The debate over whether the US will experience a hard, soft or no landing was of little consequence during the quarter. Despite the market now pricing in just three rate cuts in 2024 compared to six at the start of the year, the MSCI All-Country World Index rose 8% in the first quarter. Anything artificial intelligence (AI) remained the dominant theme, however, performance broadened across sectors and regions. Both the MSCI World Index of developed markets and the MSCI Emerging Markets Index were higher, while the former outperformed – an all too familiar dynamic.
The considerable clout of the “Magnificent 7” (Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia and Tesla) – which together accounted for more than two-thirds of the gain in the S&P 500 in 2023 – all but require funds to assimilate their weightings to keep up with their benchmarks.
While certainly not an academic term, FOMO, or the fear of missing out, is a very real phenomenon in markets. Three factors that accentuate FOMO are funds’ propensity to hug their benchmarks, seeing peers outperform and the ongoing rise in passive exchange traded fund (ETF) flows. These factors result in market participants crowding into the largest, most popular companies. This creates a self-reinforcing flywheel of momentum – which is itself boosted by momentum-based algorithmic trading platforms.
Investing based on FOMO and momentum, without due regard for valuation, eventually leads to bad outcomes. Furthermore, the boom/bust nature of such a strategy can lead to even worse outcomes for underlying investors because it magnifies cognitive biases. In Morningstar’s latest Mind the Gap study, it found that the average US mutual fund in the 10 years to the end of 2022 gained 7.7% per year. However, the average underlying investor in those funds earned 6% per year. The loss of one-fifth of the funds’ return illustrates the propensity of investors to chase performance and then sell when the fund declines. This behaviour results in significant underperformance for the average investor relative to the underlying fund return. A clear takeaway derived from the study was that investors are more likely to mistime their investments in highly volatile funds than they are in less volatile funds.
There is growing evidence of investment managers crowding in the companies that are exposed to anything AI, whether that be Nvidia’s leading position in graphics processing units (GPUs) needed to train AI models, datacentre infrastructure companies like Vertiv and SMCI, and even Caterpillar has received a boost from the expected growth in generator demand for datacentre backup power.
It is important to differentiate between Generative AI technology itself and the investment in companies offering exposure to the technology. Many investors cling onto total addressable market (TAM) estimates delivered by company management teams, which portray an uninterrupted, linear path to billions or even trillion dollars of available revenue for an industry or industry segment. These estimates are notoriously optimistic, and it is rare for anything to follow a linear trend.
While we concur with the broadly held view of the greatly beneficial impact of Generative AI technology on global workforce and facilities productivity in the longer-term, we differ on the pathway to mass adoption. The growth rates that are highly likely to be achieved over the next two years by the AI-exposed companies should not be extrapolated over the subsequent decade. Technology adoption is never linear, and we believe that certain companies are being priced for that outcome.
We are reticent of comparing the current investment environment to the dotcom bubble because the level of exuberance and underlying macroeconomic backdrop is decidedly different. But as author (and very unsuccessful investor), Mark Twain said, “history doesn’t repeat itself, but it often rhymes.”
Nvidia’s position in the development of generative AI models as the provider of the “picks and shovels” bears a similar resemblance to Cisco System’s position in the late nineties in relation to the growth of the internet. Cisco’s share price boomed during the dotcom bubble because it produced most of the equipment that made the internet work. Cisco was not a fly-by-night pets.com business, but a company that grew revenue by 31%, 44% and 56% in 1998, 1999 and 2000, respectively. In contrast to many of the tech companies that were caught up in the craze, Cisco was highly profitable as well.
The company’s share price peaked at $80 per share in March 2000, giving Cisco a market capitalisation of $569 billion (or around $1 trillion in today’s money). While its share price dropped 52% from the March peak through the end of 2000, Cisco’s results remained strong – growing its revenue by 56% in 2000 and 18% in 2001. Despite the group’s revenue reaching $57 billion in 2023 (more than double its revenue in 2000), Cisco’s share price has never again reached the March 2000 high.
It can be tempting to extrapolate current growth rates far out into the future. There is a plethora of reasons provided by analysts, brokers, and the financial media for why a company’s share price can continue to defy gravity. When a share price exhibits a parabolic move higher, it creates the FOMO flywheel as investors crowd into the name. Unfortunately for shareholders in a company like Cisco during the dotcom bubble, the FOMO flywheel can turn quickly. And just like the crowding that occurs on the way up, a sudden reversal can turn into a stampede for the exits.
