By Chantelle Baptiste,
Fairtree Portfolio Manager & Head of Equity Research
Looking Back.
At the beginning of 2023, the macro-economic environment seemed unsynchronised but predictable, with the world’s two largest single economies moving in opposite directions. Investment assumptions hinged on China’s reopening after a militant and unnecessary lockdown and the US’s expectations of softening under tight monetary policy conditions in response to the highest levels of inflation seen in more than three decades. However, these conventional expectations proved to be completely incorrect.
China disappointed last year from both a recovery and growth perspective and Chinese financial markets performed poorly relative to both emerging and developed markets. Déjà vu was felt in the last month of 2023 as Chinese regulation once again caused ripples, but this time to their financial market’s detriment unlike the 2022 reopening. China’s policy direction has become opaque, and any attempt to encourage market participation has largely fallen flat. Investor concern regarding China’s invest-ability was only accentuated late December, when an unexpected release from the National Press and Publication Administration of China relating to gaming regulations sparked fears of another crackdown on the Chinese tech sector, creating a significant headwind for Naspers and Prosus, given their single largest investment remains Tencent. After the release the regulator appeared to soften its stance, which saw some unwind of the downward pressure on the Tencent share price, but overall investors remain sceptical.
Throughout the last quarter of 2023, economic activity and inflation data underwent accelerated softening, prompting central bankers to adopt a less hawkish stance. Market participants began entertaining the possibility of a “soft landing”, leading to a repricing of softer growth, causing global bond yields to decline, the US dollar to weaken, and a decrease in oil prices. Beyond weakened demand, the oil market faced challenges from record US oil production, and doubts emerged regarding OPEC+’s ability to sustain production cuts. As a result, financial conditions eased significantly towards year-end, catalysing a strong rally across most asset classes. However, notable exceptions included oil and Chinese equities.
Looking Ahead.
Inflation concerns and the timing of inflation rolling over dominated 2023. We expect that 2024 will be dominated by growth concerns while the same macro themes will continue to hold centre stage, namely, China, the Fed and regional conflicts, and wars.
Global inflation has continued to soften, and the Fed’s dovish pivot last November sparked a significant market rally. Market expectations for interest rates going into 2024 seem somewhat of a dichotomy. How does a central bank aggressively cut rates in the face of a strong economy displaying a resilient labour force? The answer to that question would be simple in any ordinary year, but 2024 is a US election year and domestically the country remains heavily divided. The incumbents may do what it takes to avoid anything close to a recession or even a slowdown to ensure that power is not transferred to the opposition.
Globally there is more division than unity, not only in the form of hot wars pronounced in the northeastern part of the world, but a technological war as key players compete to win the race on tech supremacy, which is creating a further divide in the form of trade bans and tariffs. These divisions are further accentuated against a deglobalisation backdrop and are an optimal breeding ground for inflation.
China remains a wildcard.
At the beginning of 2023, we were firmly of the view that the re-opening of trade in China was a given, and we had a high conviction that it would be consumer rather than infrastructure led. That was an incorrect assumption, and throughout 2023, China consistently disappointed. Another anomaly was how strong bulk metals were in the face of a property bust and, albeit weak, a consumption-lead recovery (see Graph 1 below).
Graph 1: Iron ore top performer in non-equity category during in 2023
Source: Bloomberg, Fairtree. Data shown as total return indices.
Three key concerns will remain front of mind this year when making a call on China, namely Taiwan, Sino-American relations, and Chinese policy direction.
1. Taiwan
The incoming Taiwanese Lai administration is pro-independence, but as it is expected to face legislature stalemates it is unlikely to pose an immediate threat to China. That said, China will use tried and tested punitive trade measures and psychological tactics to ensure that Lai doesn’t try to cross any red lines. A full-blown Taiwan attack is unlikely in the near term and would be catastrophic.
China believes that Taiwan belongs to the mainland, and this ideology will not dissipate. China will also continue to seek out greater supply security, epitomised by growing reliance on Russian oil, which travels over land, as opposed to Middle Eastern oil which is vulnerable to the US Navy. Along with an energy blind spot, China appreciates that it has two other key national weaknesses: its reliance on the dollar and its dependence on external technology, hence its slow but consistent mission to dethrone the dollar and reach global technological supremacy. When these goals are achieved, the risk of a Taiwanese war will escalate.
2. Sino-American Relations
The relationship between the People’s Republic of China and the United States of America has been mostly complex and, at times, antagonistic. They have close economic ties and are significantly intertwined, yet they also have a global hegemonic power rivalry. China and the USA are the world’s largest single economies, accounting for 44% of global GDP. Thus, when these behemoths are in tension with each other, the global ripples are immense, but (perversely) also why they cannot be mutually exclusive. The US election will add further complexity this year, given how anti-China the Trump administration became. Trump launched trade wars against China, accused China of currency manipulation, revoked preferential treatment towards Hong Kong and went as far as recognising the treatment of the Uyghurs in Xinjiang as a “genocide” on the last day of the Trump administration in January 2021.
Although tension has not abated under the Biden administration, as Biden has only expanded the US support for Taiwan, Biden has also stated that the US seeks “competition, not conflict”. In the most recent US visit, President Xi pledged “heart-warming” steps to attract foreign capital and stated that China seeks to be “friends” with the US. If President Xi prefers the incumbent, does that mean China will do what it can to support a Biden re-election? Could we expect lower inflation and a soft BUT non-recessionary environment?
3. Chinese Policy Direction
The growth target for China this year is anticipated to remain around 5%, with support from specific policies inside and outside the property sector. China’s growth outlook depends on policymakers’ ability to boost confidence amid tight regulations, especially in the property sector. Infrastructure investment may firm up, and more monetary policy easing is expected, potentially dependent on the US economic conditions.
