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Market Overview - July 2023

Market Overview

Global markets recovered in June with the US being one of the strongest performing regions amid a continued rally in the tech sector and robust economic data providing additional support. The latter was one of the dominant themes across major markets with those that reported softer-than-expected economic data seeing a sizable lag in returns. Investors also remained focused on monetary policy as central bankers continued to reinforce the notion that policy rates still need to be “sufficiently restrictive“ and kept elevated for as long as necessary. In terms of recent moves, the Bank of England (BoE) raised rates more than expected in June, while the US Federal Reserve paused its cycle but signalled more hikes ahead. The European Central Bank (ECB) remained hawkish and noted that a July hike was ‘very likely‘. This rhetoric has continued to fuel fears for a contraction in global growth.

US markets delivered a robust performance over the month (S&P 500: +5.3% at the time of writing), which was once again mainly driven by the tech sector, particularly counters with strong demand for generative AI. On aggregate, economic data out of the region surprised to the upside (most recently, US GDP growth came in at 2% for 1Q23 compared to expectations for 1.4%). This contributed to the positive market performance, showing that the world's largest economy is holding up relatively well compared to initial expectations. While the US Federal Reserve left rates unchanged at the prior meeting (this was the first pause after ten consecutive hikes that lifted US borrowing costs to the highest level since September 2007), Fed Chair, Jerome Powell, stated that more restrictions are needed to tame inflation with at least two more rate hikes expected this year, with the probability of a 25bp hike at the July meeting recently increasing to 81.8% from 76.9%, according to CME's FedWatch Tool. Powell also noted that the US economy is quite resilient and a recession, although possible, is not the most likely case. The target rate was left unchanged at 5% to 5.25% in June but may go to 5.6% by year-end if the economy and inflation do not slow down further.

On the other hand, economic data out of Europe surprised to the downside, contributing to the lagging performance in the Euro Stoxx 600 (+1.3%). Core inflation in the region remains elevated and is expected to remain sticky according to comments from European Central Bank (ECB) President, Christine Lagarde. Policymakers see little reason for a pause in rate hikes at this stage, as the central bank needs to bring interest rates into sufficiently restrictive territory to lock in policy tightening, despite signs of a slowdown in the Euro Area. In June, the ECB raised interest rates by another 25bps and maintained the view that more ground needs to be covered going forward.

While China locked in positive gains (MSCI China: +4%), upside potential was limited due to a batch of softer-than-expected economic data, which heightened concerns that the “re-opening rally“ had run out of steam. As a result, the People's Bank of China (PBoC) cut two key lending rates at its June “fixing“, as authorities sought to prop up growth. The one-year loan prime rate, which is the medium-term lending facility used for corporate and household loans, was lowered by 10bps to 3.55%; while the five-year rate, a reference for mortgages, was trimmed by the same margin to 4.2%. While investors saw this as a move in the right direction, some market participants were hoping for larger cuts, particularly to the five-year rate as a show of support for the property market.

The local market saw a strong recovery over the first half of the month (All Share: +4.6% as at 15 June 2023) as the heightened risk environment seen in May - spurred on by several major concerns including severe levels of load-shedding, the subsequent risk of a grid collapse, as well as geopolitical angst - began to subside. This led to a significant improvement in the rand, with the local unit breaking to below the critical R19/$ level. As a result, SA Inc. stocks were the standout performers for the month even though the overall bourse ended relatively flat. Meanwhile, headline inflation came in at 6.3% y/y in May (April: 6.8%) which was better than expected and at its lowest reading in a year. This reflects the higher base created last year, which should support lower inflation going forward and is now closer to the upper limit of the South African Reserve Bank's (SARB) target range of 3% to 6%.

Economic data overview

The US Federal Reserve paused rate hikes but remains hawkish with Chairperson, Jerome Powell, guiding for two more hikes

Flash estimates showed that the S&P Global Composite PMI for the US decreased to 53 in June 2023, from a final reading of 54.3 a month before. This signalled the slowest upturn in private sector output since March, as factory production fell at the steepest rate since January and service sector activity expansion cooled from May's 13-month high. Retail sales for May increased 1.6% y/y, higher than expectations for growth of 1%. In April, the trade deficit widened to $74.6 billion, compared to forecasts of $75.2 billion, as exports declined and imports increased. The unemployment rate in May increased to 3.7%, above market expectations of 3.5%. Annual inflation declined to 4%, the lowest since March 2021, and below market forecasts. The Fed kept rates unchanged, in line with expectations, as nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year. The Fed will continue to make decisions on a meeting-by -meeting basis, based on the totality of incoming data and their implications for the outlook for economic activity and inflation, as well as the balance of risks. At the same time, inflation pressures continue to run high, and the process of getting inflation back down has a long way to go and will take time for the full effects of monetary restraint to be realised.

