“We are navigating by the stars under cloudy skies”
The markets seemed to decompress in August as market participants waited with bated breath for Jerome Powell’s address at the Fed’s annual Jackson Hole symposium for any signs as to the Fed’s next move.
With the U.S. economy showing impressive resiliency in the face of 11 rate hikes and a regional bank wobble in March, while inflation has rapidly retreated to 3%, the potential for a soft landing has gained momentum. The subsidence of inflation has driven optimism that the Fed may be done hiking rates and the focus has shifted to when the first cut could be expected. Rate cutting cycles have traditionally proved to be a catalyst for global equity markets to rally.
The Fed Chairman reiterated the Fed’s desire to bring inflation down to 2% and in his words “are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” This continued hawkish tone took some air out of the market’s sails as the potential for one more hike begins to be factored into rates. Likewise, any cuts in 2024 are being pushed out further. The “higher for longer” mantra also increases the risk of potential policy errors.
Given the strong run-up we have experienced across the equity markets up until August, it is hardly a surprise that equity markets have taken a breather.
August also saw the end of 2Q earnings reporting season. 79% of companies beat expectations, in aggregate earnings came in 7.5% above estimates. 2Q earnings growth came in at -4% Y/Y, marking the second consecutive quarter of negative earnings growth; reflecting the tough operating conditions US companies are currently facing. What’s more, we have seen an upward revision to 3Q earnings estimates which runs against historical norms. Analysts are now expecting earnings growth for 3Q. This would represent the end on the earnings recession.
While 2023 earnings growth looks to be lacklustre at 1.2%, 2024 earnings growth is expected to return to a healthier 12%. Expectations continue to be adjusted higher. A clear positive for multiple expansion and equity markets.
In this month’s edition of “Wood For The Trees” we take a closer look at China and its property woes and ask the question whether longer term growth expectations need to be lowered or not. On the local front, the SA banks have just reported a stellar set of results and look well set to continue their solid performance we have seen year-to-date. Additionally, we are excited about the recent acquisitions at Aspen Pharmacare but believe patience is needed to allow the benefits to come through. In the meantime, Aspen’s undemanding valuation makes it a buy and hold opportunity.
We hope you enjoy this month’s edition.
International section
By the Numbers
Global equity markets declined in August as worries about the health of the global economy, a slowdown in China, and the Fed keeping interest rates higher for longer, weighed on sentiment. August is traditionally known to be a weaker month for equity markets with the leading indices losing ground this month; S&P 500 (-1.6%, +17% YTD), Nasdaq (-1.2%, +40.4% YTD), Stoxx Europe (-2.7%, +6.6% YTD), FTSE 100 (-3.4%, -0.2% YTD), and Emerging Markets (-5.9%, +2.2% YTD).
In the U.S. the Fed Chair Jerome Powell reiterated their hawkish tone and commitment to pull inflation back to its goal of 2%. Recent US economic data continues to surprise to the upside; reflecting a resilient economy. The Tech sector remains an outperformer, with software and cloud-related stocks Arista Networks (+27.6%), Splunk (+15.3%), CDW (+13.4%), and Cisco Systems (+10.6%). Eli Lilly (+20.7%) and Novo Nordisk (+19.3%) rallied after launching weight-loss medication with surging demand. In contrast, First Republic Bank (-58.5%) dropped during the month after U.S. banking regulators proposed heightened rules to ensure regional banks can be safely dissolved in times of stress. Dollar Tree (-19.6%) fell after a disappointing earnings report highlighted consumer spending shifting to lower-margin products. PayPal (-16.5%) dropped as investors were disappointed by weak margins that overshadowed a strong outlook.
In the U.K., the BoE increased rates by 25bps to tackle sticky inflation, with the market pricing in another two hikes before the end of the year. In Europe, inflation slowed slightly, raising hopes that the ECB will hold interest rates steady this month. Some of the European movers this month include United Internet (+32.1%) after a network deal was announced in Germany. UBS Group (+21.6%) rallied after announcing strong results that gave confidence to investors after its takeover of Credit Suisse in March. In contrast, Adyen (-53.6%) dropped after the company missed estimates and management noted increased price competition.
Emerging markets have lagged developed markets, with Chinese companies being the biggest laggards on the back of weaker-than-expected economic data, Hang Seng Index (-9.1%, -6.1% YTD) and Shanghai Composite (-5.1%, +1.0% YTD). Investors’ concerns intensified over real estate, with Shimao Property (-70.0%) and Country Garden (-48.9%) falling as they look to restructure debt and extend debt obligations.
