Sasfin Quarterly Review – September 2021

Wake me up when September ends

Following a strong run of gains, global equity markets finally experienced a notable pullback as the MSCI All Country World Index, a benchmark for global equity markets, declined by over 4% during September leading to a negative return of 1% for the third quarter of 2021. Factors that contributed to the decline in global stocks include the prospect of reduced monetary support and the continued crackdown taking place in China.

United States

The S&P 500 Index, a broad measure of US equity markets, was one of but a few regions that managed to eke out a small gain for the quarter but slid nearly 5% during September. Its high-flying tech-heavy counterpart, the Nasdaq Composite Index, however ended the quarter in negative territory having fallen over 5% during September. The withdrawal of monetary of monetary support or at least the commencement thereof as well as possible systemic risks emanating from China have led to concern for investors over US equities.

The reality has begun to sink in that the US Federal Reserve (“Fed”) will soon begin to taper the accommodative monetary policy that it put in place during the pandemic last year in an effort to stabilise the then falling markets. Since the bottoming out of equity markets late last year in March, US stocks have mounted a strong comeback and the US economy has recovered to its pre-pandemic level.  Inflation is however running at its highest level in over 13 years as strong demand and supply-chain bottlenecks have exacerbated price increases and a period of prolonged high inflation has become more probable. The prospect of higher, persistent inflation has prompted the Fed to consider withdrawing its support (tapering) sooner than expected following the most recent meeting between Fed officials, in a bid to reign in the spiralling costs of inflation. The tapering process, which is likely to commence in November later this year, will see the Fed reduce the size its bond buying programme as a start, followed by the raising of interest rates, though rate hikes might only start next year at the earliest.

The stimulus measures put in place by the Fed have helped prop up the stock market as keeping interest rates at rock bottom levels has resulted in historically low bond yields, essentially pushing investors towards riskier asset categories such as stocks. However, with the prospect of higher interest rates on the horizon, equity markets have begun to experience price falls. Bonds will become more attractive to investors as their yields begin to rise and equities will decline in value as their future earnings or cash flows will now be discounted at a higher discount rate. Higher duration equities, those more sensitive to changes in interest rates as a relatively larger portion of their cash flows are expected to arise in future years, have declined more so than most thus accounting for the larger decline in the Nasdaq Composite Index above.

Bond yields have risen from their August lows as the 10-Year US Treasury yield rose above 1.5%, its highest level in three months. With the Fed poised to combat the threat of persistently high inflation through interest rate increases, the US Dollar has strengthened in value. The US Dollar Index which measures the US currency against six other currencies (Euro, Japanese yen, British pound, Swedish krona, Swiss franc, Canadian dollar) reached its highest level in over a year. The rand has also weakened against the greenback having breached the R15 level on more than one occasion during the quarter.

Europe

European markets tell a similar story to that of the US for the most part. The Bank of England predicts that inflation in the country will rise above 4%, setting the stage for a “modest tightening of monetary policy over the next few years”, increasing the likelihood of interest rate increases. The European Central Bank (“ECB”) has said it will slow down the rate at which it is purchasing bonds, but ECB president Christine Lagarde insisted that the “lady isn’t tapering”, a reference to Margaret Thatcher’s “The lady’s not for turning” speech in which she rebuked expectations that there would be an about-turn on tough economic policies. European stock indices such as the FTSE 100 and STOXX Europe 50 delivered minor gains for the quarter in local currency terms but when converted into US dollars, returns for both indices were negative.

China

Beyond the actions of central banks, another factor that has created uncertainty in global equity markets is the stricter regulatory regime currently taking place in China. Putting aside the political rationale behind such a regime shift, Chinese corporates continue to suffer at the hands of the ruling party as the Hang Seng Index declined more than 10% during the quarter. The shift effectively began in November last year, in what would have been the largest IPO in history, government officials blocked the listing of the Ant Group, China’s largest digital payment platform, following outspoken comments against the Chinese government by the company’s founder, Jack Ma. In the months that have followed, numerous rules and regulations have been imposed by the government, targeting technology-based companies in the fields of e-commerce, ride-sharing, video gaming and online education. Chinese president Xi Jinping has signalled the need to regulate excessively high incomes and encourage higher income groups and enterprises to return more to society – a redistribution of wealth if you will.

