• Quarter in review
• Dollar prospects
• Portfolio positioning
• Outlook

2022 ended with a late rally in risk assets during a year beset with crises. From reserve banks tackling rampant inflation with sizeable interest rate hikes, to energy supply fears driving oil and gas prices higher due to Russia’s invasion of Ukraine, to China’s hard-line policies on the property & internet sector combined with an economically destructive zero-covid approach; it has been a tricky period for investing given this backdrop of uncertainty.

Yet markets were able to eke out substantial gains over the final quarter and, as the end of January approaches, the rally continues unperturbed by recessionary fears. In rand terms global equity fell 18% in 2022 while global bonds uncharacteristically joined equities with a -16% return. The popular “60/40 portfolio,” which involves allocating 60% to equities and 40% to bonds in order to minimise risk, would have provided no protection last year. In fact, as Chart 1 indicates, this strategy would have produced one of the lowest returns in over 100 years.

Source: Alpine Macro

In the context of negative global returns for the year, the JSE All Share index shone with a positive 4% with banks (+18%) and miners (+6%) leading the charge. The resource shares benefitted massively from a final quarter surge in commodity prices which came on the back of a confluence of positive developments – Chart 2 below shows how the aggressive unwinding of the strong dollar aided the buoyant recovery of risk assets.

Source: Bloomberg

Throughout most of the year inflation in the US exceeded street expectations, driving bond yields higher as the Fed hiked rates aggressively to tame inflation and prevent a 70’s style runaway inflation scenario. A rampant consumer-lead recovery in the hard-hit services industry (think airlines, hospitality) following the end of Covid restrictions was aided by the utilisation of excess consumer savings built up during the height of the pandemic. This “revenge spend” added further fuel to the inflationary fire, already being driven by high fuel and food costs, as shown in Chart 3 below.

Source: Bloomberg

Towards the latter half of the year, however, an easing in energy prices occurred in conjunction with rolling over inflation across much of the world (Chart 4). A major shift in China’s zero-Covid policy following years of draconian lockdowns provided further impetus for improving global growth prospects as the world’s largest consumer of industrial commodities & exporter of goods finally scrapped them.

Source: Bloomberg

These factors provided the much-needed catalyst for dollar weakness which aided the Q4 market rally. Within this supportive backdrop, commodities such as iron ore (23%), platinum (11%) & copper (12%) all rallied sharply this quarter, lifting the FTSE/JSE Africa Resource 10 Index 18%. JSE Financials rallied 14% as the ALBI (SA bonds) as well as the rand/dollar rate strengthened by 6%. However, it was the stocks highly exposed to China that rallied the hardest – MSCI China itself up 13%; Naspers rose 25% as its major investment Tencent was a prime beneficiary of Chinese reopening exuberance. While Richemont, whose Chinese sales comprise a quarter of its revenue, rose 30%.

With Naspers, Prosus & Richemont making up a quarter of the JSE All Share Index these few stocks were weighty contributors behind the index’s 15% surge for the quarter. Other notable markets that rallied from depressed levels were MSCI Emerging Markets with 10% in dollar terms, Euro Stoxx 50 with 20% in euros, and to a lesser extent the S&P500 with 8% in dollars.

One of the big calls to make this year is the direction of the US dollar against the crosses. Given the correlation between commodity prices and a weaker dollar, emerging markets stand to benefit the most from a cyclical upswing. Chart 5 shows this potential upside for emerging markets in the first pane, while the second pane demonstrates the link between commodities and the dollar which in turn are largely influenced by the economic cycle.

The Obsidian Economic Indicator combines monthly surveys conducted of private sector companies operating in the USA and Germany to illustrate where the global economy is in the cycle. It appears from the chart that a cyclical inflection point following a period of deceleration is likely over the next 12 months and, hence, riskier assets could stand to benefit from such an outcome.

Source: Iress, Bloomberg

Another factor supporting the further reversal of dollar strength is the potential unwinding of the “carry trade” that drove it to such stretched, overbought levels. Chart 6 compares the dollar vs an equal-weighted index of the euro and yen in blue with the 2-year government bond yield spread between that of the US vs Europe & Japan in red.

Source: Iress

Given the fiscal tailwinds behind the US economy last year as well as being relatively more insulated from a potential global energy supply crunch, a booming economy resulted in higher demand-lead inflation which forced the Fed to act by hiking rates rapidly. The scene was set at the onset of the Covid crisis when the Fed took the drastic action of cutting interest rates by 1.5% to 0.25% in addition to quantitative easing which mostly found its way into consumer wallets via government stimulus checks. Although economic output was artificially restrained via lockdowns a recovery soon ensued, with US GDP returning to its pre-Covid trend by the end of 2021. This recovery was largely assisted by the combined effect of the monetary and fiscal stimulus.

