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Wood for the Trees | March 2023
11 April 2023

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.

graph, major equity indices

While the Fed had to step in to prevent a full-scale bank run and stabilise the financial system, its method was far more surgical compared to the broad strokes applied during the 2008/9 financial crisis. Clearly, they have learned a thing or two. Credit must be given to the Fed on this occasion for preventing the situation from spiralling out of control.

graph, black background, orange line, short duration bond valatility
Graph, US 2 year yields, black background, orange lines

The market quickly priced in the potential impact of tighter financial conditions as banks become more discerning about making loans – essentially doing the Fed’s job. Forward rates now predict the next move in Fed Fund rates will be a cut. This was a massive shift from the beginning of the month, which forecasted three more hikes and an exit rate closer to 6%. For now, the forward rates market forecasts an exit rate of 4%.

Graph, dark and light green lines, Feds rate cut forecast

In this emotionally driven, volatile environment, it is crucial that you stay level-headed and focus on the secular growth drivers, operating fundamentals, and valuations.

In this month’s newsletter, we highlight the pending rebound in China’s economy and the emergence of positive data points supporting Chinese-focused stocks. Locally, we revisit the very suppressed valuations of JSE-listed companies. We continue to see opportunities around every corner for the patient investor.

Finally, we take a look and try to simplify the emergency financing mechanisms put in place by the Fed, which played a big role in stabilising the US regional banking sector.

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By the Numbers

Major indices gained momentum towards the end of the month, with performance recovering as the threat of a banking crisis receded due to regulators and the banking industry extending helping hands to those banks struggling with tight money conditions. The notable causalities were First Republic (-88.6%), Charles Schwab (-32.8%), Standard Chartered (-21.7%), and Credit Suisse (-71.2%); causing bank-concentrated FTSE100 (-3.1%) to feel the brunt of the pain compared to global index peers. In the US, the Fed’s favoured inflation gauge came in lower than expected and reinforced the prospects of approaching the end of the tightening cycle. Tech stocks outperformed the broader market (S&P 500 +3.7%), with the tech-focused Nasdaq 100 (+9.6%) moving into a bull market year-to-date. Momentum was boosted by big names such as Alphabet (+15.3%), Meta (+21.2%), Nvidia (+19.6%), and Intel (+31%). Economic data in Europe and China is looking strong, with China bouncing back from last year’s trough and supporting the recovery boost. Chinese listed stocks such as Tencent (+12.3%) and Foxconn (+79.4%) released positive earnings reports, with upbeat guidance.

Graphs of market performance and indicie movements

Chinese Comeback

China is in the early stages of a cyclical upturn; conviction continues to remain low on the sustainability of any recovery. However, this is an exciting stage of ascent as the economy rebounds, with year-to-date data points providing further evidence to support this recovery story.

Overall, the data suggests that the economy is bouncing back from last year’s trough when COVID swept through the country. The recovery this year will mainly be led by consumption, while exports and the property sector are still lagging. However, the property market’s improvement is causing consumer confidence to recover from record weak levels.

The Purchasing Managers’ Index (PMI), which measures the change in economic activity within the manufacturing and services sectors, has shown expansionary activity with a reading above 50 over the past three months. This was boosted by the removal of the zero-COVID policy. This month, the National Bureau of Statistics of China summed it up perfectly, saying, “In March, the Chinese economy continued its upward trend in the higher booming range, indicating that the overall production and operation of China’s enterprises continues to improve.”

While the National People’s Congress set a moderate GDP growth target of “around 5%” for this year, it is more of a floor than a target. As mentioned above, this growth will be led by a rebound in consumption, given such a low base last year.

We expect regulation and monetary policy to remain supportive. Chinese consumers are sitting on a lot of cash; consumer household deposits have surged to a record high of over 120 trillion RMB. This exceeds the size of the Chinese GDP and provides a good launchpad for consumption growth.

In an indication of their intent to spur economic growth, China’s policymakers have made it a priority to boost consumption. “The key to the economic recovery is to convert current total income to consumption and investment to the largest possible extent,” said Guo Shuqing, the party secretary of the People’s Bank of China. Guo also pledged to use financial policies to boost the income of people affected by the pandemic.

Sentiment regarding the recovery boost is echoed in last month’s WFTT, where we mentioned why Alibaba is one of our top stock picks for this year. Since then, Jack Ma, the co-founder of Alibaba, has also returned to China, demonstrating a change in the Chinese government’s attitude toward big businesses. The billionaire is one of China’s most prominent business figures, and this move is widely interpreted as a positive sign to alleviate concerns in the country’s tech sector after a regulatory crackdown.

This leads us to another Chinese large cap. Tencent is a prime example of turning the corner with positive revenue growth.

At their most recent earnings release in March, Tencent recorded its first beat on revenue estimates after five consecutive quarters of misses. The gain was driven by a beat in the online advertising segment as demand improved notably in eCommerce platforms and gaming advertising, cementing faster-than-expected growth in advertising due to continued macroeconomic recovery.

blue logo, Chinese writing, Tencent

Gaming revenue was in line with estimates, with international gaming being a key outperformer and continuing to grow from strength to strength. Gaming was fuelled by the successful launch of strong-grossing new games, as Chinese regulators approve more game titles. We consider Tencent a global games powerhouse, with a proven track record in developing successful games.