The ECB remains steadfast in its battle against inflation as the core reading remains sticky

On a preliminary basis, the HCOB Eurozone Composite PMI decreased to 50.3 in June, compared to 52.8 a month before. This was below expectations of 52.5. Retail sales in April were down 2.6% y/y, compared to forecasts of a 3% decline. A trade deficit of €11.7 billion was recorded in April, compared to forecasts of a $21.5 billion surplus, as imports tumbled 11.9% and exports declined 3.6%. The unemployment rate edged down to 6.5%, in line with market estimates. Consumer price inflation for May came in at 6.1%, in line with consensus expectations. The ECB raised its key interest rates by 25-bps during its June meeting, as expected. ECB President, Christine Lagarde, said that inflation in the Euro Area is too high and is set to remain so for too long. Wage growth is now pressuring inflation, which is entering a second stage and is set to linger for some time. As a result, the ECB needs to bring interest rates into sufficiently restrictive territory to lock in policy tightening. Additionally, Lagarde stated that the ECB had more ground to cover and would likely continue raising rates in July.

The BoE raised rates once again with further tightening expected

Initial reports showed that the S&P Global/CIPS UK Composite PMI fell to 52.8 in May (forecast: 53.6). Retail sales decreased 2.1% y/y in May, compared to forecasts of a 2.6% drop. In April, the trade deficit narrowed to £1.52 billion as exports increased 1.3% and imports fell 0.6%. Slightly below market expectations, the unemployment rate came in at 3.8%. Annual inflation in the UK held steady at 8.7% in May, still exceeding market expectations. The BoE raised its policy interest rate by 50bps in June 2023 (ahead of expectations), marking the thirteenth consecutive rate increase. Policymakers have also pledged to deliver further rate hikes if the ongoing inflationary pressures persist. The BoE initiated rate hikes nearly a year and a half ago, making it the first major central bank to take such action and resulting in the fastest policy tightening in over 30 years.

The PBoC cut lending rates to stimulate growth following the release of softer economic data

China's composite PMI rose to 55.6 in May, from 53.6 a month before. It was the fifth straight month of growth in private sector activity and the steepest pace since December 2020. Output rose faster across both the manufacturing and service sectors, with the latter seeing a quicker rate of rise. Retail sales expanded 12.7% y/y in May, missing market expectations. The country's trade surplus dropped to $65.81 billion in May (forecast: $68 billion), compared to $78.4 billion over the same period a year ago, as exports fell more than imports, amid persistent weak global demand. The surveyed urban unemployment stood at 5.2% in May. China's annual inflation rate edged up to 0.2% in May, below market consensus of 0.3%. The PBoC slashed two key lending rates for the first time since August 2022 at the June fixing, as authorities seek to prop up growth. The one-year loan prime rate (LPR), which is the medium-term lending facility used for corporate and household loans, was lowered by 10bps to 3.55%; while the five- year rate, a reference for mortgages, was trimmed by the same margin to 4.2%, in line with market expectations. Meantime, several global investment banks, most recently Goldman Sachs, cut their 2023 GDP growth forecasts for China following weak economic data for May. The economy is also coping with a steady disinflationary trend, amid feeble consumer and business spending.

Inflation decreased ahead of expectations in Japan, however, policymakers remain cautious

Early estimates showed that the Jibun Bank Composite PMI reading in June fell to 52.3. This was the sixth straight month of growth in private sector activity but the softest pace since February amid lingering global economic uncertainty, as the services economy grew at a softer pace while the manufacturing sector saw a fresh contraction. Retail sales for May increased 5.7% y/y, exceeding expectations for growth of 5.4%. Japan's trade deficit fell to ¥1.37 trillion in May, compared to ¥2.37 trillion in the same period a year ago. This slightly was higher than the estimated gap of ¥1.33 trillion. The unemployment rate dropped to 2.6%, below market consensus of 2.7%. Annual inflation unexpectedly declined to 3.2% in May, coming in lower than market forecasts of 4.1%. The Bank of Japan (BoJ) kept its key short-term interest rate unchanged, in line with market expectations. While mentioning that inflation in the country would slow later this year, policymakers added they would patiently continue with monetary easing and respond to uncertainties faced by the economy and the dynamics of prices as well as financial conditions.