Despite these potential green shoots, it is undeniable that China remains in a confidence crisis both internally and externally. Internally, the Chinese property melt down caused by regulation created significant wealth destruction as this sector remains a core store of value for the Chinese people. Furthermore, China experienced some of the most militant lockdowns seen globally, which infringed on their personal space and family life. When something so sacred is violated by your government, trust is fundamentally broken to the point that no policy will encourage or entice domestic spending at scale. Externally China has gradually become less and less investable, coinciding with more and more policy opaqueness.
Graph 2: China Economic Policy Uncertainty has escalated over the last 5 years
Source: Bloomberg, Fairtree. As at 16 January 2024
The announcement made in December by the National Press and Publication Administration of China relating to gaming regulations betrayed investors and Chinese corporates alike. Not only was the timing careless, being the Friday of Christmas weekend when liquidity and investor concentration alike are lacking, but the announcement came at a time when the government had begun an amicable approach to large-scale regulation. 22 December 2023 was the third largest single-day market outflow experienced over the last 10 years, including COVID-19. The said individual was swiftly fired, but the damage was done. One should expect neither a fundamental shift in policy nor an ideological gear change from President Xi. But what investors often get wrong about China is that they label everything as socialist when, in fact, the Chinese economy is capitalist at heart, and when broken down to its raw form, it behaves in that way. We need to take a harder look at how corporate China responds to this regulatory malaise, how they navigate and if they can still eek out returns. For example, Tencent used the recent share price reaction to increase its daily buy-back purchases, enhancing future shareholder returns.
Graph 3: US vs China Tech, the bifurcation has become too extreme
Source: Bloomberg, Fairtree as at 9 January 2024
Chinese equities have been impacted by geopolitical tension, regulatory announcements, and macroeconomic challenges, largely relating to concerns around the property sector. This has resulted in Chinese shares, including Tencent, trading at significant discounts to global peers. We think this is overdone, as the underlying fundamentals of the Chinese economy remain robust, and despite political rhetoric, China remains a large and crucial part of the global economy. This discount and the underweight positioning of global investors has created an opportunity which we think could be unlocked on a narrow shift in sentiment and investor flows.
US Remains Predominant Global Player.
A key question remains whether the market has optimistically priced in too many Federal Reserve rate cuts. The timing and extent of necessary cuts to stabilise a slowing economy will be a key source of volatility in 2024.
- However, in the bigger picture, the following macro trends that will steer markets are:
Slowing global growth, leading to a likely mild recession in the US while China could provide some offset, although that did not play out last year. - Continued disinflation below target levels over the short term but sticky to the upside over the long term, which will require structurally higher interest rate levels for longer than what the market seems to think.
- Central banks’ ability to cut rates and navigate the tension between premature loosening versus later-but-deeper cuts.
What is surprising is the short-term memory of the market and how it is overlooking the fact that we have been in a relatively higher interest rate environment for a relatively brief period of time, following decades of low rates and easy money. One must remember that declining and low interest rates had a huge but underrated influence on the market preceding COVID-19. Monetary policy was easy, and money was practically free. It was easier to run a business with the stimulated economy growing unchecked for decades, easy for investors to enjoy asset appreciation, easy and cheap to lever investments and for businesses to obtain financing, and easy to avoid default and bankruptcy. Often, these easy times create weak investors, which in turn create tough markets. While a US “soft landing” is possible, it is considered unlikely given the rapid tightening by central banks and the long and variable lags typically associated with monetary policy tightening.
We need to be aware of this and appreciate that timing is everything when it comes to investing and it has only been 6 months since the last rate hike. How can we assume everything is behind us, and a soft landing is a given? The timing of a potential recession hinges on the strength of US households. Factors supporting households such as excess savings, strong income growth and fiscal easing are fading, and evidence of labour market weakness is emerging. A mild recession could lead to job losses and wage reductions, impacting core inflation. The Fed may have room for rate cuts, but a mild recession and swift demand correction are anticipated.
Global Events will Dwarf the South African Political Calendar.
The South African economy shows potential for improvement, but growth remains hampered by near-term challenges, including elevated inflation, higher interest rates, political uncertainty, and weak global growth. Economic reforms are needed, and while some progress has been made in the energy sector, the transport and logistic reforms are lagging. Cyclical and structural catalysts may present themselves over the coming year with potential rate cuts, which would be supportive of household consumption and economic growth, as well as improved electricity supply off a low base. South Africa experienced its worst year of power outages ever recorded during 2023, which is crippling for any economy. If the country could demonstrate any sustained improvement in energy supply, company earnings would improve through a reduction in the cost burden of power disruption and foreign investment flows back into the domestic counters could follow, something we have not witnessed for some time.
Given the difference in election timing and holding of office between different countries, it is not often that we see both a South African national election year and a US presidential election year coinciding. The US election will dominate the South African election. However, the South African election outcome will be closely monitored, and it is possible that the ruling party will be forced to form a coalition with smaller parties. To remain in control over the coming years, the ruling party will need to reform. The country’s fiscal situation has deteriorated over the last 18 months but less than initially feared.
Conclusion.
An election year will always be noisy, and the political shenanigans will cause market angst and caution, both domestically and in the world’s single largest economy. This timed perfectly with China’s policy uncertainty amid trade tensions and hot wars makes for a rather spectacular global political cacophony. As equity investors we are wired to seek out alpha opportunities in any market and macro environment and occasionally there are periods where valuations dislocate from fundamentals creating for excellent alpha opportunities.
Disclaimer:
Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available upon request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information, such as fund prices.