Essentially, the Chinese government intends to regulate the social behaviour of Chinese citizens particular those that don’t embrace the mantra of “common prosperity” whilst adopting behaviours that enhance the “social good”. The luxury industry, whose growth will be driven by Chinese consumers, stands at a juxtaposition with this approach. Affluent consumers in the region might curb their luxury spend lest they draw the ire of the ruling party. An industry that does not line up with ruling party’s quest for social good is that of gambling which is considered illegal and has been outlawed in the country for over 70 years. However, there are legal forms of gambling such as participating in state-run lotteries and of course those looking for a fix could travel to the region of Macau, the world’s largest gambling hub, where gambling is legal and thriving, at least for now. It appears the region may be next in line to suffer the wrath of the regulatory crackdown which could see casino operators “urged” to devote more resources to the community as well as government representatives brought in to supervise casino operators directly – sounds remarkably similar to Nicky Santoro’s (Joe Pesci) role in Scorsese’s epic crime film Casino.   

Whilst the actions of the Chinese government have led to significant declines for corporates tied to the industries mentioned above, the latest cockroach to crawl out from under the fridge is the crisis facing the China Evergrande Group (“Evergrande”). It may not be a household name to those outside of China but Evergrande is one country’s largest property developers. It is also highly leveraged and with more than $300 billion in loans owing, one of the most indebted companies in the world. The crisis that is unfolding for the company has resulted from a missed debt payment on a dollar-denominated loan. What makes this particular crisis significant is that for many years, real estate has been a core driver of economic growth in China, with real estate and real-estate-linked industries accounting for nearly one-third of economic output. However, there is a vast amount of residential real estate that remains unoccupied and oversupply has been a problem for several years. It is reported that there is enough empty property in China to house more than 90 million people. To put that into context, that amount of vacant space could house the entire population of France or Italy.

Much of the excess growth has been fuelled by debt. Ordinarily, debt would be serviced by property sales as Evergrande would often rely on its customers to prepay for their apartments before they were even completed. However, problems began to emerge last year during the pandemic following a slowdown in property sales. To see itself through, Evergrande might have taken on more debt but it appears the authorities in Beijing have had enough of excess borrowing by property developers. In August last year, an initiative was introduced by the Chinese government called the “three red lines” which was designed to reduce debt levels. It would require that the property developer maintain three debt and liquidity ratios below a certain amount. Should the company breach all three, it would be forbidden from taking on additional debt. Evergrande was the first major developer to fail all three tests.

Without the support of new funding and with property sales struggling, Evergrande has found itself in a liquidity crunch, unable to meet its obligations. This has sparked concern that we could be witnessing the start of a systemic crisis. Fears that multiple financial institutions are exposed to potential default risk, to Evergrande as well as other property developers, has led many to draw comparisons to what took place during the global financial crisis with Lehman Brothers. As much of the outstanding debt is owing to Chinese banking institutions, which are essentially state-owned, the Chinese government could easily step in and require banks to restructure their loans thus averting the crisis at hand. However, this does not appear to be the case with the government reluctant to intervene, perhaps in a bid to enforce the importance of the three red lines as well as teach a lesson to those that are non-compliant by making an example of Evergrande – something the ruling party has shown it is not afraid to do.

The fallout so far has seen Evergrande’s share price capitulate and its shares have now been suspended from trading. Bondholders have been left bleeding with bonds trading as low as $0.26 on the dollar. Without government support, it is likely that the company will have to sell-off assets and restructure to continue to survive as well as rely on the generosity of some wealthy donors. Taking a broader view, whilst Evergrande has found itself the poster child for breaching the new property lending rules, it is unlikely that President Xi Jinping will allow the sector to evolve into a fully-fledged systemic crisis. It’s effective control over the banking sector should see to this. However, the invigorated approach of deleveraging the sector poses a different risk, the future growth of the country. By reducing lending and real estate construction, the future economic growth of China, at least in the near-term is likely to suffer and it will be difficult for the world’s factory to maintain the elevated growth rates that we have come to expect.

