Economic and Market Overview

June 2022

Global 

Economic growth around the globe is likely to be lower than was anticipated at the start of the year. Combined with the war in Ukraine, strict COVID-19 lockdowns in China, higher inflation for longer, and steeper than expected interest rate increases, it has had a significant negative impact on the expected earnings for companies which has been reflected in recent share price movements.

In a recent report, RMB Global Markets adds that the global growth outlook is vulnerable to both the impact of elevated commodity prices and increasingly restrictive monetary policies. Their base case is that output in advanced economies will slow, most notably in Europe, which is directly impacted by the war. Some resource-rich developing economies will continue to benefit from the higher commodity prices, but the net export position will be the differentiator. 

In their May 2022 Global Outlook, the Blackrock Investment Institute identifies three investment themes. In the first theme, “Living with inflation”, they note that central banks are facing a growth-inflation trade-off. Hiking interest rates too aggressively risks triggering a recession, while not tightening enough may cause runaway inflation. The US Federal Reserve has made it clear it is ready to dampen growth, which is partly why investment markets have retreated significantly in recent months. Their second theme pivots around cutting through all the confusion. The Russia-Ukraine conflict has aggravated inflation pressures. Trying to contain inflation will be costly to growth and jobs. They see a worsening macro outlook due to the Federal Reserve’s hawkish stance, the commodities price shock, and China’s growth slowdown. In the third instance, they highlight the navigation towards net-zero, where carbon emissions equal carbon recycling. Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios. The net-zero journey is not just a 2050 story; it’s a now story. Investors should, however, be mindful of how green investments truly are – many product providers have green-washed their assets so that they could get on the bandwagon of this theme rather than providing a truly sustainable investment proposition.

In summary: geopolitical, monetary, and renewed supply chain shocks have led to both global bonds and equities selling off this year. According to Blackrock, there will have to be significant positive surprises to the economic outlook for equities to have a proper rebound:

South Africa

The South African Reserve Bank’s Monetary Policy Committee (MPC) decided to increase the repurchase rate by 0.5%, taking it to 4.75%.

Four members of the Monetary Policy Committee voted for this increase, with one opting for a more modest 25 basis point hike. In his statement following the meeting, the governor said that the implied policy rate path of their Quarterly Projection Model indicates gradual normalisation through to 2024. The market’s consensus view is that all else being equal, the repo rate will normalise at 6.25% in two years’ time. This is still below the policy rate of 6.5% (in 2019) before the Covid-19 pandemic significantly influenced monetary policy.

Source: South African Reserve Bank, Bloomberg

The increased cost of servicing debt that is associated with interest increases, coupled with the ever-rising cost of energy and less than reliable electricity supply will continue to weigh on the growth prospects of the South African economy. Much of this is already reflected in share price movements – if it’s in the press it’s in the price.

Despite the significant increase in fuel prices, South Africa’s inflation seems to be far more under control than in the rest of the world. The Reserve Bank expects inflation to average 5.9% in 2022, falling to 5.0% in 2023 and 4.7% in 2024.

Their growth outlook remains anything but rosy though. The economy is forecast to expand by 1.9% in both 2023 and 2024. At these rates, growth remains well below potential, impacted by loadshedding, infrastructure, and policy constraints. Investment by the government sector has weakened significantly in recent years and that of public corporations is forecast to be very modest. Household spending remains supportive, as a result of good growth in disposable income, rising asset prices, and low-interest rates. Private investment has also proven to be more resilient than previously expected. Tourism, hospitality, and construction should see stronger recoveries as the year progresses. Current assumptions are quite gloomy, which implies that modest upside surprises could spark short-term rallies. The recent arrest of two Gupta brothers in the UAE may be a small victory, but it will help in the war against corruption.

Commentary – Kings (And Queens) Of Capital Allocation

There are primarily two ways in which a company can reward its shareholders – paying dividends or buying back shares. Both of these options have pros and cons and also depend on the tax treatment of dividends received versus capital gains (the latter is typically a direct result of share buybacks).

