Allan Gray SA Equity Fund

Volatility was a key characteristic of equity returns this quarter. Despite the MSCI World Index recording new highs at quarter end, this performance did not come in a straight line. The US, which accounts for more than 70% of the MSCI World Index, was largely responsible for the rocky ride. The S&P 500 rose by 4% in the two weeks to mid-July, before falling by 8% over the next three weeks on weaker-than-expected July US employment data, which triggered fears of a looming recession. Thereafter, it rose by 9% over the next month on strong US GDP growth and weaker inflation versus expectations, before falling by 4% over the next week on another US employment data release. The US Federal Reserve (the Fed) cut interest rates by 50 basis points (bps) in late September (for the first time since the COVID-19 pandemic), serving as the quarter's defining gambit. Investors cheered the prospects of easing US inflation into a soft economic landing, resulting in the S&P 500 rising 6% overall for the quarter and bringing 2024 year-to-date gains to 22%.

The outsized moves above highlight an adage by the pioneer of value investing, Benjamin Graham, who said that the stock market is a voting machine over the short term. In a period of heightened uncertainty and low visibility, investors are severely punishing asset prices where outcomes miss expectations even slightly and, conversely, are excessively rewarding stocks that slightly beat consensus estimates. The current “vote” is that US inflation is structurally heading back to the 2% average it enjoyed in the 20 years to 2021, with a terminal interest rate 2% lower than current levels, and without the US falling into a deep recession. However, we take a more conservative view, acknowledging that we have little edge in predicting macroeconomic outcomes. If indeed the US consumer remains robust, which is likely given still-low unemployment and still-strong wage growth, then cutting interest rates prematurely should see another rise in inflation down the road and the need to tighten conditions once more. On the other hand, deep interest rate cuts may be a leading indicator of a weak US economy. Either scenario will be bad for global stock prices.

Benefiting from positive global sentiment, local stocks were further buoyed by improving investor confidence in South Africa following the formation of the government of national unity. The FTSE/JSE All Share Index returned 10% for the quarter and 16% year to date. Companies that predominantly face the South African economy boosted performance: Over the quarter, local retailers rallied 23%, property 19%, life insurers 16%, food producers 14% and banks 13%. The rand also strengthened by 9% versus the US dollar from its post-election trough in early June to quarter end.

Short-term prospects for the South African consumer are looking better than a year ago. Following the Fed’s lead, the South African Reserve Bank cut interest rates by 25 bps during the quarter, with more cuts likely. Lower oil prices and proceeds from the two-pot retirement reform will also put more money into the hands of consumers. A reprieve in loadshedding will reduce non-productive expenditure and improve revenue opportunities for local companies. However, we remain concerned about growth prospects beyond these temporary tailwinds. South African capital investment is contracting, policy reform is painfully slow and state-owned enterprise performance remains broadly woeful. South Africa’s position as a resource economy is also precarious given a slowdown in China, which consumes more than 50% of most industrial commodities. The impact of the recently announced Chinese policy stimulus is still untested.

A useful rule of thumb is that good equity returns follow periods when expectations are low and outcomes are better than anticipated. Expectations, as represented by equity valuations, are currently elevated versus history, and we would contend that outcomes, represented by company earnings, could be worse for the reasons discussed earlier. As such, the Fund is positioned to minimise downside risk and protect absolute returns. The Fund is tilted towards rand-hedged local shares, particularly those with relatively defensive economics, such as British American Tobacco and Anheuser-Busch InBev (AB InBev). The Fund also has a healthy allocation to precious metal miners, which tend to outperform in times of global chaos. Lastly, the Fund’s stock exposure is also skewed to those companies with self-help levers to grow their earnings, even if the South African economy is weaker than we would have hoped.

During the quarter, the Fund added to its positions in AB InBev and select miners, and reduced its holdings in several banking shares.

Commentary contributed by Jithen Pillay