Commodities

The fallout in real estate development has spilled over into the commodity markets, specifically the demand for iron ore, a core component in the production of steel. With the construction of residential properties likely to slow, so has the demand for steel. Chinese authorities added more heat to the furnace that led to the price meltdown when they announced mandatory reductions in crude steel production in an effort to tackle air pollution in preparation for the 2022 Winter Olympics in Beijing. The combined impact was a 44% decline in the price of the metal for the quarter having ended the period at $120 a tonne.

Iron ore is not the only commodity that has fallen victim to the influence of the Chinese though the government may be less to blame in the following instances. The price of thermal coal has more than doubled in less than a year, the price of aluminium continued to rise during the quarter nearing $3,000 a tonne and the price of natural gas rose more than 50% during the quarter which in turn has significantly increased the cost of electricity in parts of Europe. The common thread, coal mines in China. The demand for electricity in China has increased since coming out of COVID and the weather in the country has been exceedingly warm. China produces the majority of its electricity from coal and hydropower but an underinvestment in coal and a drought in the region has led to a shortage in electricity from these sources. As a result, China has had to curtail its aluminium production, which is incredibly electricity intensive, and as a major producer of the metal, the price has consequently spiked. China has also resorted to sourcing coal and natural gas from outside its borders from the seaborne market which resulted in an unusually tight global market for coal and natural gas. As a consequence, prices have spiked, especially in Europe. Exacerbating the price increase in natural gas is the current situation of low inventories in Europe. A significant portion of natural gas production which would have ordinarily landed on European shores in time for its Winter season have instead been re-routed to China.

While it may not be surging, the price of Brent crude has continued to strengthen and has now risen above $80 a barrel. There are number of factors that underlie the rise in the price of oil. For starters, Opec have forecast that demand for oil in 2023 would exceed 2019 levels. Opec has also declined to accelerate production amidst growing demand. Compounding matters were production disruptions on the US Gulf Coast following the devastating event that was Hurricane Ida.

Japan

As China’s equities continue to battle against the government crackdown, across the water Japanese equity markets are enjoying a green patch. The TOPIX Index, a broad measure of Japanese securities, returned 5% during the quarter. Following the resignation of prime minister Yoshihide Suga, investors are betting that his successor will implement more stimulus measures to combat the fallout from COVID-19.

South Africa

Including dividends, the JSE All Share Index delivered a negative return of 1% for the quarter. Much of the decline can once again be attributed to China. Naspers has a significant weighting in the local index and its holding in Tencent, a Chinese tech giant that is also the world’s largest video game publisher. The fall in Tencent led to Naspers declining by 17% during the quarter, roughly in line with the fall experienced by Tencent. Richemont, another company with a large weighting in the index, fell by nearly 10% due to its involvement in the luxury industry and exposure to China. Commodity stocks with large exposures to industrial metals fell during the quarter following the sharp drop in the prices of the metal commodities.

Precious metal miners endured a challenging quarter as gold miners fell in the midst of a weaker gold price which has fallen over 8% year-to-date to end the quarter at $1,743 an ounce. JSE platinum counters fell between 10% and 24% during the quarter as the prices of platinum, palladium and rhodium declined by 10%, 31% and 32% respectively. Platinum metals are key components in catalytic convertors used in internal combustion engines to reduce emissions. A shortage of semiconductor chips for cars has meant that the production of vehicles has been reduced as production cannot take place without said chips. As a result, the demand for platinum metals has fallen sending the respective commodity prices lower. It wasn’t all bad news for the local market and there were some positives to be had. Financials delivered improved financial results for the period leading to strong gains for banking groups and insurers. Telco’s, MTN and Vodacom, as well as pharmaceutical group Aspen all produced solid results, showing resilience in the current environment which led to strong double-digit gains in the respective counters.

Cryptocurrencies

To end, the final word can be given to Chinese authorities, in this instance the People’s Bank of China, with the Chinese central bank expanding on the country’s crackdown as it declared all activities relating to digital coins would be treated as an illegal activity. The announcement rattled crypto markets with the price of Bitcoin falling 8%. Perhaps the most surprising part is that the price drop was not more severe given the extent of China’s share in the bitcoin market. Since the announcement, the price of digital asset has recovered and is currently trading above the $50,000 level. As the Chinese proverb says “He who rides a tiger is afraid to dismount”.