The success of share buybacks often depends on the capital allocation skills of company management: if they could always buy low and sell high they would add immense value to the value of shares, but this is not always the case. If they were to stick to paying dividends, the capital allocation decision (whether to buy more shares in the company) lies with each investor. So the question is whether company management teams are better positioned to get the timing of share buybacks right when compared to other investors in the company.

In a 2011 report by McKinsey, they open the debate by stating that company managers, like investors, often gauge the performance of share repurchases against that old investment adage: buy low, sell high. If they could consistently time repurchases to periods when shares were undervalued, as some try to do, they could reward loyal shareholders at the expense of those who sell out. Of course managers, like investors, can’t always do what old adages suggest. Markets are volatile and unpredictable, and what seem to be longer-term trends can quickly reverse course. Overconfidence can lead executives to buy back shares even at the peak share price — and a bias for caution can restrain them from buying shares when prices are lowest. The result is that companies seldom consistently pick the right time to buy back their shares at advantageous prices. Indeed, for the years 2004 through 2010, McKinsey’s analysis finds that a majority of companies repurchased shares when they and the market were both doing well—and were reluctant to repurchase shares when prices were low relative to their intrinsic valuations. Few stopped repurchases even as the market peaked in 2007. And when the market bottomed in 2009, few companies were buying back shares.

McKinsey looked at the S&P 500 companies between 2004 and 2011. It turns out that companies don’t just tend to buy back more shares when the underlying earnings are strong — they also seem more willing to do so when their share prices are high. The result is a cyclical pattern: companies pay out disproportionately large amounts at the top of a cycle and withhold repurchases at the bottom. Over longer-term periods, such as the up-and-down market cycle from 1998 to 2005 or 2006 to 2010, share repurchases came at the expense of long-term loyal shareholders by delivering lower returns than they might otherwise have received. The study compared the actual repurchases of S&P 500 companies from 2004 to 2010 with a modeled strategy of buying the same dollar amount of shares each quarter, much as an investor might regularly purchase shares as part of an income-averaging approach or as a company might think of a share repurchase as akin to a regular dividend. McKinsey found that the latter strategy significantly outperformed what actually happened. For companies that repurchased 5 to 25 percent of their outstanding shares, the median return of actual buybacks lagged behind that of the modeled strategy by 4.5 percent. For companies that bought back more than 25 percent of their shares, the median return of actual buybacks lags behind that of the alternative approach by 3 percent. Only 31 percent of the companies earned a positive return from buying back shares—less than you would expect from a random throw of the dice.

These findings suggest an easy fix: companies should give up trying to time the market. Long-term shareholders will be better off if management would simply forecast total excess cash and evenly distribute it each calendar quarter as “dividends” in the form of share repurchases. CFOs can approach such regular buybacks in two ways. First, they can repurchase shares as excess cash becomes available. This is the easiest approach and the one least likely to send adverse signals to investors around the potential for excess cash or cash shortfalls. It is probably right for most companies, even if it generates lower returns.

Second, companies can evenly distribute similarly sized repurchases over time. For those willing to stand by their forecasts of future cash flows, this dividend-like approach will probably generate higher returns for shareholders.

Investors will, however, inevitably try to determine exactly what management is thinking, given the level of repurchases it sets. And it’s worth bearing in mind that as with dividends, investors may react negatively if repurchases eventually decline, viewing this as a signal of management’s pessimism.

If the kings and queens of capital management (i.e. management teams of companies) struggle to successfully time the buying of their own shares it stands to reason that it’s no easier for investors to do the same. The debate around the value creation of share buybacks versus paying dividends is far from over – it’s certainly more complex than described above. It’s in these instances where a seasoned investment manager may be able to add value as they could consider other opportunities for capital allocation when opting for a dividend rather than a share buyback. As long as your capital spends time in the market you’re better off than timing the market…