In South Africa, inflation fell to a 13-month low with abating idiosyncratic risks supporting sentiment

In May 2023, the SACCI business confidence index dropped to a nine-month low of 106.9 (April: 107.1), while the leading business cycle indicator fell 1% from a month earlier in April 2023. Sentiment in South Africa was impacted by lower trade volumes, fewer inward tourists as well as a weaker rand compared to other major trade and investment currencies. The composite PMI in May decreased to 47.9 (April: 49.6), signalling a further downturn in private sector activity. Manufacturing PMI fell to 49.2, from 49.8 a month before. Retail sales in April contracted 1.6% y/y, marking the fifth consecutive decline in retail activity. This was slightly worse than market expectations of a 1.4% decrease. SA recorded a trade surplus of R3.5 billion, below expectations of R4.9 billion, as exports tumbled 14.5%. The value of recorded building plans passed in SA's larger municipalities rose 3.7% y/y, following a downwardly revised slump of 17.4% a month before. Mining production recovered 2.3% y/y in April, better than the forecasted increase of 0.9%. This followed a downwardly revised drop of 2.2% in the previous month. Manufacturing production increased 3.4%, signalling the first annual gain in six months as extreme load-shedding-related pressures were eased. This was better than expectations (+2.5%).

Consumer price inflation (CPI) dropped to a 13-month low of 6.3% in May, compared to forecasts of 6.5%. This was mainly due to the cost of food and non-alcoholic beverages increasing at a slower pace. Nevertheless, SA inflation remains above the Reserve Bank's target range of between 3% and 6%. As expected, core inflation edged lower to 5.2%. Also in line with expectations, producer price inflation (PPI) slowed to 7.3% in May, compared to 8.6% a month before. Due to the significant depreciation of the rand and the mounting pressures of inflation, the SARB implemented another 50bps rate hike during its May meeting, bringing the benchmark interest rate to 8.25%. This was the tenth consecutive rate hike since policy normalisation began in November 2021 and borrowing costs are at their highest levels since May 2009. Headline inflation for 2023 is expected at around 6.2% (previous guidance: 6%).

Market Outlook in a nutshell

Local

• Global growth prospects have become less pessimistic. The World Bank's forecast for global growth this year lifted to 2.1% in June, versus 1.7% in January, but a slowdown from 6.0% in 2021 and 3.1% in 2022 is still a primary feature of the outlook. In addition, while global inflation has been slowing, it remains elevated and there are signs of reflation in emerging markets where exchange rate and wage pressures have edged higher.
• Exchange rate pressures are also slowing the deceleration process in South Africa, worsening imported inflation, and compounding the passthrough of marginal input cost pressures from intensified load-shedding. We predict headline inflation to average 6.2% this year, slowing to around 5% in 2025. Our anticipation that local inflation will remain above target over the medium term mainly reflects global trade tensions and frictions related to climate change and should result in interest rates remaining above pre-pandemic levels over the forecast horizon.
• The repo rate should lift to 8.5% at the July MPC meeting, ushering in the end of the current hiking cycle. A halt to the hiking cycle would be supported by an improvement in risk sentiment and the rand since the previous MPC meeting. In addition, a continued moderation in inflation outcomes, with a likely reversion to the inflation target band in June, will be supportive. Upside risks would stem from further rand weakness ahead of the BRICS summit, as well as a resumption of the Fed hiking cycle.
• Elevated inflation and tighter financial conditions should weigh on household consumption expenditure growth. Furthermore, net trade benefits will be curtailed by logistical inefficiencies. With mainly the ongoing replacement cycle and investments in energy supply driving growth this year, we anticipate no expansion in the economy and GDP growth should average -0.1%. Risks to this view are balanced, with upside risk driven by less intense load-shedding and more positive 1Q23 growth, which indicated that some sectors of the economy may be less reliant on electricity from the grid. Downside risk would be driven by more pronounced cost of living pressures.
• Growth is predicted to improve to 1.5% on average over the period to 2025, supported by higher global growth and easing energy constraints.

