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Wood for the Trees | February 2023
9 March 2023

After a tremendous start to the year in January, with the market looking forward to Fed rates peaking in May and forecasting several cuts going into the end of the year. We hit some turbulence in February as global markets faced stronger-than-expected economic data in the face of rising interest rates. Despite US government bond rates moving up between 70-80bps, equities proved more resilient only coming off 2.5%.

In this month’s WFTT we take a closer look at how the market has adjusted to this stronger-than-expected set of economic data and what to expect going forward. At risk of stating the obvious, all eyes are firmly on Jay Powell and the Fed going into the March meeting. 

We continue to remain constructive on Equity markets, with this in mind we take you through some of our top picks for the year.

On the back of the recently announced government subsidies to encourage the take-up of solar power as a solution to our Eskom woes; we take a deeper look at the potential for Solar investments to drive bank earnings as solar systems become an affordable alternative.

Looking at how the major equity indices finished the month, it is hard to believe what actually transpired in March.

In the space of a 2-week period, we had the second and third largest bank failures in US history, as well as Credit Suisse, a “too big to fail” bank, being sold to UBS to prevent contagion. In addition, the Fed’s balance sheet expanded by $300 billion, and interest rates were increased by 25 basis points. On top of this, locally we had an attempted national shutdown and a surprise 50 basis points increase in repo rates. Despite all of this, global equity markets actually ended March flat to up, with the S&P 500 up 3.5%.

The real impact was felt in the bond markets, with short-duration bond volatility going through the roof as US 2-year yields dropped a full percentage point to finish the month closer to 4% versus 5% at the start of the month.

Looking at how the major equity indices finished the month, it is hard to believe what actually transpired in March.

In the space of a 2-week period, we had the second and third largest bank failures in US history, as well as Credit Suisse, a “too big to fail” bank, being sold to UBS to prevent contagion. In addition, the Fed’s balance sheet expanded by $300 billion, and interest rates were increased by 25 basis points. On top of this, locally we had an attempted national shutdown and a surprise 50 basis points increase in repo rates. Despite all of this, global equity markets actually ended March flat to up, with the S&P 500 up 3.5%.

The real impact was felt in the bond markets, with short-duration bond volatility going through the roof as US 2-year yields dropped a full percentage point to finish the month closer to 4% versus 5% at the start of the month.

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By the Numbers

After a challenging 2022, 2023 started off on a better footing as global equity markets rallied in January before experiencing a slight pullback in February. In the US, strong labour and inflation data suggested that the Fed’s interest rate hikes may have to move higher for longer. Triggering the S&P500 index to drop 2.5% for the month after a 5% rally in January. Notably in the US, Nvidia (+18.8%), Tesla (+18.8%) and Facebook parent Meta (+17.4%) all had a stellar month as they were amongst the few bright spots in US large-cap tech stocks. European equity markets benefitted from a change in risk conditions and sentiment, with FTSE 100 up 1.3% and EU 600 up 1.6%. Rolls Royce was a key standout, up 37.1% after the company sharply beat expectations; driven by its civil aerospace and power systems. Anglo American was down 16.8% in the UK, on the back of a weaker commodity market and lower production results. Optimism spiked around China’s economic recovery, causing a rebound in Chinese listed stocks at the start of the year. However, the Chinese market reversed some of those gains as they remain closely tied to investors risk appetite. JD.com was down 25.3% for the month as investors await upbeat reports on the Chinese consumer. On the other hand, HSBC performed better as interest rates continue to increase, and was up 2.3% in Hong Kong as the reopening in Asia will drive loan demand and banking activity.


Air Pockets Ahead

Our outlook for 2023 is based on the premise that cooling inflation will allow the U.S. Fed to halt interest rate increases after the May meeting, and then look towards cutting rates as we head into the latter part of the year. Expectations in January were for a year-end exit rate of 4.75%, versus the Fed’s expectations of 5.50%. We included the disclaimer that we did not expect this transition to be linear in nature and that some volatility should be expected. However, we did not expect this volatility to occur as early as February.

A series of stronger-than-expected economic data points quickly caused the market to reassess the path of the Fed Funds Rate in 2023. This adjustment weighed on global equity performance in February after a very strong performance in January.

February kicked off with a very strong Nonfarm Payrolls number that significantly beat expectations, coming in at 517k new-adds in January versus estimates of 185k; a data point that is the antithesis of a slowing economy. This was followed shortly by an ISM Non-Manufacturing number of 55.2, signaling growth in non-manufacturing businesses versus a contraction in December. This left the market having to digest the view of an economy that was not only not slowing but in fact reaccelerated. A week later, inflation data for January came in hotter than expected at 6.4% Y/Y, with the month-on-month data showing acceleration. Similarly, the balance of economic data seen in February has come in stronger than expected.

