Strategy and Asset Allocation 3Q21

  • Market Overview

ECONOMICS

As we enter the second half of 2021, (and notably a year and a half since the onset of the COVID-19 pandemic), the global economy is poised to stage its most robust post-recession recovery in 80 years. However, the rebound is expected to be uneven across countries, as major economies look set to register strong growth even as many developing economies lag. The key risk to global growth prospects continues to be the pandemic. The rapid spread of the more transmissible Delta variant across the globe is a cause for concern. However, evidence suggests that vaccinations are an effective tool against this new variant, breaking the link between infections and hospitalisations. Despite the rapidly evolving risks, economic sentiment continues to track higher, resulting in some central banks heading towards monetary tightening. The US and China are each expected to contribute about one quarter of global growth in 2021. The US economy has been bolstered by massive fiscal support and a rapid vaccine drive under President Joe Biden’s administration. Subsequently, growth is expected to reach c. 6.8% this year – the fastest pace since 1984. China’s economy (which did not contract last year) is expected to grow by a solid c. 8.5% YoY in 2021 and then moderate as the country’s focus shifts to reducing financial stability risks.

Growth among EM and developing economies is also expected to accelerate, assisted by increased external demand and higher commodity prices. However, the recovery of many countries is constrained by resurgences of COVID-19, uneven vaccinations, and a partial withdrawal of government economic support measures. Regionally, the recovery is expected to be strongest in East Asia and the Pacific, largely due to the strength of China’s recovery. In South Asia, recovery has been hampered by serious renewed outbreaks of the virus in India and Nepal. The Middle East, North Africa, Latin America, and the Caribbean are expected to post growth too shallow to offset 2020’s contraction. Sub-Saharan Africa’s recovery, despite being boosted by spillovers from the global recovery, is expected to remain fragile given the slow pace of vaccination and delays to major investments in infrastructure and the extractives sectors.

Amidst the global easing of social restrictions and strengthening demand, one market segment that has seen some notable moves has been commodities. For example, YTD, oil and gas prices have witnessed gains of 47% and 42%, respectively, whilst other hard commodities such as iron ore and copper , amongst others, have also seen double-digit gains. The sharp rebound in activity is pushing up commodity prices, driven by factors such as supply shortages and logistical bottlenecks. Ultimately, this is showing up in various inflation figures, albeit on a temporary basis. Despite clear evidence of price pressures within the US economy, Federal Reserve (Fed) Chair Jerome Powell has remained committed to the message that this upward momentum in prices is transitory in nature. Markets are pricing in a slightly more aggressive Fed in the near term, while appearing more convinced that inflation will be under control. Our baseline expectation is that inflationary pressures will indeed subside, although we do acknowledge the risk of more persistent price rises than first envisioned.

Locally, SA’s third wave of the pandemic was always a likely event, and indeed a fourth and even a fifth wave as well, given the very slow pace of vaccine rollout – which only started to accelerate in June. Whilst notable downward risks remain, economic recovery is still progressing fairly well. Nonetheless, SA’s economic activity will be patchy, with this unevenness between sectors influenced by lockdown levels. Positively, SA has seen a recent quickening in its pace of growth-enhancing economic reforms (and notably a strong and committed anti-corruption drive), which supports the view of a longer-term acceleration in economic growth once the distorting effect from last year’s base effects dissipates. Concerningly, unemployment sits at a record high of 32.6%, with 1.4mn South Africans, who were previously employed before the harsh lockdown restrictions of level 5 last year, still out of work. This has set SA’s job creation back by seven years. With some EMs hiking interest rates, SA will follow suit, although likely only from next year onwards. The rand has seen marked strength but will not see the same extreme appreciation it has since April 2020. Whilst consumer spending has rebounded soundly thus far, further growth will be dependent on consumer confidence, employment, access to credit, the effects of inflation, as well as disposable incomes (which could suffer in 3Q21 amid the third wave of the pandemic), with light lockdown restrictions key to the overall outlook.

SA EQUITIES

After a strong first quarter performance at an index level for the JSE, 2Q21 proved to be more challenging, with the FTSE/JSE Capped SWIX only managing to eke out a marginally positive return (+0.6% for the quarter), bringing the YTD number to a 13.3% gain. Looking through the headline number, 2Q21 brought about a big sectoral shift in leadership, with the most notable being the outperformance of domestically focussed counters over the basic materials producers and rand-hedge industrials. The latter’s returns being somewhat suppressed by the appreciation of the rand by c. 3% QoQ against most major trading currencies.

Much has transpired over the past quarter for investors on the JSE, including better-than-forecast operating results from large economically sensitive bellwether companies, which provided an underpin to the domestic bourse’s outperformance. Commodity prices, even though they are off their recent highs, remain at levels far higher than the consensus forecasts are currently expecting over the next 12 months. The increased earnings expectations 12-months out, coupled with a roughly flat quarter for the index, has resulted in our one-year forward, total return expectation increasing to 14%, up from the 12% we were expecting in 1Q21. The key risks to our return forecast remain the disappointingly slow vaccine rollout in SA, and the onset of a devasting third wave of COVID-19 and the much more contagious Delta variant. However, these factors remain a more serious humanitarian concern than necessarily one for the stock market, which will once again most likely be more influenced by outside events linked to the rapid improvement of the US economy, which will influence the global cost of capital, and the demand for key commodities from our largest commodity trading partners – China and Europe.

Not since the change in the ANC leadership at the end of 2017 (when Cyril Ramaphosa became president of the party), have we seen such a sharp outperformance of domestic counters on the JSE. We note that, not only has sentiment seen a marked shift in the right direction but, for the first time in many years, the outperformance of these stocks has been underpinned by better-than-expected financial performances across the board (from banks to retailers to industrial businesses) and positive earnings revisions, not merely multiples expanding. The onset of President Cyril Ramaphosa’s New Dawn brought about much hope, but not a lot in the way of positive earnings revisions, and the outperformance of JSE-listed shares faded relatively quickly. This time round, with earnings expectations too low and some high-quality operational performances across the various sectors, the outperformance has been more fundamentally driven than merely sentiment driven.

Nevertheless, as the third wave of the pandemic ravages the country it is difficult to conclude that, at the margin, on the ground, conditions locally are incrementally better than they were at the start of this year. However, from our interaction with many stakeholders and continuously better-than-expected hard data points and company results, this does seem to be the case. Market participants have once again been reminded of just how important the commodity cycle is for the country, not necessarily the direct GDP impact (this remains relatively small at c. 8% of overall GDP), but more the second- and third-order impacts that tend to permeate across most spheres of the economy.

Unfortunately, commodity markets and cycles are notoriously fickle and, in the short term, are clearly masking the deep structural challenges faced by SA. Unemployment and the lack of fiscal flexibility, underpinned by inefficient policy, has become more self-fulfilling as many of the companies we analyse and speak to remain unwilling to deploy meaningful capex that would not only provide a kicker to earnings but would also kick-start the economic flywheel. Still, we are particularly encouraged by government’s decision to allow independent power producers (IPPs)to produce up to 100 megawatts of power, up from the initially suggested 1 MW.

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