The parabolic move higher and subsequent crash in the share price of a fundamentally attractive company like Cisco illustrates the pitfalls of valuation-agnostic investing. When a valuation multiple rests on sentiment alone, share prices are vulnerable to air pockets. We are seeing the euphoria around AI being reflected in investor sentiment indicators. With the S&P 500 up 47% from the October 2022 low, the alure of a continuation of the advance is pushing more investors into the “bullish” camp, with a declining proportion of investors responding “bearish” to the established sentiment surveys. As fund managers and advisors have become more confident of further gains in equities, the average US household’s equity allocation as a proportion of total financial assets moved up to 40% exiting 2023, being exceeded only by levels above 41% through 2021 and the first quarter of 2022.
The graph illustrates the contrarian relationship between the proportion of US advisors’ reporting that they are “bullish” versus the S&P 500. While this sentiment indicator is volatile, it is most useful at the extremes, where we have used the standard deviation of the long-term average – depicted by the top and bottom dotted lines. Because sentiment measures generally tend to be contrarian indicators, investors would have earned the best return when the proportion of advisors describing their outlook as bullish was at the extreme lows (less than 30) and a worse return when investing at the extreme highs (over 60). However, this measure has no predictive power on the magnitude nor the exact timing of subsequent moves.
Warren Buffett’s famous adage of, “being fearful when others are greedy, and greedy when others are fearful,” is demonstrated by sentiment indicators such as this.
On the other end of the sentiment spectrum, there’s China. Domestic sentiment has been knocked by the heavy handed and unsuccessful handling of COVID, and more pertinently, the stress in the very important real estate sector. From a foreign investor perspective, these domestic issues are exacerbated by growing fears of a potential conflict with the United States via Taiwan, worsening trade relationship with the United States, and the potential for China to drift back towards a more communist system (the re-election of Xi Jinping for a third term and stacking the politburo with likeminded individuals reinforced that fear).
The troubles being experienced in the real estate market are front and centre of any decision of whether to invest in Chinese companies. Comparisons are made to the Global Financial Crisis in the US, and Japan real estate bubble of the 90s. A key difference is that Chinese households are not over-leveraged, with the stress being concentrated amongst the real estate developers.
Generally, those buying their primary residences in China will put down a 30% deposit and finance the remaining value. Xi Jinping’s adage that “Property is for living, not speculation” implies that Chinese households have been a on a debt-fuelled real estate buying spree over the last decade. An interesting counter to that assumption is that Chinese banks won’t lend to finance a second apartment and many Chinese cities forbid owning a second apartment. That means that the additional apartments owned are not mortgaged.
For two decades, property was used as a store of wealth for the Chinese upper middle class. The experience and expectation that property prices will continue to rise, kept demand high for new developments. While consumers are not over-leveraged, some of the country’s largest developers were leveraged to the extreme. With the confidence around real estate being rattled by questions on the solvency of many of the largest developers, the pre-sale of new developments has been negatively impacted. At the same time, the Chinese government have been steadfast in their implementation of the “Three Red Lines” policy, forcing the highly indebted developers to deleverage as a main priority.
Due to the leverage dynamics of household purchases of properties, there isn’t a household solvency issue because of the drop in aggregate home prices and therefore, little risk of a US style real estate market collapse. The pressure on households stems from the negative sentiment associated with a decline in value from the predominant store of household wealth. The negative wealth effect brought about by the problems in the real estate market have impacted consumer confidence, with a resultant knock to consumer spending.
If there was a Chinese equity market sentiment indicator, it would be close to extreme lows. China’s H-share (Hong Kong listed and accessible to foreigners) index and the Hang Seng (Hong Kong Index) Technology Index, are down 45% and 58% from the start of 2021. The steeper decline experienced by the H-share relative to the A-share (Shanghai-listed) index reflects the collapse in foreign investor sentiment. Chinese companies represented around 40% of the MSCI Emerging Markets Index at its peak. The contribution has declined to 25% today as emerging markets-focused funds redeployed capital from Chinese companies to the Indian market, which now contributes 18% of the MSCI Emerging Markets index.
The weak foreign investor sentiment is reflected in the share price and price/earnings multiples of Alibaba and Tencent in Hong Kong.
