Investment Perspectives – The equity markets in Q2 2023

Equity indices ended higher in Q2 2023, led by developed markets. Returns were driven by a selection of large-cap US tech shares benefitting from the excitement around the future of Artificial Intelligence (AI).

Emerging markets such as China lagged as US tensions flared, and their economic recovery lost steam. Most central banks continued to hike rates, however, the US Fed opted for a pause in June, after a year of consecutive rate hikes. Negative sentiment in South Africa (SA) spiked in May, sending the rand to 20 against the dollar on concern around the possible impact of SA allegedly supplying arms to Russia.

Market performance
The SA equity market (FTSE/JSE Capped SWIX) was up modestly in the quarter (+1.2%) thanks to the rally in June, which drove the index back into positive territory year-to-date (+3.6%).

Financials stocks rallied (+6.0%), driven by banking stocks, which continue to trade on attractive valuations while proving resilient in the difficult macroeconomic environment. Industrials were also up (+3.7%), extending their year-to-date advance (+18.7%), led by shares such as Aspen, Bidcorp, Life Health, and Naspers/ Prosus.

On the other hand, resources shares were down (-6.4%) this quarter, and lower commodity prices and platinum stocks performed especially poorly.

Foreign equity (MSCI All Country Index) was up materially in rand terms (+13.1%), with half of the overall return having come from rand depreciation. Year-to-date, foreign equity remains substantially ahead of local equity (+26.5% vs +3.6%), with the rand having lost a tenth of its value against the dollar this year. The recent rally in foreign equity has been narrowly driven by US tech shares, which stand to benefit from AI developments.

Outside of equities, SA interest-sensitive asset classes such as domestic property (+1.0%) and nominal and inflation-linked bonds (-1.5% and -0.7% respectively) were mixed this quarter, with rates locally still firmly on an upward trajectory. Foreign property and bonds delivered muted dollar returns, which were more significant when translated to rands (+6.8% and 4.6% respectively).

Portfolios positioning?
Portfolio positioning has stayed somewhat defensive over the quarter, with our house view continuing to advocate a neutral allocation toward SA equities and underweight foreign equity. Our view on SA equity is premised on the fact that SA shares are cheap in relation to where they have traded in the past. Though the domestic growth outlook is weak, and confidence is low, such elevated pessimism often paves the way for reasonable equity returns going forward. We take comfort from having substantial scope to add to SA equity once called for.

In terms of foreign equity, the strength of the rally this year has come as a surprise but is testament to what can occur when pessimism reaches an extreme level, as it did last year. Admittedly, the rally has been driven by a narrow segment of the market, to the extent where it is reasonable to now expect a degree of consolidation. Market sentiment is also approaching levels of elevated optimism, while valuations have risen. Recent US Federal Reserve signaling also seems to suggest further rate hikes, while overtightening is a key risk worth monitoring. Staying underweight foreign equity is the appropriate call at this juncture.

Being somewhat underweight, equity in the portfolios requires being somewhat overweight elsewhere, and for us that is cash. Interest rates have risen dramatically in recent months, to the point where holding cash is a viable investment (i.e., positive real rates). This is unlikely to persist over the long term, but while it does, the opportunity cost of positioning defensively through holding lower risky asset exposure is reduced. One is therefore being compensated to some extent while waiting for a more opportune time to upweight risky asset exposure.

Looking ahead, the business cycle will do what it will do, and our job as investors is simply to recognise where we are along that path, and to position accordingly given the opportunity set in front of us. Neither we, nor anyone else knows precisely where we are headed in the near term, and while we may have a probabilistic sense, we instead prefer to position for a variety of potential outcomes, by blending managers with a diverse range of skills in a sensible way.