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Portfolio Management

Market Overview - November 2023

Market Overview

October saw another month of negative market returns across the globe with the MSCI World Index and MSCI Emerging Markets Index falling 4.2% and 3.4%, respectively. Sentiment remains dominated by elevated interest rate expectations, with recent geopolitical tensions in the Middle East, while supportive of safe haven assets such as gold (+8.5%), adding further pressure to equity markets. Another round of robust economic data out of the US (strong consumer spending numbers, labour data, and 3Q23 GDP growth) bolstered expectations for the US Federal Reserve to maintain its relatively hawkish stance with interest rates expected to remain higher for longer - expectations for a rate cut have been pushed out even further and is now only expected towards the third quarter of 2024.

US markets continued to trend lower with the S&P 500 giving back 3.9% in October as investors remained on edge while monitoring central bank commentary. In a widely anticipated speech delivered to the Economic Club of New York a few weeks ago, US Fed Chair Jerome Powell acknowledged recent signs of cooling inflation, but noted that the central bank would be "resolute" in its commitment to its 2% mandate. Powell further stated that inflation is still too high, and a few months of good data is only the beginning of what it will take to build confidence that inflation is moving down sustainably towards the central bank's target. It is still relatively early for the Fed to know whether these lower readings will persist, or where inflation will settle over the coming quarters. Year-on-year inflation hovered at 3.7% in September, still nearly double the Fed's 2% target, with Bloomberg's latest poll showing a 55% probability for a recession in the next 12 months. In terms of rate hike expectations, the market is currently pricing in a 97% chance for rates to remain steady at the upcoming November meeting, according to CME's FedWatch Tool, with only a 29% chance for a quarter-point hike in December. While markets widely expect the Fed to hold off on additional rate hikes, there is still a lot of uncertainty over when officials might begin cutting rates.

In Europe, interest rates were maintained at 4.5% at the October meeting. While in-line with expectations, this marked a shift in the European Central Bank's (ECB) stance and is reflective of a more cautious "wait-and-see" approach as recessionary fears continued to gain momentum. The decision followed a series of ten consecutive rate hikes since July 2022, which resulted in the main refinancing rate reaching a 22-year high. The decision aligns the ECB with the US Federal Reserve and the Bank of England (BoE), as the world's leading central banks pause to assess the impact of the sharpest hiking cycle in decades. Short-term headwinds are expected to persist with ECB President Christine Lagarde noting that "the economy is likely to remain weak for the remainder of this year." The EuroStoxx 600 was down around 4.5% towards month end.

China (MSCI China Index: -3%) tracked the global sell-off with additional pressure stemming from concerns over slowing global demand for the regions exports and an ailing property sector. However, the economy seems to be stabilising, with a slew of economic data coming in ahead of expectations. The Chinese government has acted to help the economy with several pro-growth initiatives (including raising spending on building ports and other infrastructure, cutting interest rates, and easing curbs on home-buying) providing support. Economists, however, are calling for wider reforms to address long-term problems that are stifling growth.

Locally, the JSE fell 3.7% (-3.3% in USD terms) as investors remained focused on international developments. Inflation was in the spotlight with the headline number accelerating to 5.4% in September (in line with consensus) from 4.8% in August. Inflation is expected to trend upwards due to higher fuel prices and headwinds associated with the recent avian flu outbreak as well as an undervalued rand. Traders will also look ahead to the 2023 Medium-Term Budget Policy Statement (MTBPS) in November. The 2023 Budget in February noted that major risks to the fiscal outlook were clustered around low (or no) economic growth, which has implications for tax revenue and borrowing costs - especially in an environment of high interest rates and spending pressures from the wage bill, social relief of distress (SDR) grant, and SOEs. Some of these risks have materialised and, while the fiscal framework is materially challenged, we expect the fiscal authority to commit further to consolidation.

Economic data overview

The US Federal Reserve maintains a relatively hawkish stance with future moves to be data dependant

Flash estimates showed that the S&P Global Composite PMI for the US increased to 51 in October, in line with expectations. This marked the fastest expansion since July, supported by a quicker rate of expansion in both services and manufacturing activities. Retail sales in September increased 0.7% y/y, compared to a 0.8% rise a month before - this was better than expected. The US trade deficit narrowed to $58.3 billion in August 2023, the lowest since September 2020, and below forecasts of a $62.3 billion deficit, as exports were up 1.6% and imports declined 0.7%. The unemployment rate in September was at 3.8%, above market expectations. The annual inflation rate remained steady at 3.7% in September 2023, defying market expectations of a slight decrease to 3.6%, as a softer decline in energy prices offset slowing inflationary pressures in other categories. The Federal Reserve kept the target range for the federal funds rate at a 22-year high in its September 2023 meeting, as expected. The Fed is proceeding carefully, and policymakers will make decisions about the extent of additional policy firming and how long policy will remain restrictive based on the totality of the incoming data, the evolving outlook, and the balance of risks. Fed Chair Jerome Powell also noted that inflation is still too high and that a sustainable return to the 2% inflation goal is likely to require a period of below-trend growth and a further softening in labour market conditions.

