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Economic Perspectives – Markets - Second Quarter 2022

05 August 2022 Reza Hendrickse, Portfolio Manager at PPS Investments

What were some of the key themes shaping this quarter?

Markets sold off in April following COVID-related lockdowns in China which spooked the market, while June saw a further significant sell-off after a weak inflation print in the US caused the Fed to deliver a 75bp interest rate hike, and to adopt an even more hawkish tone.

How did the markets perform?

The South African (SA) equity market, as measured by the FTSE/JSE Capped SWIX, fell sharply this quarter (-10.6%). Resources stocks were the hardest hit (-21.9%) as commodity prices corrected, but financials also came under pressure (-15.6%) on economic concerns, while industrials (-2.6%) proved relatively more resilient alongside the weaker rand. Among interest-sensitive asset classes, SA listed property fell in line with the equity market (-12.1%), and nominal bonds also declined (-3.7%), while inflation-linked bonds were a safe-haven in the broad-based market sell-off (+2.9%).

Foreign asset classes benefitted from dollar strength in the flight to safety, enhancing their performance when measured in rand. Foreign equities were down (-5.4%) in rand terms, with developed markets (-6.0%) underperforming emerging markets (-0.7%) significantly as Chinese equities bounced. Global listed real estate (-8.6%) also sold off sharply, while global bonds (+2.1%) rallied in response to declining US Treasury yields over the quarter.

How are the portfolios positioned?

The most significant change to multi-asset portfolios this quarter follows on from our tactical asset allocation house view decision to adopt an underweight stance when it comes to offshore growth assets. Although valuations at an index level provided limited underpin coming into the year, the main attraction for these asset classes remained the largely favourable economic backdrop. Over the course of the year however, the macro environment had progressively deteriorated to the point where early in the quarter we felt that an overweight could no longer be justified, hence the decision to move to an underweight in both foreign equity and foreign property. The portfolios remain overweight South African equity.

With the MSCI All Country World Index being down close to 20% year-to-date, one might think that most of the negativity has now already been priced in. This year’s move has mostly been due to a derating(a contraction in P/E multiple, driven by falling stock prices rather than company earnings), while analyst predictions of future earnings do not yet reflect the potentially weaker environment for profit growth.

Even though markets have fallen significantly, there is scope for further declines should the environment for revenue growth stall further and should profit margins get squeezed given increased cost pressures. It is worth pointing out that much of the overvaluation of the market, as well as much of the decline, has been driven by the US, while the rest of the world is relatively cheaper and still presents opportunity for astute active managers.

In terms of South African equity, our view has remained unchanged, and we still consider being overweight to be appropriate in multi-asset portfolios. The SA equity market is still attractively valued (trading on a single digit forward P/E multiple). Cheap valuations are widespread and not just limited to resources. On a relative basis, SA valuations are also favourable compared to offshore markets. Although SA equity is cheap, and this points to the likelihood of promising medium- to long-term returns, it is possible for the market to become cheaper over the short term should a deterioration in the global macroeconomic environment affect the earnings outlook negatively, or should sentiment deteriorate further.

Looking ahead, the fluidity of the investment landscape calls for an agile approach. Although we have grown more defensive, we note that sentiment readings have also become quite negative, signalling the potential for a significant counter-trend rally. Being overly active in an environment such as this can do significant long-term damage to portfolio performance, so our approach is to filter out the noise and to take deliberate steps to position portfolios appropriately given their investment horizons. We continue to take comfort in our diversified multi-manager approach that seeks to deliver compelling investment outcomes over the long term.

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