Economic Overview
China reopening gathering steam
The much-anticipated reopening of the Chinese economy ignited markets as the Chinese government, pressured by social unrest, adopted a surprising full-scale reopening of the economy as opposed to an expected slow-phased approach. By the end of the quarter, the economic environment appeared to be shifting in a more business-friendly direction, in stark contrast to the unfriendly tone of the 20th Communist Party Congress held in October. Alibaba’s subsidiary Ant Financial has been permitted to take up a capital raise, although founder Jack Ma has had to surrender control; whilst new game releases have finally received regulatory approval. The Chinese property sector, plagued with challenges over the last two years, will also receive more stimulus with plans for the relaxation of borrowing restrictions for property developers. The sustainability of a more business-friendly environment in China remains to be seen. In the interim markets, seem to be giving China the benefit of the doubt with asset valuations rapidly accelerating in the last 2 months.

Chinese equities and foreign companies benefiting from the reopening and regulatory changes have seen a significant increase in valuations. JSE shares include Naspers/ Prosus, diversified miners that have benefited from a higher iron ore price, and Richemont, which will benefit from a recovery in Chinese spend on luxury goods. Our exposure to China’s reopening has been primarily via the Mining and Luxury sectors. Emerging markets should benefit from China reopening its economy via improved commodity prices and demand for goods from emerging markets. Flows into EM markets as a result of this often benefits South African markets. This benefit might be more tempered than has historically been the case given our struggling economy.

US equity valuations facing headwinds
Market participants mostly expect a recession in 2023 which has become more likely given persistent inflation coupled with stringent monetary policy. Interest rates are expected to decline to 3% in 2 years with the US market pricing for inflation to return to approximately 2% by the end of 2023 and remain there. Long-term real rates are priced at approximately 1.4% which seems a reasonable level relative to sustainable US economic growth. However, the risk of inflation staying elevated compared to levels over the last few decades seems high given that globalization benefits are no longer present. In the short term, a tight labour market will also keep the pressure on inflation (via wage inflation above 4%) once the benefit from goods deflation is worked out of the base over the next year. Real yields staying elevated means falling bond yields are unlikely to be a source of help for equity markets. Currently, the equity market valuation does not appear to be reflecting a higher real yield environment. The S&P500 Price Earnings (PE) of 16.8x is in line with the average of the last 10 years when real rates averaged 0.35%. A multiple of 14x would be more reasonable assuming real rates remain above 1%. If we use a lower earnings base than what appears to be captured in the optimistic consensus earnings forecasts, this will raise the PE further to over 18x. The US economy is slowing down indicated by weaker economic data (PMIs and ISM metrics), however, the market is not pricing for any meaningful slowdown. Over the long term, there are several headwinds that could weigh on US earnings expectations including:
• Higher taxes to fund growing budget deficits
• Less government spending
• Deglobalization may well depress profits if higher costs cannot be passed on to
consumers
• Higher interest and debt funding costs
The US market is approximately 60% of the global equity market and may weigh on the overall market, however, equity valuations in other regions are reasonable relative to history. In the short term, a reopening of China and lower energy costs will be positive for European and Emerging Markets equities.

SA’s persistent power pressures
Loadshedding increased and will continue to weigh heavily on the SA’s economy placing further cost pressures on corporates and consumers (especially the lower LSM groups) over the next year. The resignation of the CEO is clearly disappointing. On the political front, the positive outcome of the ANC elective conference helps offset some of the negative fallout from the well-publicised Phala Phala incident. President Cyril Ramaphosa will need to make a second term matter if SA is to escape a growth quagmire. The noise and uncertainty regarding the future leader who will ultimately replace Cyril Ramaphosa will amplify from here. This might be more of a medium-term concern. We have positioned the portfolio more in favour of offshore exposed counters as a result of the concerns expressed above. However, we do concede that valuations of many domestically exposed shares are relatively cheap, and we therefore maintain some domestic exposure. Financials may deliver muted earnings growth but will pay out generous dividends over the next year. China’s reopening is positive for commodity prices which should help our current account and budget deficit. This should help ameliorate some of the pressure that the rand would otherwise face. This should also be positive for domestic bonds.

2023 outlook more challenging
Globally, several factors driving the bull markets of the past decades have changed. From an interest rate perspective, any significant declines in long rates will likely be accompanied by recession while the disinflation benefits of deglobalization that helped lower rates are unlikely to repeat. This will have negative implications for equity and housing markets. More reasonable valuations outside of the US will ameliorate some of this pressure in respect of global equity portfolios. Fiscal positions have weakened, and budget deficits and debt levels are high in many of the world’s large economies. The need to reign these in will not be positive for global growth. We’ve seen the first sign of bond markets acting against reckless deficit spending by a developed market with the resultant resignation of the UK prime minister and Chancellor of the Exchequer. The desire from the world’s Treasuries for higher inflation to erode debt levels versus Central Bank mandates to rein in inflation could be a source of additional volatility. Geopolitical tension with the potential increased conflict between large powers and the rise of populism is difficult to quantify. They will also create volatility as witnessed in 2022. Valuation opportunities will no doubt arise as the above factors play out. This will require a more dynamic investment process. Locally, positive political moves and an ability to repair power issues remain the biggest challenges to the 2023 growth trajectory.

Portfolio Positioning
Contributors and detractors
South African equities had a strong although volatile quarter with the Capped SWIX up 12,2%. This was despite a weaker December when markets priced for political uncertainty. Technology stocks rebounded significantly in November following a weak October, led by Naspers and Prosus. Investors responded positively to the surprising full-scale reopening of the Chinese economy. SA banks performed well over the quarter largely driven by a strong October - one of the best-performing local sectors that month. Exposure to Investec and ABSA contributed positively to portfolio returns as did Richemont which also benefitted from positive market sentiment to a China reopening.

Portfolio movements
Exposure to domestic medium-term duration bonds contributed to returns over the quarter in line with Rand and Emerging Market performance. We reduced exposure to some of the coal counters in the fund given current valuation levels and we added exposure to Anheuser-Busch given favourable valuations. We switched some British American Tobacco into Anglo American to better position for the China reopening.