The ECB changes its stance and adopts a 'wait-and-see' approach

On a preliminary basis, the HCOB Eurozone Composite PMI dropped to 46.5 in October, compared to 47.2 a month before. This was below expectations of 47.4. The latest reading signalled the fifth consecutive month of falling business activity and the steepest decline since November 2020, as both service and manufacturing activity continued to contract. Excluding the pandemic months, the fall in activity was the sharpest since March 2013. Retail sales in August were down 2.1% y/y, compared to expectations of a 1.2% decline. A trade surplus of €6.7 billion was recorded in August, compared to consensus for a €12.5 billion surplus, as imports tumbled 24.6% y/y and exports fell at a softer 3.9% y/y. The unemployment rate in August fell to 6.4%, matching consensus. Consumer price inflation for August came in at 4.3%, lower than consensus expectations. The ECB kept interest rates unchanged (as expected) during its October meeting, marking a significant shift from its 15-month streak of rate hikes and reflecting a more cautious "wait-and-see" stance among policymakers, influenced by the gradual easing of price pressures and concerns about an impending recession. This decision follows a series of ten consecutive rate increases since July 2022.

The Bank of England (BoE) is expected to keep rates on hold at the upcoming meeting

Initial reports showed that the S&P Global/CIPS UK Composite PMI came in at 48.6 in October, little changed from September's 48.5, and broadly in line with market expectations. Retail sales decreased 1% y/y in September, compared to forecasts of a 0.1% drop. In August, the trade deficit widened to €3.42 billion from €1.42 billion in the previous month, as exports declined 1.6% y/y and imports rose 1.2% y/y. In line with market expectations, the unemployment rate came in at 4.2%. Annual inflation in the UK remained stable at 6.7% in September 2023, holding at August's 18-month low but defying market expectations of a slight decrease to 6.6%. The BoE held its policy interest rate steady at 5.25% in September, compared to expectations of a 25bps rate hike, keeping borrowing costs at their highest level since 2008, as policymakers opted for a wait-and-see approach following the latest inflation and labour data, which suggested that the accumulated impacts of previous policy tightening might be taking effect. It was the first pause in nearly two years, following an unprecedented 515bps hikes. Policymakers have reiterated their commitment to tightening policy further if deemed necessary.

China's economy showed some resilience with recent data being better-than-expected

China's composite PMI fell to 50.9 in September 2023 from 51.7 in August. This was the ninth straight month of growth in private sector activity but the softest pace since January, as new orders rose at a softer pace, with manufacturers and service providers recording only marginal increases in sales. Retail sales climbed 5.5% y/y in September accelerating from a 4.6% gain in the prior month and exceeding market estimates of 4.9%. Ahead of market forecasts, the country's trade surplus narrowed to $77.71 billion in September compared to the previous month of $82.67, as exports and imports declined at the same rate reflecting persistent weak demand both domestically and internationally. The surveyed urban unemployment inched down to 5% in September. China's consumer prices remained unchanged in September from a year earlier, following a 0.1% rise in the previous month and falling short of the market consensus for a 0.2% gain. The People's Bank of China (PBoC) maintained lending rates at the October fixing, as was widely expected. The decision came amid growing signs that the Chinese economy is stabilising. The PBoC recently implied that more monetary easing is still on the cards if needed, trying to reassure investors that Beijing still has room to deal with "unexpected challenges and changes."

The Bank of Japan (BoJ) remains dovish but will continue to monitor economic activity

Early estimates showed that the Jibun Bank Composite PMI reading in October fell to 49.9, from a final reading of 52.1 in the prior month, turning contractionary for the first time since December last year amid ongoing weakness in manufacturing. Retail sales for July increased 7% y/y, exceeding market consensus for a 6.6% growth. Japan's balance of trade unexpectedly shifted to a surplus of JPY 62.44 billion in September 2023 from a deficit of JPY 2.1 trillion in the same period of the prior year, beating market estimates of a shortfall of JPY 425 billion. The unemployment rate was unchanged at 2.7% in August, compared with market forecasts of 2.6%. The annual inflation rate edged down to 3% in September from 3.2% in the prior month, pointing to the lowest reading since September last year. The BoJ kept its key short-term interest rate unchanged, in line with market expectations. The BoJ mentioned that it would patiently continue with monetary easing and respond to development in economic activity, the dynamics of prices, and financial conditions, amid extremely high uncertainty at home and abroad. The committee reiterated it will take extra easing measures if needed while being aware of rising inflation expectations. In a recent interview with a local newspaper, Governor Kazuo Ueda hinted that an end to negative interest rates could come sooner than previously expected if supported by enough data on wage hikes.