China Reform
China’s slowdown has been a dominant story in headlines over the past few months, as economic data has largely painted a gloomy picture of the world’s second biggest economy. However, in our view the deterioration is isolated mainly to the property sector, and overall, the Chinese economy remains steady.
In our minds, the property sector is clearly going through a tough period with several issues that need to be addressed. However, other areas in the economy remain healthy and are going unnoticed by myopic news reports. From a bigger picture perspective there are some structural issues surfacing in the Chinese economy that may cause us to reconsider the trajectory of Chinese growth going forward.
The Troubled Property Market
The biggest drag on China’s economy is undoubtedly the country’s depressed property market. Home prices are falling, housing starts are down, and developers are defaulting – all of which are contributing to negative sentiment, a drop in consumer confidence, and a consumer that is saving too much. China has been trying to steady the sector by cutting interest rates and making sure builders have access to financing, but nothing has been able to turn the tide just yet.
The state of the Chinese property market is being exacerbated by investors experience of the 2008 U.S. property crash, which may be melodramatic. However, looking beyond the property sector, you see that other sectors are holding up and the underlying economy is still growing – albeit at a moderate level.
The Industrial, Construction and Service sectors continue to show low- to mid-single-digit growth; offsetting weakness in Real Estate.
Fixed Asset Investment (FAI) outside of the property sector remains robust. Manufacturing investment has grown – as seen in the red line below. The country continues to invest in infrastructure that supports their independence from the West; such as renewable energy, EVs, data centres, semiconductor equipment etc.
The banking sector can be thought of as the barometer for the overall health of the economy. Any poor performance in the financial sector in general, is a canary in the coal mine for the entire economy. Chinese listed banks have performed relatively well over the last 12 months suggesting local investors remain comfortable with their prospects. Notably, when you compare the performance with the U.S., Chinese listed banks have outperformed their western counterparts.
Even though near-term challenges for the housing market could contribute to further weakness and concerns about financial health, broader risks for the wider economy seem to be contained.
Unlocking Incremental Growth
Chinese householders are sitting on record levels of deposits. Improving sentiment and unlocking consumer spending is key to achieving incremental economic growth.
The resolution clearly revolves around the government’s ability to steady house prices and stimulate demand for new homes. Government officials are yet to find a solution to the conundrum.
To date, there has been a handful of incremental measures that are leading to short-term boosts in the market. For example, authorities have cut rates on existing mortgages as well as lowered the down-payment ratio for home purchases. However, none of these have been sufficient enough to turnaround consumer behaviour for any length of time.
It is suggested that bigger and more impactful stimulus options be made, such as:
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- Large rate cuts
- Renminbi devaluation
- Major easing of property purchase controls
- Step-up in fiscal support
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Their approach so far has been to try a little bit of everything, but they aren’t moving forcefully enough on any front. There is upside potential to the market if authorities decide to pull out substantial stimulus that will combat the slowdown and provide incremental growth.
Structural Factors May Mean a Lower Growth Environment
There are structural headwinds within China that threaten the pace of growth; namely demographics (falling birth rates), migration trends (weaker urbanization), and global fracturing impacting exports. These structural trends affect housing and retail sales, as people don’t have the need to buy bigger houses for growing families, furnish new homes, or shop for more children, all while saving more towards retirement.
Weak exports have been a headwind to economic growth in China, as countries shift to onshoring and invest domestically. This is in addition to the already weakening demand that is being experienced in international markets such as the U.S. and in Europe.
China is also focused on state-led growth, with a reluctance to embrace a more market-led growth model, which is typically required to reach high income status.
All these headwinds have the potential to drive down the structural rate of economic growth over the long term.
Revisit Thesis
Despite valuations being beaten down in China, we are confident that the general economy is not going to descend into depression. However, it may be prudent for investors to readjust growth expectations going forward, given the structural factors already mentioned. We believe China is transitioning to a new normal and we are managing our growth estimates accordingly. Even though authorities have a target of approximately 5% growth for this year, stimulus policies have disappointed thus far and are yet to show material impact. It is difficult to be confident China can grow at 5% ad infinitum.
By the Numbers
The JSE ALSI recorded a 5.1% decline in August, in line with other major global markets. Weakness was noted across the board, with general retailers (+1.46%) and property (+0.77%) the only sectors that recorded gains for the month. Resources were down 9.14%, while industrials and financials were down 5.14% and 2.02%, respectively.
