Market Commentary

 

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3Q21 Equity Market Commentary

New Normal

After a pro-longed period of economic recovery off a low base, the third quarter of 2021 saw some disappointments in economic data prints relative to expectations. At the same time inflation has remained elevated and it remains debatable whether this episode is likely to be transitory or durable. Many economic variables remain distorted by abnormally weak 2020 bases given the COVID-19 crisis, and hence are difficult to interpret. The crisis has also led to some behavioural change, with consumers having been unable and unwilling to spend on services which has resulted in an increased saving rate and higher demand for goods. At the same time the pandemic has disrupted global supply chains, which has limited the supply of goods, leading to depleted inventories and surging prices.

The world is currently recovering from its third wave of COVID-19 infections in as little as 12 months. The progress on vaccinations, particularly for high-income countries has seen a dampening of excess deaths resulting from these infections. Vaccine inequality is quite stark with emerging markets and low-income countries more at risk as they struggle to reach herd immunity levels. The economic damage has gone alongside the health impact with most countries unable to regain their pre-pandemic trend of economic activity over the medium term; the worse affected regions being Asia and Latin America. Of the major economies only the United States (‘US’) remains on a better economic path than before the pandemic, with that itself being primarily due to the extra-ordinary monetary and fiscal policy rather than superior health interventions.

While some of the fiscal packages proposed by the Biden-led administration have been reduced through political negotiation, the US has delivered a very significant fiscal thrust, with direct transfers to consumers forming a major portion. This has resulted in an extremely strong US labour market and a surge in household savings. The European Union (‘EU’) has come close to matching the US stimulus effort in form and magnitude.

Demand for electronic goods has surged lately as the transition to virtual and online activity accelerated. These goods are dependent on the supply of semi-conductors, an industry with an alarmingly high degree of geographic and supplier concentration. Several supply incidents have led to shortages of semiconductors and constrained demand for related goods. These constraints are evident in automotive manufacturing with production volume unable to recover from the low 2020 base. This has had a knock-on impact on Palladium and Rhodium metal prices, which are almost wholly dependent on automotive demand, resulting in the basket of related metals selling off more than 20% during the quarter putting pressure on Platinum Group Metal (‘PGM’) shares.

The Northern Hemisphere is currently experiencing an acute energy shortage as it heads into winter, particularly countries in the EU and Asia. The causes of this energy squeeze are multi-faceted. China instituted a ban on Australian coal imports, following a political dispute with Canberra relating to the origins of the Corona virus. Europe has a high and increasing dependence on less reliable renewable energy as well as gas imports and is entering winter with low gas inventories. Generally, climate change pressure has also resulted in decreased investment in fossil-fuel supply, which has led most producers to harvest their assets. During the quarter spot Liquified Natural Gas (‘LNG’) prices have almost tripled while seaborne coal prices have more than doubled. In turn this has led a surge in power prices and decreased availability with a resulting adverse impact on industrial production. In the local market this has benefitted energy producers like Sasol (‘SOL’) and coal miners as well as power intensive industrial companies that are now relatively advantaged against global competitors. The energy squeeze provides an interesting backdrop for the upcoming COP26 Climate Change Conference in Glasgow which has already seen ambitious greenhouse gas reduction pledges from prominent countries.

Chinese President Xi Jinping has used his country’s strong economic footing to drive several reforms under the banner of “common prosperity” in the lead-up to his third term starting in 2022. The concept is the revival of a Maoist idea from the 1950’s that seeks to reduce inequality, a growing and significant problem globally. The real estate sector remains a significant contributor to Chinese economic activity. The government, mindful of the excesses in the real estate sector, instituted a “three red lines” policy in late 2020 to limit debt levels. Large and systemically important real estate developers disregarded these limits, with the notable examples being Evergrande and Fantasia. The resulting funding squeeze has led to a slowdown in the property market and the related commodities, particularly iron ore. Iron ore has also suffered from the Chinese government clampdown on the growth in steel production, with the government decreeing that 2021 production should be in-line with 2020 implying a significant reduction required in the second half of 2021. The iron ore price halved during the quarter, placing significant pressure on the general and diversified miners that derive a large proportion of their profits from the commodity.

Another element of China’s “common prosperity” drive has been its regulatory crackdown on the online and private education sectors. New regulations in technology aim to prioritise quality sustainable growth, improve labour welfare, and increase the benefits to society. As a result, the Tencent share price fell over 20% over the quarter, with a similar impact on Naspers and Prosus on our local market.

The South African economy has continued to perform poorly relative to advanced and developing economies. Besides the slow pace of economic reforms, the economy has been hindered recently by restrictions associated with the third COVID wave as well as significant social unrest and looting centered in Kwazulu-Natal (‘KZN’) at the start of the quarter. With a fourth wave of COVID-19 infections anticipated towards year end it is imperative that the country overcomes its vaccine hesitancy to achieve herd immunity. At the time of writing only 17% of the total population, 25% of adults, were fully vaccinated, which is only half the global and emerging market rate. The current account remains a bright spot with record terms of trade driven by high commodity prices.

Global markets traded flat across the quarter, with the financial and energy sectors leading while the material sector lagged. The JSE underperformed world markets in-line with other emerging markets, reversing some of the good performance since the lows of March last year. The underperformance was driven mainly by currency weakness as the US Dollar strengthened and commodity prices weakened. Within the JSE, value shares as well as mid and small cap shares continued to outperform from their low bases. Merger and acquisition activity has been elevated as value is evident in the SA market.

In global markets value indices have given up their gains given the loss of economic momentum and continued drop in real rates. With the US Federal Reserve (‘Fed’) signaling an imminent resumption of tapering its quantitative easing and rate hikes beginning in 2022, market preferences are overdue a shift in regime in favour of cyclicals and relatively cheaper parts of the market.