Today we sit with US interest rates that are 4.5% higher than they were a year ago while 2-year inflation expectations have rolled over to more normal levels, shown in Chart 7. What the market is saying is that the Fed has acted sufficiently to cool inflation and that they are nearing the end of their rate hiking cycle. Notice the US’s real yield, the Fed funds rate minus expected inflation, is higher than that of Europe’s and, hence, it would appear the US has more room to cut rates. This could provide further impetus for the dollar to weaken, supporting the case for Emerging markets over Developed markets. The caveat to this though is that in the event of a severe global recession, risk assets may feel the pain and the inflection point for EM outperformance over DM is further out. However, we feel that this risk is sufficiently priced by the market and that prospects of a cyclical upturn over the next 6-12 months provides a good entry point for EM assets.

Source: Bloomberg

Bringing it home, the JSE All Share Index remains in undervalued territory. Using copper as a proxy for a cyclical upturn in Chart 8, there is a fair chance that continued strength would lift the rand as well as the JSE All Share Index.

Source: Bloomberg

Despite miners being a clear beneficiary of higher commodity prices, we are cognisant of the fact that:

• Commodity prices have rallied hard in the short-term and thus a pullback may be likely,
• South African domestics, particularly banks and insurance companies, have more scope for an earnings recovery relative to miners in the shorter term and
• SA domestics have underperformed world equities since June of last year in the face of compressing local long bond yields vs US yields – symbolic of a narrowing risk premium that has materialised in the bond market but uncharacteristically has not in the equity market.

These points are illustrated in Chart 9 and are factors supporting our higher exposure in domestics compared to miners, at least on a tactical basis. Despite the higher allocation to domestics though, over the quarter we had been increasing our exposure to miners due to the confluence of positive developments discussed earlier.

Source: Iress

Given the peak in the global inflation cycle as well as the prospect for a rate-cutting cycle over the next 12 months, we have positioned our funds for a weakening dollar environment. As highlighted, EM assets are ripe for a rebound and are already in the midst of one versus MSCI World. Because of this, we remain underweight US equity exposure due both to valuation and currency exposure. Within the developed world though we favour the European market via the manufacturing-heavy DAX index which could see further scope for recovery both due to a cyclical upswing as well as an improvement in energy security.

We continue to favour interest rate-sensitive assets within SA but have increased our exposure to cyclical commodity exposure given still cheap valuations combined with improving economic prospects, particularly in China which will be a big driver in 2023.

Material changes to the portfolio over the quarter include:

• Sizable Purchase of ALSI futures
• Increases in domestics such as Standard Bank, Truworths & Woolworths
• Sizable increase in BHP and iShares DAX ETF
• A significant increase of iShares Emerging Market Bonds ETF as well as SA long-term bonds
• Purchase of Sirius Real Estate & Redefine
• Reduction in Transaction Capital as well as Thungela Resources

The largest positive contributors to SCI Obsidian Balanced Fund’s 7.2% performance over Q4 2022, in descending order, were:

• Investec, Standard Bank, R209 local bond, Tiger Brands, Redefine

The largest negative contributors were:

Thungela Resources, Transaction Capital, Spar, Foschini Group

The global economic outlook remains mixed. The worst-case scenario of an extended energy crisis in the EU appears to have reduced as an un-seasonally warmer winter has bought time for a sharp rebuild of gas stocks into the summer months. The precipitous fall in gas and coal prices should provide a short-term boost at least as far as the industrial outlook is concerned and as such we believe the EU economy should improve into 2023. The caveat is the Ukrainian War is likely to materially escalate into 2023 and any fall-out from this is difficult to predict.

The earlier than expected re-opening of China should boost consumption and travel within China but a rapid acceleration in industrial activity may not be as forthcoming. The US economy should continue to weaken into 2023, the yield curve remains sharply negative and the base of money supply remains significantly above trend as a consequence of the Covid stimulus. As a result, we anticipate anaemic-to-weaker US consumption trajectory in the year ahead. Cross winds will remain, but we are confident that the aggressive upward move in global interest rates should abate in 2023. All else being equal this should support financial markets particularly relative to the significant pressure witnessed through 2022.

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^{PERFORMANCE TABLE DISCLOSURE
Source: Morningstar, December 2022
Launch dates: Balanced (01 October 2013), Equity (28 December 2015), Multi Asset Hedge (25 October 2007), Long Short Hedge (01 July 2008)}

Annualised performance since inception available on MDD’s found on website.

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