Fortress Real Estate (+21.4%) led the gains in the property sector, following the release of the 2023 results. The group reported that vacancies were at historic lows while seeing growth in the value of its property portfolio. Sirius (+11.3%), Equities (+9.7%), Nepi (+7.9%), while Resilient (-9.0%), Investec Property (-7.3%) and Growthpoint (-6.9%) were down for the month.
Curro (+19.1%) and ADvTECH (+10.8) led the gains in retailers following strong first half results supported by rising student enrolments. Cashbuild, despite disappointing results, was up 13.8% for the month. On the flipside, Steinhoff was down 33.3%, followed by apparel retailers Mr Price (-18.3%), Pepkor (-5.7%) and Woolworths (-5.4%).
In financials, Quilter was up 13.4% after reporting a substantial improvement in its first half profits and healthy fund inflows. Alexander Forbes was also up a decent 7.8% for the month. Capitec (-11.5%) sold off on concerns about asset quality rose following reports of increased credit loss charges by other banks. African Rainbow (-9.2%), Reinet (-8.7%) and Nedbank (-7.8%) were also down for the month.
MTN (-14.9%) and Aspen (-11.5%) weighed on the industrials as the shares sold off following the release of earnings results. Following the release of interim results, Anheuser was up 5.1% after months of being under pressure from the Bud Light scandal. British American Tobacco (+4.6%) and Bidvest (+4.1%) also recorded solid gains.
The weak performance in resources was led by PGM stocks. Anglo (-25.1%), Impala (-24.2%), Northam (-17.9%), AngloGold (-17.7%) and Kumba (-14.0%) were down on a broad sell-off in commodity markets, that saw commodity prices come under pressure. On the other hand, Montauk Holdings and AECI were up a solid 18.8% and 14.6% respectively.
Banks Riding the Cycle
Most earnings results over the past months have been overshadowed by higher operating costs that offset solid top line growth. Companies reported margin pressure as they absorbed additional costs from loadshedding, while higher finance costs from increasing interest rates added to the pressure.
This picture was somewhat different for the SA banks. Although they also battled with a tough operating environment, they have been a benefactor of the rising interest rate cycle. This is evident in the results released in August by the big four banks, where earnings shot the lights out.
On average, earnings growth was driven by strong revenue growth (+17%) and well-managed costs (+11%) despite higher inflation. A slight offset came from increased impairment charges, as management noted strain in the retail banking book. Despite this, the benefit from the higher interest rates outweighed the increased impairment charges.
Taking a closer look at the results, revenues were supported by robust growth in net-interest income (+22%), which benefitted from higher interest rates and continued strong loan growth (+9%). Non-interest revenue (+12.5%) also supported revenues, benefitting from increased transactional activity and client growth.
In a rising interest rate and high inflation environment, it is expected that the consumer will come under financial pressure. We have started to see signs of the consumer beginning to be stressed as banks reported increased credit impairment charges in retail banking, while the corporate banking book remained intact.
The pressure on the consumer is expected to ease going into the second half of the year, as we approach the end of the interest rate hiking cycle, and we see inflation moderate. Improving loadshedding prospects are also expected to ease some of the pain going forward. Therefore, as noted by management, credit loss ratios are expected to have peaked and will come down from current levels, approaching the top end of the credit loss ranges.
Despite the tick-up in credit charges, we have not seen any significant cracks in asset quality. The banks remain well-provided for with total coverage remaining at healthy levels.
Over the near term, we believe that the benefit from the higher rates and continued loan growth will continue to outweigh credit charges. Together with efficiencies in cost control, will continue to boost earnings growth going forward, supporting ROEs.
Local banks have traditionally been a great barometer of the economy’s health. Given the strong performance year-to-date by the SA banks we take to heart the resiliency of the SA economy despite the negative investor sentiment in general.
SA bank valuations remain attractive and continue to offer attractive prospects over the next 12 months. Implied ROEs are below the current levels achieved by the banks in the recent results. We believe that there are enough tailwinds to drive earnings growth and support ROE levels going forward. As such, we remain comfortable with our positioning in the sector.
Aspen Pharmacare Patience is the Active Ingredient
The once darling of the stock market has had its fair share of challenges. Some originating from its own decisions, others from factors outside of management’s control. However, Aspen Pharmacare enters 2024 with a strong balance sheet, drivers for strong earnings growth and a management team determined to get it right.