Tencent has de-rated from a high of 45x earnings entering 2021 to 15x currently, while Alibaba has seen its PE multiple de-rate to 8x from 26x over the same period. On top of the domestic and foreign concerns, China’s tech sector has been impacted by a series of regulatory crackdowns, most notably the scrapped listing of Alibaba’s payment subsidiary, Ant Financial, and pause in the approval and monetisation of Tencent’s mobile games in China.
In Tencent’s most recent results, normalised net income rose by 44% in the fourth quarter and 36% for the 2023 financial year. The company exited the year with $7.7 billion of net cash and a listed investment portfolio valued at $78 billion. Furthermore, Tencent announced that it would double its share repurchases to $13 billion in 2024, enough to repurchase around 3% of its shares in issue at the current price and fully offsets the impact of Prosus’ sale of Tencent shares in the open market. Despite the company’s exceptionally strong fundamentals, Tencent’s share price is down 20% over the last year and less than half of what it traded at in February 2021.
We aren’t advocating for investors to pile into Chinese equities. But by highlighting two equity markets at extreme ends of the sentiment spectrum, we are seeking to illustrate that subsequent performance is a function of price relative to expectations rather than absolutes. China’s economy doesn’t have to reaccelerate to double digit GDP growth or turn its real estate sector around overnight for its equities to outperform. It needs just a slight improvement in domestic sentiment that is not being priced into its equities. On the other end of the spectrum, high absolute growth achieved by richly valued companies need only fall marginally short of elevated expectations, to underperform.
Staying on the low sentiment road, South Africa is another market that has been shunned by foreign investors over the last five years. Unlike China, South Africa’s institutional investors are not constrained by restrictions on outward capital flows. In fact, Regulation 28 that governs the management of pension and related funds, increased the offshore investment limit to 45% in 2022 from 30% under the previous regime. Amidst the worst year on record for loadshedding, fund managers consistently moved allocations offshore during 2023. Selling by both foreigners and domestic managers has created a significant headwind to the performance of South African equities over the last two years. The capital emigration is reflected in the declining average rand value traded in the JSE All Share index. From a peak of R31 billion in June 2022, daily average value traded has fallen to just under R26 billion in March 2024.
The JSE All Share Index declined by 3% in the first quarter compared to a 12% gain in the MSCI All-Country World Index and 6% rise in the MSCI Emerging Markets Index (both in rand). After outperforming in 2023, financials were the largest detractors from the index’s performance for the quarter as the yield on the 2032 South African government bond jumped 90 basis points – following the rise in global bond yields during the quarter.
All eyes are on the election, particularly following the emergence of Jacob Zuma’s MK party. Recent polls released by the Brenthurst Foundation have shown remarkable popularity for a party that has only been in existence for 4 months. With the former president at the helm (despite being ineligible to be president due to his contempt of court conviction), Brenthurst’s poll have the party garnering around 25% of the vote in KZN. On a national level, they are polling at 13% of the vote and taking considerable share from the ANC, EFF and IFP.
Brenthurst Foundation National Election Poll Results:
Based on historical precedent, there is likely to be changes in the polling results leading up to the election. Historically, ANC support has risen closer to the election date as the party uses its considerable scale to rally supporters. However, one thing looks more certain – the ANC is set to lose its majority for the first time.
The weakness being displayed by the ANC in the polls has increased the possibility for both very positive and negative outcomes. The positive outcome is determined by the ANC falling short of the votes to be able to string together several smaller parties to form a coalition. Instead, the ANC and the DA form a coalition government at both a national and provincial level where required, paving the way for a more right-of-centre governing coalition. The negative scenario results in the ANC forming a coalition with the EFF and/or the MK party, creating a far left of centre coalition.
We still believe the base case scenario is for the ANC to lose its majority but garner enough votes to form a coalition with several smaller parties. In the event the ANC’s share of vote reflects the latest Brenthurst poll, we are optimistic that the ANC would partner with the DA rather than the EFF.
This election looks set to alter the political landscape indefinitely, as the country moves away from the liberation party dominated environment that has been in place since 1994 and towards a more mature democracy.
We see the status quo and right-of-centre coalition outcomes as both positive for domestic equities. Markets hate uncertainty and a scenario in which the EFF has a hand on the keys to power is enough to keep investors on the sidelines in the lead up to the election.
From an investment perspective, we are prepared for all three highest probability outcomes. Despite the country’s own goals over the last several years, we continue to see tremendous value in the local market that could be unlocked by a favourable election outcome. With little, if any, improvement being priced in, equities are poised to rally on any news that portends a less negative outcome.