Global Market Overview – 1st Quarter 2021
The first quarter of the year was dominated by rising bond yields and a value-led equity market rally. The two key drivers of this performance were the Democrat victory in Georgia at the start of the year, paving the way for massive further US fiscal stimulus, and the success of the vaccine rollout in the US and UK. It is now just over one year since equity markets bottomed out, and the MSCI world has rallied 79% since then and is 18% above its pre-Covid highs and up 5% year to date (ytd). The 10-year US Treasury yield now stands at 1.75%, vs. 0.5% at its low in August and 0.9% at the start of the year. The rise in bond yields has been closely correlated with significant outperformance in financials and value stocks. Value stocks are up 9.8% ytd compared with 0.3% for growth stocks. Higher commodity
price increases have also helped value stocks, with oil up 22% and copper up 13% ytd.
The common theme driving all these moves has been the rising optimism about the outlook for global growth. With over 37% of the American and 58% of the British adults now having received at least one dose of the vaccine as well as the number of people being hospitalised (with Covid) much lower than at the start of the year, the continued rally in these equity markets makes sense, as investors look ahead to a hopefully sustainable reopening of their economies. Small cap stocks, which tend to be more domestically focused, have performed particularly well, with the Russell 2000 up 12% and the UK FTSE Small Cap index up 9% ytd. Even in markets where the vaccine rollout has significantly lagged, the UK and the US have performed well. Eurozone equities are up 8% and Japanese equities are up 9%, despite these regions having vaccinated only about 11 and 1% of their populations, respectively. Both regions have been assisted by a strong rebound in global goods demand, and financials have benefited from steeper yield curves.
Despite low vaccination rates, Japan has seen very few Covid cases whilst Europe is experiencing an increase in their cases, which could delay their domestic recovery. Business surveys improved in March, with manufacturing expanding strongly in Europe, the US and the UK. The US service sector continued to perform well, but the most notable improvement was in the UK service sector, with businesses noting improving consumer confidence and signs of pent-up
demand. The European service sector was the clear laggard. March also saw the passage of President Biden’s bumper stimulus package, worth 9% of the US GDP.
This has led to upgrades in consensus forecasts for US growth this year, with 7% growth now expected. Biden also doubled his vaccination goal from 100 million to 200 million in his first 100 days. Some investors are worried that the size of the US stimulus package, combined with pent-up savings, could lead to a pickup in inflation, potentially leading the Federal Reserve to tighten policy to an extent that could be damaging for equity markets. However, despite upgrading their growth forecasts for this year and expecting unemployment to decline to 4.5% by the end of this year and 3.5% by the end of 2023, the Fed does not believe that inflation will be sustainably above target and still expects that they will not raise rates before 2024.
Emerging market equities have had a difficult few weeks after a strong start to the year, ending the quarter up 2%. Chinese equities sold off from mid-February; however, we believe that concerns around moderate policy tightening are overdone. Given the attractive long-term outlook for Asia, we are inclined to view the recent pullback as an opportunity for long-term investors, rather than a reason for significant concern. Potentially of more concern are the increases in Covid infections in some other parts of emerging markets, such as Brazil and India. However, India may be less disrupted by another wave of infections given its young population, with only 7% of people aged over 65.
Overall, it was a bad quarter for government bonds/fixed income and a good quarter for most “return to normal” equities. The stocks that benefited the most from Covid have been underperforming since November as the Covid losers have played catch up. A big driver has been rising rates and inflation expectations. The “fog of inflation” will likely increase in coming months. The path of least resistance for oil prices and conventional energy (and uranium) stocks remains higher, as they play catch-up with green energy stocks that had “gone vertical”. Inflation expectations and bond yields may spike, as happened in 2010, but that will provide an opportunity to buy Treasuries and upgrade megacap tech stocks. Already toward the end of March and into April tech and other growth names have been making a comeback. The major market narrative at present is that rising interest rates are bad for stocks – growth stocks in particular. The reality is that stocks can go up (and down) with both rising and falling interest rates.
In Figure 1 (below), we highlight the Nasdaq (dark blue line, intended to represent tech and growth stocks) and the US 10-year yield (light blue), while the shaded green and red areas are periods of falling and rising interest rates, respectively. Interestingly, you will notice that, over the past decade, the Nasdaq rose irrespective of the direction of interest rates.
With US inflation expectations and rising yields, emerging markets were generally on the backfoot throughout this quarter, especially in debt markets. South Africa was no different although the strength of the rand has surprised many as it bucked the broader trend, ending the month 2.5% stronger and only 0.5% weaker over the quarter against the greenback. Nominal bonds fell 2.5% in the month, ending the first quarter 1.7% lower. The recent steepening of the local curve (thanks to narrowing yield differentials between the US and emerging markets) has once again drawn the attention of institutional investors, many of whom see the recent steepening as an attractive entry point after considerable flattening in the second half of 2020. One of our managers for example has pointed out that the curve is now two standard deviations cheap relative to the 10- year average. Nominal bonds are once again offering equity-like returns and a healthy allocation is
warranted for growth investors with medium to long term time horizons.
Local equities continued their strong run in March, delivering a 1.6% return and their fifth consecutive monthly gain. Even more interesting that the string of good returns is the strong month on month outperformance of local equities over global equities (MSCI ACWI) in ZAR terms. Over the last 13 months, the JSE All Share Index has outperformed its global counterpart 77% of the time (or 10 months of 13). This coincides very well with a wave of flows out of the domestic growth ASISA fund categories into the global growth categories, once again highlighting that investors far too often chase the recent winners (most often to their own detriment).