In South Africa, inflation ticked higher but still remains within the SARB's target range

The leading business cycle indicator edged 0.4% higher in August, following an increase of 0.1% a month before. The composite PMI dropped to 49.9 in September, from 51 in August, pointing toward a further stagnation in private sector activity. This was evidenced by the downturn in manufacturing PMI to 45.4 (August: 49.7). Retail sales contracted 0.5% y/y in August, marking the ninth consecutive month of a decline in retail activity. Nevertheless, this was still better than the forecasted drop of 1%. The trade balance amounted to a surplus of ~R13.3 billion, which was well ahead of expectations (+R7 billion). This was driven by a 4.5% rise in exports, amid higher shipments of mineral products, base metals, and machinery and electronics.

Mining production slumped 2.5% y/y in August (against expectations of a 2% decline) due to lower yields in diamonds, manganese ore, and other metallic minerals. This followed an upwardly revised drop of 4.4% in the previous month. Growth in manufacturing production rose 1.6% y/y but was behind expectations (+2.3%). This marked the fifth consecutive monthly increase in industrial activity, albeit at the slowest pace.

Consumer price inflation (CPI) accelerated to 5.4% in September (against forecasts of 5.2%) on upward pressure in food and non-alcoholic beverage prices as well as transport (fuel) costs. Nevertheless, CPI remains within the SARB's target range of between 3% and 6%.

Core inflation (which excludes the price of food, non-alcoholic beverages, fuel and energy) eased to 4.5%. During its September meeting, the SARB left its benchmark interest rate unchanged at 8.25% (in-line with expectations) but emphasised that the fight against inflation was not done yet. Policymakers were particularly concerned about the continued depreciation of the rand as well as prevailing inflationary pressures.

Market Outlook in a nutshell

Local

• Global growth projections suggest a more supportive external environment than initially anticipated but some countries are more resilient than others - India leading the pack and the US shifting more towards a softer landing.
• SA lags many emerging economies, highlighting the impact of infrastructure constraints. We still predict growth of 0.7% in 2023, rising gradually to 1.8% in 2026 as structural reforms take shape. Nevertheless, real GDP growth has fallen behind the rate at which the population is growing, and the average person is getting poorer. As potential growth rises over the forecast period, so should real GDP, placing the economy in a better position to absorb the available labour supply and create ripe conditions for entrepreneurship.
• The consumer landscape highlights important nuances between low and high-income earners. While the balance sheet strength of high-income households has supported relative resilience in spending capacity, lower-income households are more vulnerable. Despite continued job creation and nominal income growth, real incomes have lagged cost-of-living pressures. Furthermore, demand for credit has shifted towards the unsecured segment, in both banks and non-banks, highlighting some distressed borrowing. Households taking up pricier forms of credit should have implications for discretionary spending, as more income goes towards servicing debt.
• A weaker consumer explains the limited passthrough of elevated input costs, as core inflation continues to surprise to the downside. This should support a continued deceleration in headline inflation, even as a resurgence in food inflation and exchange rate pressures make for a bumpy trend. We forecast average headline inflation of 5.9% this year, falling to 4.7% in 2026.
• Unfortunately, monetary policy should still be concerned about funding risks. This is as SA shifts back to a twin deficit and fiscal consolidation continues to be tested by revenue underperformance and spending pressures. Furthermore, rising real neutral rates means borrowing costs are more challenging. To hedge for these risks and the impact on the exchange rate, the MPC is likely to keep interest rates restrictive, with upside risk to nominal rates should inflation surprise to the upside or neutral rates rise faster than anticipated. This also suggests that the cutting cycle that we anticipate from the middle of 2024 could be shallow, with repo settling above pre-pandemic levels.

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.
• 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 may well present a headwind to future earnings prospects.
• Nevertheless, if liquidity remains plentiful, the emergence of price discovery in the short-term could be prevented. It is worth noting that the Fed has articulated the need to tighten financial conditions. We believe that persistent loosening of financial conditions could embolden the Fed to remain restrictive for longer to bring core inflation levels down to more sustainable levels.
• We expect growth to slow in developed markets, particularly the U.S, Eurozone, and the UK. Monetary policy will likely remain restrictive as inflation levels remain well above central bank targets. As a result, consumers and businesses will face higher borrowing costs in the near-term.
• In emerging markets, it is certainly encouraging to see the People's Bank of China maintaining loose monetary policy and further injecting liquidity into the banking system. Also, the government lifted the country's fiscal deficit, this should provide new fiscal stimulus to boost the economic recovery. However, economic data has not fully turned and there is still weakness in the economy, particularly in the property sector. 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.
• Although bond yields have increased recently, risk of interest rate re-pricing in bonds remains. Labour market is still strong, and inflation has not shown a persistent downward trend. 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 more attractive with a higher yield compared to longer duration bonds.