Global

• Our primary concern going forward is whether the resilience of company earnings can be extrapolated into the future. We believe that this may prove difficult as fiscal and monetary policy, particularly in the US, will likely be on a restrictive path. In particular, the lagged effect of tightening monetary policy actions will likely begin to filter through to changes in both corporate and consumer spending patterns.
• Higher borrowing costs for both businesses and consumers will likely suppress economic activity, particularly in discretionary related areas, as economic agents look to rein in expenditure to tighten their balance sheets and income statements.
• For now, households will likely continue utilising various credit instruments, particularly credit card debt, which is currently at all-time highs, to prop up short-term expenditure prospects.
• At the moment, households will likely continue utilising various credit instruments, particularly credit card debt, which is currently at all-time highs, to prop up short-term expenditure prospects.
• Moreover, the reactivation of over $1.6 trillion of student debt in October may well present a headwind to future earnings prospects.
• Nevertheless, if liquidity remains plentiful, this may prevent price discovery from emerging in the short-term. Similarly, it is worth noting that the Fed has articulated that they need to tighten financial conditions, but the reverse has indeed occurred.
• Against this backdrop, we believe that the loosening of financial conditions in recent months will likely embolden the Fed to tighten interest rates further as we progress into the second half of the year, as this will likely be needed to bring core inflation levels down to more sustainable levels. Similar sentiments are certainly shared by the Bank of England with their surprise 50bps hike, as well as the Eurozone Central Bank, which recently lifted the refinancing rate by 25bps.
• The treasury general account will likely be replenished amid the debt ceiling being lifted with much higher interest rates increasing the US government's debt servicing profile. This may also have net negative impact on liquidity dynamics if the drawdown in the reverse repurchase programme does not offset this occurrence.
• In emerging markets, it is certainly encouraging to see the People's Bank of China ease monetary policy conditions further by slashing several different interest rates over the month. However, weakness in coincident to lagging economic data, particularly sluggish consumption expenditure amid pre-payment of mortgages by locals, highlights a potential confidence issue in the broader economy. With low levels of inflation and notable excess savings combined with attractive valuation multiplies, we are of the belief that selected opportunities remain in the Chinese economy and will be on the lookout for more palatable policy responses from fiscal authorities.
• Once peak hawkishness of the Fed has been sufficiently priced in by market participants, labour market weakness emerges and inflation is firmly on a downward trajectory, we will be looking to take a more explicit position on the long end of the curve. This will be to reflect a deterioration in growth dynamics that will begin to overshadow inflation fears. For now, T-bills remain attractive with a higher-yield offering compared to most sovereign bond curves without taking on too much duration risk.

Various macroeconomic developments have resulted in volatile swings across global markets to date. Higher interest rates, currency weakness, and assertive central bank intervention around the world are amongst the key themes dominating markets. Sentiment has also been influenced by a mixed bag of key economic indicators, concerns around consumer spending power, labour markets, supply chain challenges, and the general health of the global economy. Below we highlight our top picks among local blue-chip stocks across a range of sectors which provide diversified and defensive exposure through the economic cycle.

FNB Global Equity Growth ETN (FNBGEG)

The FNB Global Equity Growth Note provides investors with a concentrated portfolio of high-quality global companies through a rand-based exchange-traded note (ETN) listed on the JSE.

The Global Equity Growth Note aims to achieve long-term capital growth by investing in equities, including exposure to higher- growth emerging markets, by broadly investing in companies with an above average growth profile. In addition to direct equities the note may selectively include collective investment vehicles as deemed appropriate. The aim is to achieve above- average capital appreciation from a diversified range of predominantly large-cap companies.

• The ETN provides investors with access to leading global companies and sectors that they would not have access to without the costs and complexities of investing directly offshore.
• The Global Equity Growth Note complements domestic portfolios and provides global diversification given the concentrated nature of the SA market.
• The note also provides additional rand hedge benefits to a domestic equity portfolio.
• The strategy has been utilised since 2015 and was launched in ETN format in August 2021.

The FNB Global Equity Growth ETN offers a low-cost solution to offshore investing without eroding the investor's asset transfer limits or the additional complexities associated with investing offshore. The strategy has been utilised by the group for over seven years and the performance record has been strong.

Mr Price (MRP)

The Mr Price Group and its subsidiaries operate over 2 500 stores across southern Africa. The group consists of four retail chains, focusing on clothing, footwear, accessories, and homeware. These chains are divided into two operational divisions namely, apparel (Mr Price, Mr Price Sport and Miladys) and home (Mr Price Home and Sheet Street). The company recently acquired deep value retailer, Power Fashion, high-end homeware specialist, Yuppiechef, and branded discount business, Studio 88.

• Against a backdrop of economic pressure on consumers, the credit retailers have outperformed. We think that this is a short- term phenomenon - as pressure intensifies, lower quality credit may hamper debtor book performance in the absence of tightening up on credit granting criteria. Against this backdrop, we think that cash businesses in the high fashion, value and discount segments of the market will perform well.
• The value retail formula works through all the economic cycles.
• We are not convinced that Mr Price has a true competitor in South Africa - especially in fast fashion. While H&M and Cotton On have had an impact, their price points are much higher. Mr Price operates in an attractive space from a price point/quality perspective - coming in slightly above Pepkor brands, but below the other major SA clothing retailers.
• The company has a best-in-class historic returns profile and high, steady margins.
• Mr Price boasts a solid balance sheet and is cash rich, even considering recent acquisitions.
• We like the group's prospects in new areas such as baby, schoolwear and deep value retail, giving us confidence that there is a clearly articulated growth strategy over the next three to five years.
• Among the locally listed discretionary retailers, Mr Price has the clearest and most succinct business plan in terms of growing - utilising its strong balance sheet and grasping opportunities, complementing a history of execution.