Active equity managers with underweight positions in market heavyweights like Prosus, Richmont and BHP performed better in March as these stocks collectively detracted more than 1.4% over the month. MTN on the other hand was firmly in favour, gaining 19.5% in March after posting a strong set results mid-month. The Group added 29 million customers, growing adjusted headline earnings by 52% and more than doubling operating cash flow to R28.3-billion. The telecoms stock that derives a lot of its revenue from oil rich nations such as Nigeria has also benefitted from the rebound in the oil price in recent months.
Other notable outperformers in March include the platinum producers such as Implats and Anglo Platinum that were up 14.6% and 18.9% respectively, while Sasol and British American Tobacco were up 12.3% and +9.5%. Local property (+1.2% in March), which has been out of favour for quite some time has also been bid
up lately despite fundamentals still looking rather weak. In March, 15 of the 21 stocks that make the SAPY Index posted positive returns, while the larger constituents like Growthpoint and Redefine detracted from returns, falling 3.4% and 9.6% respectively. Firmly in focus this month was the MPC meeting which proved to be decidedly dovish with all members of the committee voting to keep rates on hold. This contrasts with other EM central banks like that of Russia and Brazil which have been forced to increase rates pre-emotively thanks to tighter monetary conditions in the US. Fortunately, SA bonds and the rand have been resilient which has allowed the SARB to remain data dependent as it should.
The SARB has made it truly clear that an accommodative monetary stance is still necessary given the large output gap and inflation still firmly at the lower end of the target band. Furthermore, Treasury appears to be towing the line in applying some fiscal restraint which should allow the SARB some room to run lower policy rates for longer. Inflation will probably pose a risk to this thesis later this year as base effects come through and as the global economy slowly begins to recover as vaccines are rolled out. This is evident in the SARB’s QPR (quarterly projection model) which suggests that we could see 50bps worth of hikes by year end.
Early economic growth figures point to a slower than expected start to 2021, most likely thanks to the re-introduction of level 3 lockdown measures implemented to combat the second wave that gripped the country late last year. This weakness is echoed by business confidence stats that declined in Q1 2021 and showed that 75% of responders are unhappy with current business conditions. On a more positive note, the SARB’s leading economic indicator expanded in the first quarter and most
economists expect an improvement as lockdown measures are eased once again.
The IZA Portfolios
While this quarter was challenging for our portfolios, it was not unexpected after our very strong 2020. Some volatility and consolidation was inevitable but it doesn’t change the fact that our funds still hold some of the highest quality funds and companies in the world. These fund managers have demonstrated time and time again their ability to identify winning companies. Something that is vital for long term outperformance. According to Ballie Gifford (Scottish mortgage Investment Manager) and Bessembinder’s paper “Do Stocks Outperform US Treasury Bills?” a mere 1 per cent of companies accounted for all of the global
net wealth creation. The other 99 per cent of companies were, it turns out, largely a distraction to the task of making money for clients. We want to make sure that we hold managers that don’t get caught up in the short-term distraction that makes up a large portion of the market and it is why we have largely avoided including managers that have a deep value focus.
This doesn’t mean that we are against the inclusion of value and in fact we have carried out an in-depth analysis to identify the very best managers in this space, with care to ensure that they still adopt a bottom-up fundamental approach to stock selection and don’t destroy capital simply because they feel a company looks cheap. As we all know a company can often look cheap for a reason. One manager in particular has stood out for us and this will likely feature in the balanced portfolio going forward. We have moved to reduce some of our exposure in Scottish Mortgage Investment Trust (SMT) while still keeping it as a core holding within our portfolios. We are in the process of carrying out further due diligence on the recent announcement of James Andersons retirement. He is such a key figure at Ballie Gifford (larger group of SMT) that we felt it was prudent to trim some of our position in the portfolios while our review is undertaken. Also given the increased volatility for the Trust of late we felt this also made sense from that perspective.
The key is making sure that the changing of the guard takes place smoothly. Based on preliminary interactions and work done we do not see any reason it shouldn’t. Tom Slater, the fund’s co-manager since 2015, is an experienced investor and we rate him highly. Thus, we do not foresee any change to the investment approach or rationale as a result of the forth coming change to its management. The way Baillie Gifford behaves is all about succession planning: every trust has more than one manager. Style drift is theoretically possible, but Tom Slater has worked with James Anderson for years: He’s not going to become a value manager the moment his co-manager retires. Also keep in mind in identifying these companies, Baillie Gifford has built a powerful network that increasingly relies on voices outside of the mainstream financial sector,
including academics and specialists. This is likely to feed the pipeline of new ideas for some time to come. There is a risk around how a new manager uses that network, but Slater and Anderson have worked together for decades. On a positive note, all of our portfolios are making a strong come back at the start of Q2 with additions like Smithson leading the pack, up over the 5% MTD and the balance up over 3%. Given the very accommodative policy stance from the Fed, global economies opening up and increased fiscal spend we continue to expect equities to the most attractive asset class going forward albeit it bumpy at times due to rotations. Further while we could see interest rates move higher it doesn’t mean that quality and growth can’t continue to be positive as long as supported by top and bottom-line growth which is clearly evident for the positions held by the fund.