Warren Buffet once said, “The stock market is a device for transferring money from the impatient to the patient”. This adage runs true with the likes of Aspen Pharmacare.
Results – A Hard Pill to Swallow for Some
Full year 2023 results saw strong topline growth of 5.4% to R40.7bn coming largely in line with market expectations. Commercial Pharmaceuticals saw revenue up 6% while Manufacturing revenue was up 3%. Management had guided for and achieved an impressive recovery in Commercial Pharmaceutical’s gross profit margin with overall group gross profit growing by 3%. However, earnings came in short of expectations, down 11% on the back of the fall in COVID-19 vaccine sales and a negative swing in net financing costs from foreign exchange losses arising from weaker emerging market currencies. The market was disappointed by the earnings print and the stock traded lower on the day.
Commercial Pharma Enhancing its Strategy
Over the course of the last financial year Aspen has announced three transactions in line with its strategy to be the partner of choice to leading global pharmaceutical and biotechnology companies for niche products in emerging markets.
The first with Amgen, to market, distribute, use and sell Amgen’s products in South Africa for an initial term of 5 years. The second saw Aspen’s AGI acquire the commercialisation rights and related intellectual property for several key products in Latin America. The deal includes household names such as Viagra, Zoloft and Celebrex. The last saw Aspen conclude an agreement with Eli Lilly to distribute and promote Lilly’s products in sub-Saharan Africa for an initial term of 10 years. These transactions are anticipated to add incremental annualised revenue upwards of R2bn in Latin America and South Africa.
Commercial Pharmaceuticals is anticipated to achieve double-digit reported revenue growth for FY2024 with stronger performance in the 2H versus the 1H, driven by organic growth and the product portfolio additions listed above.
Manufacturing Laying Idle
Towards the tail end of the COVID-19 pandemic, Aspen Pharma brokered a deal with Johnson & Johnson to package, sell and distribute its COVID-19 vaccine under the brand Aspenovax. Unfortunately for Aspen, the demand for COVID-19 vaccines nose-dived leaving their state-of-the-art sterile facilities idling.
“You can’t sit and cry in the past,” CEO Stephen Saad was quoted as saying. “We found another plan and that plan is going to deliver more than we ever could have hoped for under COVID”. Utilising the spare capacity at their sterile facilities in France and South Africa became key to their future earnings potential and the market has eagerly welcomed any update in line with this.
In 2022 an agreement was signed with the Serum Institute of India to manufacture and sell four Aspen-branded vaccines for Africa, an agreement anticipated to provide a pipeline of vaccine orders for years to come. Further, in their 2023 interims, management guided to R2bn in revenues from the sterile manufacturing business in FY2024, increasing to R4bn by FY2025 with a potential annual contribution of R8bn if all capacity is utilised. Management reiterated this guidance in FY2023 results and indicated capacity utilisation stood at 50%. Progress is being made albeit at a slow pace.
Playing the Long Game
Since the start of the year Aspen has seen its share price move over 40% higher up until their FY2023 results were released. This far surpasses the performance of the market and makes Aspen one of the top movers on the JSE over that period. In our opinion, profit taking played a role in the negative reaction to the earnings result in addition to earnings coming in short of expectations and no updated guidance provided on capacity utilisation in the sterile manufacturing business.
Fundamentally Aspen remains attractive and offers value to the patient investor. Their balance sheet remains strong with incremental earnings drivers anticipated to come online by the 2H of 2024. Management is calling 2H 2024 “a significant inflection point for the group”. They have guided to the uptake of the idle capacity with room for this to grow to a significant earnings contributor on an annual basis. While the market seemed disappointed that this was not revised higher in the 2023 results, management reiterated their target, and we feel it’s fair to give them time to do this. Aspen has also indicated its intention to increase its footprint into China, a strategic growth area going forward.
The stock trades on an undemanding PE ratio of 10x and has the potential to rerate from current levels. Aspen remains a core holding on our growth focused portfolios. All you need is patience, if only there was a pill for that…
Closing Comments
As we enter the last quarter of 2023, global central banks are approaching the end of their hiking cycles, companies are getting on top of their costs which is positive for margins and earning expectations are being revised up. All these factors create a fertile ground for investing.
As investors across the northern hemisphere return from their summer holidays, we remain optimistic global equities can continue their positive performance into year end.