Thematic investing

Thematic investing has gained in prominence over the last few years, with investors piling into big idea trades like big tech, electrification, clean energy, cybersecurity, social responsibility, genomics, and most recently, AI. Over the last few decades, we have also seen our share of "big ideas" that tended to be mere fads.

What is thematic investing?

Thematic investing seeks to capture opportunities created by long-term structural trends. It extends far beyond economics and market cycles into areas such as changing demographics, evolving consumer behaviours, innovative technologies - basically things that are changing the way we live.

Successful implementation requires correctly identifying structural shifts, finding companies or products with high exposure to those shifts, and timing the theme to enter early enough that earnings and forecasts have not fully priced in the theme's potential.

What are fads?

Fads can look like themes, and this is where the danger lies. Remember NFTs? People were buying up electronic art as if it was the real thing and many investors were left destitute once the bubble burst. More recently, Covid-19 exposed stocks like Zoom and Peloton were purported to have unlimited growth prospects, but people went back to the gym and are increasingly returning to the office. While some money would have been made by early investors, those who bought at the top have experienced substantial value destruction. In 2021 meme stocks were all the rage, with retail investors using message boards like Reddit to pick investments and drive-up stock prices to "show it to the man". The fundamentals were just not there, and many lost their savings in the process. Time will tell if crypto in its entirety ends up just being a fad - but certainly SH*T-coins were all the range a few years back and investors holding these tokens have little to show for their efforts.

How can you spot the difference?

It can be tough, but generally, you need to ask yourself whether you can see yourself buying into the long-term story. NFTs? We were a bit confused by the whole thing and as a rule never invest in things we don't understand. Pelaton? It just didn't seem practical to buy a very expensive training bike to spin "into infinity". Zoom? Sure, we have made big changes to the way we work, but even at the hype of Covid-19 the zoom fatigue started setting in. Game Stop, probably the defining meme stock, was an interesting case study to dissect, but a good investment it did not make.

It will also take time to buy into a theme. Clean energy has been gaining in prominence for years but recent shifts in what consumers deem to be important and a focus on climate change has really bought the concept home for us. As with the broader electrification theme - we weren't fully on board until we started seeing a wealth of new technologies emerging and the pace of adoption ramping up.

Valuation matters

Some of these big themes (like big fads) can get bid up to exceptionally high levels - this does not mean the structural shift is not under way, but it could mean that some of the players exposed to that theme are pricing in growth beyond what is reasonable. The dot-com bubble is a good example here. Small, unprofitable internet companies were bid up way beyond their potential in the late 90's and very few of them survived. That does not mean the excitement was not warranted and that the internet did not fundamentally change lives and lifestyles globally. It means that good investments are made at reasonable prices and not by blindly following the herd.

Today's big themes we are getting behind

Clean energy is our preferred theme currently - the continued adoption and advancement in technologies and the interesting companies in this space has piqued our interest. Electrification follows on from clean energy and there are so many opportunities across the supply chain - lithium, battery technology, and component manufacturers stand out here. Indexes exposure to these themes have come off from their 2021-highs and most of the underlying companies are now trading at much more reasonable levels.

Water security is another important theme, and we also think that despite the political chaos globally, social responsibility remains a key theme to watch. Cybersecurity will become more important as the world continues to digitise and safety in the cloud becomes paramount. We also still like healthcare technology as a theme as longevity continues to increase globally and a rising middle class - particularly in Asia - will support new investment here.

What about AI?

We are certainly fans of the technology, and we think the possibilities are substantial but believe that, as was the case with clean energy stocks a couple of years ago, valuations may now have run away from intrinsic value in this space. There may still be substantial upside, but we think that some will emerge stronger from the current trend, while others will fall to the wayside. It is important to pick your exposure carefully and always keep valuation in mind.

The easiest way to get exposure to themes are via exchange traded funds (ETFs) and exchange traded notes (ETNs). In this way your exposure is quite broad since you will be invested in a basket of stocks, and it removes the complexity of having to pick "the winning horse".

Locally, we have several JSE listed ETFs and ETNs offering thematic exposure, the FNB Clean Energy, Global Water and Social Responsibility ETNs come to mind, while Satrix and Sygnia have several interesting ETF offerings focusing on healthcare innovation, smart city infrastructure, the Fourth Industrial Revolution, and sustainable economies. Offshore the possibilities are vast. And for themes like genomics, the battery value chain, and cybersecurity, one would have to consider ETFs listed elsewhere.

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