Dear Investor
General Market Overview
United States (US) September inflation figures came out higher than anticipated, leading markets to fear that the Federal Reserve (the Fed) was not at the end of the hiking cycle and had not “tamed inflation”. At the same time, many corporations announced earnings below market expectations, suggesting diminished consumer demand. However, October inflation figures came out lower than September, reducing the concern that interest rates may rise further and Gross Domestic Product (GDP) figures for Q3 were higher than market expectations (5.2% on an annualised basis). These economic factors have helped to fuel the not-atypical “Santa Claus rally” often experienced at this time of year.
To the 24th of November, the Standard & Poor’s (S&P) 500 index had appreciated roughly 16% year-to-date (YTD), and over 12% of that price appreciation was attributable to the “Magnificent Seven”. This illustrious grouping comprises Facebook/Meta, Apple, Amazon, Google/Alphabet, Microsoft, Nvidia and Tesla. This group now constitutes just under 30% of the index. The other 493 stocks in the index have underperformed cash for the year.
Investment bank, Goldman Sachs, tracks hedge fund positions, and hedge fund crowding is now the most extreme it’s ever been in the 22 years of record. Hedge funds lifted their exposure to the Magnificent Seven to a new record in 3Q23. Together with solid inflows into retail Exchange Traded Funds (ETFs) with exposure to this top seven group has created a self-fulfilling prophecy. Retail investors and hedge funds have been momentum trading, which is fun while it lasts but may be an accident waiting to happen.
Moving away from developed markets, two economies often included in the South African peer group, Argentina and Turkey, have been making global headlines. In Turkey, the central bank just hiked interest rates by another 500 basis points (bps) (5%) to 40% to restore economic stability as inflation soared to more than 80% (currently 61% y/y) and created a currency crisis. Readers may cast their minds back to the third quarter of 2018 when we mentioned the unorthodox economic policies and political decisions of Turkish President, Recep Tayyip Erdogan, at a time when inflation in the country was 15% y/y.
Erdogan has recently been re-elected but has instituted a reversal of economic policy direction after insisting that policy rates be kept low. In June, the central bank raised interest rates to 15% (a 650 bps hike) to counter the prior years of monetary policy easing despite increasing inflation.
In October, the Argentinian central bank raised rates to 133% to attempt to combat inflation, which is now 138% y/y. This decision by the central bank comes as Argentina has elected Javier Milei, a distinctly different political leader. Milei is a controversial figure known for his outspoken views and support for free markets and individual liberty. It will be interesting to see how many of his policies he can implement within Argentina.
Another critical component of the global economy is the commodities market. An index of the Goldman Sachs Commodity Index (GSCI) relative to the S&P 500 shows the dislocation between commodity prices and the level of equity valuations. The index has shown a slight upward trend recently, and some commodity prices like orange juice and uranium have moved upward quite sharply. The commodity market has historically gone through cyclical bull and bear markets, which are tied to the cycle of capital spending within the commodity producers.
A phase of excessive capital spending leads to an oversupply of a commodity, and that glut depresses prices. Similarly, years of underinvestment in capital infrastructure create a shortage, resulting in “overnight” price spikes in commodity spot prices.
One of the commodities making new highs in price is gold. The gold spot price is above $2,040 per troy ounce, and much of the demand for physical gold has come from central banks. In the third quarter of 2023, global demand for gold by central banks continued with an increase of 337 tonnes, bringing the total accumulation to 800 tonnes YTD.
Interestingly, over 2022 and 2023, investor demand has been negative as measured by flows into physical gold ETFs. Outflows amounted to $2 billion in October, mostly from North American investors. However, bar and coin investing has remained strong, as has the demand for jewellery fabrication.
Cumulatively, the increase in the price of gold is being supported by central bank buying as well as demand for physical gold in the form of bars, coins, and jewellery. Central banks buy gold principally to diversify their reserves. Gold carries no credit or counterparty risk; therefore, a country with large gold reserves establishes credibility independent of the perception of its economy.
Gold also tends to have an inverse relationship with the US Dollar, an attractive feature for central banks, enabling them to diversify their Dollar risk. It will be interesting to observe whether investor sentiment, as measured by ETF flows, turns more optimistic given the appreciation in gold price.
General Conclusion
The economic, market and investment environment is continuously evolving. Concerns over inflationary pressures have receded, and with that has come the expectation that interest rates will not rise further. Perceptions and expectations of the path and level of interest rates have a material impact on all asset classes.
Currently, the US equity market is being significantly shaped by a small handful of technology mega-stocks, and it is hard to predict how this dominance and concentration will affect market performance and sentiment into 2024. To support high valuations, companies must consistently generate strong and increasing corporate earnings or provide very strong messaging on how they will deliver future earnings. There may be a dislocation between valuations and future expectations at some point, leading to sharp price reversals.
Commodity prices also have a future demand component to their spot prices, but commodity valuations tend to be more grounded in fundamentals rather than sentiment. Across several commodities, including soft/agricultural commodities like orange juice and cocoa, the demand-supply dynamics have created a significant mismatch, resulting in substantial price increases.
The decisions of the Fed, in combination with global economic growth and the market expectation and sentiment about those key indicators, will fuel investment flows and, therefore, asset class returns in 2024.
08 December 2023