year-to-year, from 7.8% in July and Core inflation eased to 4.4% year-on-year from 4.6%. Goods inflation fell sharply to 10.9% year-on-year from 11.5% in July, signalling that inflation may have indeed passed the cycle peak.

The South African Reserve Bank (SARB) continued with the front loading of their interest rate normalisation, raising rates by 0.75% at their September meeting, following the recent 0.75% rise at the July meeting

Market Commentary

Asset classes across the board have retreated against this backdrop, with the US dollar benefitting (up 5.4% against the Rand) from its perceived “safe haven” status. Within this context, local markets have not been spared, but have held up reasonably well on a relative basis.

The FTSE/JSE All Share Index declined by -4.1% in September but remains positive over the last year (up +3.5%). The MSCI World Index received in Rands declined by -4.4% for the month and -4.0% over the year, benefitting significantly from Rand weakness. The UK market sold off particularly hard following concerns about funding for tax cuts and mixed signals regarding monetary policy. The UK FTSE 250 Index sold off -8% during the quarter and -30% YTD in Rands.

South African yields experienced a tumultuous month, in line with weakness experienced across global bond markets. The SA All Bond Index returned -2.1% for the month whereas global bonds, measured in Rands, ended the month flat. For global bond investors, focus remains on the persistence and upside risks to the inflation outlook, with global central banks poised to continue frontloading interest rate hikes until it becomes clear that inflation is likely to fall meaningfully towards their target levels.

Impact on CWM ModelPortfolios

Looking at model performance through an asset allocation lens, the average proportionate Equity overweight compared to peers (c.25%) – across the full CWM range – detracted during September. The asset class’s return [Local: -4.1% | Global: -4.6%] compared unfavourably to Bonds [Local: -2.1% | Global: 0.0%], Cash [Local: +0.5% | Global: +5.7%] and Commodities [-3.1%]. While an overweight Equity position is detrimental in a “risk-off” month like September, it also provides for a quicker recovery when sentiment improves.

On the local side, the models that outperformed (Retirement Growth, Flexible, RI-Growth) tended to have a Growth Style underweight, Small Cap overweight, strong regional picks (either a Latin America overweight or Developed Asia underweight) and an Energy Sector overweight. For the underperforming models (Defensive, Balanced and RI-Defensive), the common thread was an overweight to Chinese Equity and weaker sector allocations (overweight to Listed Property and underweight to Energy and Materials).

In the Global USD models, the Coronation Global Strategic USD Income fund performed well in the “risk-off” environment as the Dollar continued its winning streak against all the majors (EUR, GBP, YEN) – as well as the Rand. In terms of detractors, Bailie Gifford performed poorly relative to peers (its leading detractor being its position in Taiwan Semiconductor Manufacturing Co. – down 16% for the month in GBP) as well as the Orbis Global Balanced and Orbis Global Equity funds (a leading detractor being a position in Fleetcor Technologies Inc. – down 17% for the month in USD). An overweight to the Listed Property sector through the iShares Developed Real Estate Index fund (-7.4% in ZAR) also detracted across the board.

Markets at present are in a constant state of flux due to a confluence of headwinds – more volatility  should be expected in the short term. Our focus remains the longer-term, where the models continue to deliver outperformance.

Outlook

The S&P500 started the year on a Forward Price Earnings (FPE) ratio of 19.9x. It was expensive compared to the average FPE ratio since 2008 of 16.3x. However, on the back of the US Federal Reserve’s rake-hiking cycle that commenced in March, the S&P500 dropped by c.20% by the end of 3Q22, as investors digested ever-increasing risk-free bond yields.

Importantly, the FPE ratio – currently at 15.1x – has dropped by an even larger c.25% YTD and implies that aggregate earnings expectations are still rising. Consensus analyst expectations at the start of the year for S&P500 earnings was $224 per share. Fast-forward to 3Q22 and the figure for the next 4 quarters is now $237 per share. The additional bump-up in forward-looking earnings (+6.1%) amplifies the compression in the valuation multiple.

In stark contrast to analyst earnings expectations is an array of economic indicators pointing towards a potential US recession. While there are many data points that convey the message, the Conference Board’s Leading Economic Indicator (LEI) summarises many of the variables into a convenient index. Examples of the datapoints included are new orders and number of hours worked in manufacturing; initial unemployment claims; building permits for residential housing; interest rate spreads; and consumer business expectations. A peak in the index typically pre-empts a business cycle downturn by approximately 7 months. Currently, both the short-term (i.e. 6-month) and long-term (i.e. 1-year) rates of change in the index are at recessionary levels

If the LEI is anything to go by, one could reasonably expect aggregate earnings for the S&P500 to come under pressure over the next few quarters. In fact, given that the peak in the LEI was reached 7 months ago, we may potentially be in for a weak earnings season as early as 3Q22 or 4Q22. Analysts, however, are still projecting FY22 earnings to rise by +7.3% and FY23 earnings by +8.1%.

Conclusion: while the S&P500 may be trading at a fair valuation multiple compared to its own history – analysts are yet to revise their earnings estimates meaningfully. We believe the following two earnings seasons are pivotal and could be a catalyst for such revisions. A further downswing in the S&P500 could ensue.

Opportunities outside the US?

The chart below by GMO evaluates relative global opportunities along two dimensions: equity market valuation (as per the cyclically-adjusted PE ratio) and currency valuation. The divide between over- and undervalued equity markets is the MSCI ACWI Index. In terms of this framework, the US and India both have expensive equity markets, and are expensive to access for the average non-Indian Rupee or non-US Dollar investor. On the other hand, regions like Japan and the Eurozone are cheap on both metrics. Lastly, the basket of EM countries represented by the MSCI Emerging Market index is at an average valuation in terms of its underlying currencies, but its equity markets are much cheaper than developed peers.

Conclusion: The USD looks to be overvalued enough (+17%) to pose a significant headwind for US-domiciled companies (strong Dollar making them less competitive globally) – which could weigh on the S&P500 over the next few years. The Euro area and Japan, on the other hand, are examples of developed market currencies that are sufficiently undervalued to suggest both strong local earnings and strengthening currencies over the next several years.

Opportunities, however, can’t be assessed based on valuations alone. Fundamentals on the ground also need to be considered. Europe is front of mind in this regard, where future energy security is a major concern, inflation is running at double digits, manufacturing and services activity levels are contracting sharply, and rate hikes are all but pencilled in for the foreseeable future. Given the perfect storm that is brooding over the currency bloc, the attractive valuations (both for equities and currency) might simply be reward for the additional risk assumed.

 Conclusion: The mix of valuations and fundamental factors currently at play globally present a challenging investment environment. Considering the heightened risks, we have decided to downweight risk asset exposure across our global models. We are underweight the US and Developed Europe where possible. We maintain overweights to Japan and Emerging Markets. The South African market also screen cheaply – with the Industrials and Financials sectors offering compelling 5-year returns consistent with above-trend earnings growth and multiple expansion.