The Citi Economic Surprise Index, an index that looks at whether economic data is surprising on the upside (+ve) or downside (-ve), breached through into positive territory in February and has continued this strong upward trend throughout the month.

U.S. government bond yields reacted quickly to the stronger-than-expected economic data, increasing by approximately 70bps to reflect the potential for a higher-for-longer interest rate environment.

Investment graph of the U.S. government bond yields reaction

Along with stronger-than-expected economic data, we had a plethora of Fed members suggesting that inflation and the economy was not cooling as expected, and consequently there may be a case for rates to go higher for longer. Subsequently, forward rates expectations adjusted the path of Fed rates in 2023, pricing in an additional 25bps rate hike in June and an exit rate 50 bps higher than what was priced-in in January.

Graph of the Fed rates in 2023

Despite all the strong economic data in February and the adjustment to the Fed Funds outlook and government bond yields, Equity markets held up quite well; only falling 2.5% in the month. As we head toward the next Fed meeting on the 20th of March, the market will be looking at all incoming data to confirm whether January economic data was just an aberration and weakening trends seen in the backend of 2022 re-establish themselves, or is the Fed facing an economic scenario that remains stubbornly robust in the face on raising interest rates which may require a stronger hand.

For now, we maintain that interest rate increases work with a lag, and January saw several idiosyncratic factors that supported households spending. Inflation should fall further over the next 3 months as comparison get tougher; supporting the view that end of the rate hiking cycle is approaching.

2023 Top Picks

With global equity markets starting off the year on good footing, we want to highlight some of our top picks for the year ahead.

ING Groep: Tailwind from Interest Rate Increases

We are positive on European stocks as the macro-outlook in Europe continues to improve. We are now anticipating that the eurozone economy will avoid a recession; recession, driving improved sentiment for European stocks.

ING Logo, Caps, orange male lion

The European Central Bank (ECB) is currently the most aggressive central bank, with rates still expected to increase a further 150bps over the course of this year. Improving economic outlook and increasing interest rates creates a strong outlook for rate sensitive companies.

ING Groep is one of the top European banks, that operates mainly in the Netherlands, Belgium and Germany. Given its large lending book, the increase in interest rates will drive net interest income higher, and consequently drive operating profit in the double-digit range.

On top of the improved operating outlook, we expect large capital returns from ING in the form of dividends and share buybacks, as they look to distribute excess capital. ING has significantly more capital than is required by European regulation and has the capacity to distribute 40% of its market cap in capital returns over the next 3 years.

HSBC: Asia Recovery Boost

Echoing some of the points mentioned above, HSBC is well positioned and stands to benefit.

Given HSBC’s large exposure to Hong Kong and China, a key driver for HSBC is the boost from Asia reopening, driving higher loan demand and banking activity.

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As a result of last year’s strong capital generation, management have rolled forward capital returns to start as early as Q1 2023. Quarterly dividends have been reinstated with a payout ratio of 50%, and HSBC have announced a special dividend after the sale of its business in Canada. Shareholders can also expect share buybacks to the value of $10bn over 2023-2025.

Looking at valuation, HSBC reaffirmed their 2023 ROTE (Return on Tangible Equity) target of >12%. This higher return on equity will drive the Price-to-Book Value (ROE-g / r-g). As investors favour companies that offer higher returns on equity, this will therefore translate into a higher price. HSBC currently trades at a discount to its peers, and as its return on equity continues to improve, so will its value.

Alibaba: China Consumption Boost

Recently, there has been a bounce in Chinese equity prices following positive news that restrictions have eased and borders have reopened. This has led to a recovery in consumption and sentiment; with Alibaba at the center of this recovery.

Alibaba has multiple growth drivers in the years ahead. Its core marketplace is a strong cash cow that enjoys secular growth momentum during a consumption boost in China. China remains the home of the world’s largest e-commerce market with a significant addressable market. Thanks to Alibaba’s solid execution and drive in digitalizing the retail sector, they have strengthened their leadership position in the market and benefitted from cost-saving efficiencies.

Furthermore, they are also supported by their strength and progress in their cloud business. Their cloud business is a core foundation of Alibaba, and the backbone at a critical time in Artificial Intelligence (AI) development. As China continues to prioritize high-quality technology and self-sufficiency; the importance of cloud is highlighted with focus on stability and security, generative AI, and public cloud.

After being labelled “uninvestable”, there is still a lot of cash sitting on the sidelines waiting to return to the market and increase its share price. Is it currently trading at an attractive PE multiple of 8x its core earnings (excluding other investments). We remain very bullish on Alibaba as it rides the recovery & AI wave.