Mr Price's share price hit a high of R240 in August 2021 but has underperformed the sector since. The current forward PE multiple of 10.6 times is still undemanding relative to history and does not give credence to potential growth.

Mr Price performance relative to peers

British American Tobacco (BTI)

British American Tobacco remains one of the most defensive companies globally. This was confirmed by its ability to weather high volatility in the market and the impacts of the Covid-19 outbreak. Apart from an expected continuation of reasonable price increases and growth in new generation products, the company has embarked on an ambitious cost saving strategy, which should see profitability and margins improve over the medium term.

• The business has gained market share in cigarettes every year for close to a decade. Given strong pricing power and cost control, the business has been able to consistently expand margins and deliver high single-digit earnings growth. This provides good visibility of earnings against an increasingly murky global growth outlook.
• British American Tobacco is highly cash flow generative, resulting in good dividend flows, and we expect gearing levels (net debt/ EBITDA) to continue to fall, further lowering risk.
• The company is the number one player in vapour and oral tobacco globally and has strongly grown its Next Generation Products (NGP) portfolio. The US regulatory landscape has also improved. While regulation remains a key risk, higher regulation increases barriers to entry, making it much more difficult for independents to gain market share.

British American Tobacco still looks reasonably priced on a forward PE of 6.7 times and offers an attractive dividend yield of 9.4%. The stock looks inexpensive relative to its own history and its peers, despite an above-average expected growth trajectory over the next few years

BTI forward dividend yield history

Absa (ABG)

Absa Group is one of South Africa's largest financial services groups offering a complete range of banking, assurance and wealth management products and services. Absa holds a presence in 12 countries across the African continent.

• Absa offers an exceptionally attractive dividend yield, and also holds a strong capital position.
• The company has little exposure to unsecured lending.
• New leadership has been breathing in new life into the weaker (relative to peers) retail business.
• The sector will generally benefit from higher net interest margins as interest rates increase.
• Absa is focused on expanding its “sustainable ROE“ and recent results give us confidence that it will be able to do so. At the half-year mark, Absa's ROE increased from 14.5% in 2021 to 15.6% in 2022. Guidance for 17% for the 2023 financial year was confirmed at the time of its full-year results release.
• The FY22 result showed a robust bottom-line growth, off a very high base. Double-digit top-line growth, ahead of consensus forecasts, helped to offset the higher credit losses which were detractive but previously flagged by management. The underlying operational result was upbeat amid further positive momentum within transactional activity and growth in loan advances contributing to NII and NIR growth. The cost performance was decent, with the group maintaining positive jaws as revenue growth still outpaced the notably higher y/y expense growth. Higher expenses were mainly due to staffing and IT-related costs, a similar experience to peers.

From a valuation perspective, Absa's share price appears relatively attractive on both a forward PE and forward price to book basis.

Nedbank (NED)

Nedbank Group is one of the largest financial services groups in Africa offering wholesale and retail banking services as well as insurance, asset management and wealth management solutions. Nedbank's primary market is South Africa. Outside of South Africa, Nedbank operates in six countries through subsidiaries and banks in Lesotho, Malawi, Mozambique, Namibia, Eswatini and Zimbabwe, as well as representative offices in Angola and Kenya. Nedbank owns an associate stake of 20% in Ecobank.

• While risks are still prevalent, earnings revisions have generally been upward for the sector due to a better-than-expected credit experience and widening net interest margins on the back of higher interest rates.
• Prior to Covid-19, ROE was recovering gradually and had been resilient. Nedbank's ROE should get close to 15% over the next 12 months, warranting a premium to book value.
• Nedbank is “best in class“ from an ESG perspective.
• The group may have a meaningful first mover advantage in renewable energy financing (both commercial and residential) - an area that has become even more attractive against a backdrop of sustained and intensifying load-shedding.

On valuation, Nedbank is trading at par to its book value, where in the past it has traded at a premium. It is also trading at a meaningful discount to its peers on this basis. We do not think this is warranted.

Disclaimer: All figures have been obtained from Bloomberg based on each company's latest financial results. Companies disclose degrees of geographic exposure in varying granularity, which may cause discrepancies, and figures obtained may be impacted by currency volatility and may not be representative of future exposures.

For more information regarding your investment, please contact your Portfolio Manager directly.

Regards

FNB