Alphabet (Google): AI Treasure Chest

Copious earnings calls have mentioned AI at least several times this quarter. Even though AI remains in the early stages, the hype is real. Both Microsoft and Alphabet are well positioned and play straight into this theme, but focusing specifically on Alphabet and its search engine, Google; it leads the pack.

Regardless of which AI model is used, it needs to be trained on large amounts of high-quality data, and this is where Google has a huge lead given its massive volume of search requests. This treasure chest of data gives Alphabet plenty room to monetize AI and large language models. AI may not immediately live up to the media hype, but in the meantime, Alphabet’s other core businesses continue to perform well.

Its video platform, YouTube, continues to command excellent advertising impressions and revenues. As the second largest social media platform, it is one of the best-positioned platforms. Alphabet is also putting more resources into its music streaming business, which will provide an annuity revenue stream with a significant advantage due to offering a lower priced ad-free viewing option.

This is a high-quality company with a huge moat. Alphabet has a large sticky customer base – meaning customers won’t easily switch. Google makes life easier for consumers, and they rely on Google for quick and factual info, with a high satisfaction rate.

Alphabet is a great business for a good price and offers attractive long-term compensation. Even after some early stumbles in AI, it is a massive opportunity for Google. After the recent pullback in share price, it has rarely been cheaper. Alphabet is a dominant growth stock, trading at 9.3x EV/EBITDA, compared to its other tech peers that trade at high teen multiples – showcasing the attractiveness of this opportunity.

Unilever: Pricing Power & Margin Expansion

Unilever is one of the leading consumer-staples companies and has been able to increase pricing with a marginal impact on volumes – a crucial advantage in an inflationary environment. In this most recent quarter, they raised pricing by 13.3%, while volumes declined 3.6%, showing strong brand strength and customer resiliency.

Looking at profitability for the year ahead, Unilever has the potential to surprise on the upside with profit margin expansion as input costs have peaked and begin to roll over.

As of October last year, Unilever had hedged only 20% of their input costs for 2023; so the remaining contracts will be reinstated at lower prices.

This means that profitability will increase as costs come down and pricing remains the same. Adding to this, there is more upside potential if Unilever is able to achieve their cost-saving targets.

Unilever also provides a consistent dividend income, with a current dividend yield of 3.5%. This is in the upper range for a consumer-staples company and is higher than its peers.

As a consumer-staples stock, it provides more stable and resilient earnings during uncertain times. The global nature of its operations provides a certain degree of diversification that adds value across our portfolios.

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By the Numbers

Following the strong start to the year, the JSE ALSI ended February 2.19% lower with the rand weakening further. Despite this negative performance, the financial sector returned 2.3% and were the top performers for the month. This follows positive updates and strong operational performances from the banks, with the exception of Capitec which was down 2.1%, amid concerns over a strained SA consumer. The Industrial sector was up 1.66% this month, with Anheuser returning a solid 7.8% for the month. On the flipside, the mining sector was the worst performer, shedding a massive 12.5% for the month. Within the sector, the platinum miners were the biggest drag, down by teens (Amplats -20.8%, Sibanye -18.2%, Implats -14.8%) following weaker production updates that were impacted intensified loadshedding and other operational challenges. The SA retail sector was also down for the month, impacted by a generally tough operating environment and continued negative consumer sentiment. Despite the resilient operational performances, the general retailers shed 1.47% for the month, with the exception of Woolworths, that continued the strong performance returning 2%. The property sector was also down for the month, with Redefine down 4.7% and Growthpoint down 4.1% with EMIRA, on the other hand, returning a solid 10.2% for the month.



The SA Power Crisis – Reaching the

Tipping Point

Generation issues, loadshedding, grid capacity constraints and alleged corruption are nothing new as we head into another year with our economic handbrake fully engaged. The woes of the electricity crisis in South Africa have been discussed in much depth so to avoid flogging a dead horse we have turned our attention to the potential solutions and of course, how we can position ourselves to benefit from these.

REIPPPPs – the Not so Bright Light at the End of the Tunnel

As discussed in our outlook for the year, Renewable Energy Independent Power Producer Procurement Programmes (REIPPPPs) offered a potential solution. Through various bid window’s the South African Government allowed the private sector to put forward bids in an initiative to increase electricity generation via renewable energy solutions. This has been around for some time but what differed in the most recent bid windows was the significant increase in the size of the potential megawatt allocation being sought out by the government. Alas, despite the government’s sudden willingness to allow further private sector participation in the face of an electricity crisis, Eskom’s grid constraints are unable to carry the expected increase in generation until the grid itself has undergone significant transmission and distribution upgrades. The result, bid window 6 saw a total of 860MW allocated out of a potential 5200MW.

The potential from these projects and bid windows remain. However, until such a time as the grid is upgraded, it is unlikely to be the driving force behind assisting Eskom in its generation constraints.


Are Households and Businesses the Answer?

The next likely source of reprieve to Eskom may surprise some as it is closer to home than you may realize – pun intended. The average South African household may in time offer far more support to the ailing grid than one could have imagined and its simply down to the cost tipping point being reached. If enough households are moved off the grid, it will allow Eskom the room to deal with the issues at hand while still providing enough power to support the balance of the economy.

For many, the idea of a solar “near off-grid system” for their household has been unattainable. The capital required to install such a system has been too expensive for the average south African household making the cheaper Eskom offering the only solution – loadshedding and all. However, the scales are starting to tip against Eskom. Electricity price increases over time including the latest 18.65% increase due this year versus the reducing costs of solar systems and the ability to increase one’s mortgage to pay for an off-grid system has the cost of increased mortgage payments now only slightly more expensive than the Eskom alternative.

In the example below, the analyst has used the average house price in SA of around R1.4m to illustrate this. He shows on the left the cost of running off Eskom which equates to R2,778 per month and on the right, how a R300,000 near-off grid solar installation would cost the individual around R3,198 per month via the increase in their monthly mortgage repayment. The difference here is now only a mere R420pm which in the face of loadshedding appears insignificant.


It is important to note that in the above example a top end solar installation is used to inflate the potential cost and costs relating to running other power alternatives are not considered such as a diesel generator during loadshedding. Further, no tax incentives are priced in nor the increase in value of the property given the investment. When taking all of this into consideration, the difference becomes negligible.


The Rebate that Broke the Camel’s Back

In SA’s latest budget, Finance Minister Enoch Godongwana announced a solar panel tax incentive for individuals. Individuals will be able to claim a tax rebate to the value of 25% of the cost of new and unused solar photovoltaic panels, up to a maximum of R15,000 per individual for this tax year only. Arguable, the cost of the solar panels relative to an entire rooftop solar installation (batteries, wiring and labour included) is relatively small, somewhere between 25% to 40% of the total cost. However, in bringing that tipping point closer to even, this rebate will not be ignored.


SA Banks are Ready and Waiting

Based on analyst forecasts, SA banks could potentially see R1 trillion in incremental loan growth on the back of households moving off grid; a figure not being priced in by many and, in our opinion, an important consideration for any bank valuation going forward.

Assuming these projects will be equally financed by the big 4 banks, we estimate the incremental benefit on loans, net interest income and earnings growth. 

Graph: WHL SA food sales growth relative to peers

The additional R250 billion per bank from off-the-grid projects could see loan growth of between 16% to 28% across the banks.

On our back of the envelope calculation, this translates to additional net interest income of R10.4 billion, on average, representing increases of between 13.9% to 28%. After adjusting for the additional impairment charge, this represents a significant upside of between R1.23 and R11.1 to earnings per share, an increase of between 17.6% to 40.4% from current levels.

The potential growth from these projects provides significant tailwinds for the banks. This, together with the continued strong operational performances and other sector tailwinds will continue to provide support for bank valuations, which, in our view, remain attractive.

Woolworths’ share price performance has been nothing short of fantastic since the lows of 2020; returning over 200% from those lows and 50% over the past 6 months.

When we initially took our position in Woolworths (WHL), there were three catalysts that we believed would be the drivers of a revaluation in the stock and drive price performance:

  • a solid food division
  • a turnaround of the fashion business
  • the sale of David Jones
Woolworths holdings limited logo

Over this time, we have seen Woolworths management execute according to plan, maintaining their superior offering in the food division, and successfully turning around the fashion business. The turnaround culminated in the announced sale of David Jones in December.

Given the solid performance of the stock and the achievement of our 3 catalysts, we reassessed our valuation for Woolworths.

Based on our Sum-of-the-Parts analysis (leaning on Standard Bank research), at R80 per share, WHL valuation was looking very stretched and priced at a significant premium to its peers.

Despite excellent execution by management, we have certain concerns about the sustainability of the current valuation. Within the food business, we have concerns about the levels of inflation and its impact on consumer purchasing power, as well as the impact of load-shedding on the Woolies’ fresh food department. Additionally, the sale of David Jones will lead to a 5% decline in earnings.

We are also battling to find any catalysts going forward to justify the valuation Woolworths is currently trading at.

As a result, we have decided to exit our position and recycle the funds into better opportunities.


Closing Comments 

The next few months of economic data is going to be telling and potentially drive the direction for the rest of the year. We remain focused on quality companies that have the ability the endure through this short-term turbulence. A large about of cash remains on the sidelines waiting to re-enter the markets. Any datapoints that confirm the previous rates hikes are having an impact will be seen favourably by global markets.  We remain well positioned to benefit when this occurs.