Management noted that they are “gearing up for global expansion” in video games as well as exploring opportunities in consumer loans and online insurance services. Importantly, they also expect AI to be a growth multiplier as they have strength across the AI value chain. Thus, displaying Tencent’s multiple revenue drivers.

They also noted on the analyst call that they are very optimistic about consumption in China and that they are becoming more active in making investments domestically. They are aware that Chinese consumers have built up substantial excess savings over the past three years, and at some point, there will be an opportunity to tap into those household deposits.

Tencent trades at a forward P/E of 22.5x earnings, with the core business trading at a forward P/E of 18x. We are confident about the prospects for further revenue growth and margin expansion. We continue to see meaningful room for share price growth in Chinese listed companies, as prices catch up to booming economic data.

Fed to the Rescue

March was dominated by concerns seeping into the US banking system, particularly US regional banks. The Fed and the Federal Deposit Insurance Corporation (FDIC) jumped in to stabilize the financial system, preventing a catastrophic run on the banks. I am not going to go into the details surrounding the collapse of Silicon Valley Bank and Signature Bank, as there are a plethora of articles out there that have done a great job on that. In this article, we are going to take a closer look at the various programs that the Fed has put in place to stabilize the financial system.

Firstly, it is important to make the distinction between a credit-driven crisis like the one that occurred during the Global Financial Crisis and a liquidity-driven crisis that occurred in March. A bank’s main function is to take on deposits and then use the deposits to provide funding to those who have the ability to pay them back or alternatively invest the funds in higher-yielding assets, all while being able to provide depositors timely access to cash. As long as depositors are confident that their deposits are safe, they are very unlikely to withdraw their funds all at once. SIMPLE!

In a credit-driven crisis, the bank makes bad loans that can’t be paid back in full, leading to asset values (loans) falling below deposits. This causes panic as depositors try to get their funds back in full and consequently creates a solvency issue. On the other hand, in a liquidity crisis, the value of assets equals liabilities, but the volume of withdrawal requests leads to the bank becoming a forced seller of assets at discounted prices. This further impacts their ability to meet requests and has the potential to become a solvency risk if left unattended.

SVB and Signature Bank fell victim to a liquidity crisis, as depositors’ funds were tied up in “safe” government bonds. If held to maturity, these bonds would almost certainly pay out 100% of the principal investment, but as interest rates increased sharply, causing current market prices to drop, this led to someone shouting fire and a stampede of depositors heading for the exits, forcing the banks to sell assets at a discount and creating a potential crisis.

In this case, the FDIC stepped in and assured depositors that not only would insured deposits (<$250k) be covered, but uninsured deposits too, slowing down deposit withdrawal. Additionally, the Fed stepped in to provide a liquidity window that allowed banks to meet short-term money calls without having to sell assets and realize losses.

The Fed introduced the Bank Term Funding Program (BTFP) to ensure that banks can meet their deposit obligations without permanently impacting their balance sheets. This new program is added to the existing emergency funding facilities already in place for the banks: the Fed’s Discount Window and the Federal Home Loan Bank (FHLB). All these funding programs can be confusing, so let’s try to simplify them (summary table at the end).

  • Fed’s Discount Window

    The Fed’s Discount Window is a facility that is available to banks, credit unions, and basically any depository institution for short-term borrowing against eligible collateral. The discount window has been available since the beginning of the Fed and is used as a source of liquidity in times of distress. The discount window has a term of 90 days, and the collateral pledge is discounted from face value. The interest rate applied is the top of the Fed funds rate (currently 4.75%). There is a stigma placed on those banks that access the discount window, and the names of the banks that access the window are published weekly.

  • The Federal Home Loan Banks (FHLB)

    The Federal Home Loan Banks (FHLB) are congress-chartered institutions primarily responsible for maintaining order in the home lending market. The FHLB provides liquidity to the banking sector by providing loans against the banks’ mortgage loan books. Loan terms vary, and the interest rates charged are typically more expensive than other sources of liquidity. Thus, the FHLB is typically used as a last resort. The FHLB publishes its debtors on a quarterly basis.

  • BTFP

    Set up by the Fed in March to calm markets and re-establish confidence in the financial system, the BTFP program allows banks to access funding using an array of eligible collateral, all valued at 100% of face value, for a period of up to 1 year at rates more attractive than the discount window. Importantly, the banks accessing this facility will remain anonymous for now.

BTFP program allows banks to borrow against their asset portfolios at full value, without being forced to sell and realize losses given the current rapidly rising rate environment.

Currently, $330 billion has been lent out across the three funding programs, slightly down from approximately $350 billion when SVB ran into trouble. So, clearly, the facilities are being used and US regional banks are still working their way through this crisis.

Graph, Fed funding windows

In conclusion, for now, the Fed has created an effective program that provides liquidity to the banks without them having to realize any losses on their investment portfolios as forced sellers. At this stage, it appears to have held off a fully-fledged run on the banks.

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By the Numbers

March proved to be yet another volatile month in the equity markets, with the JSE ALSI shedding 2.10%. The JSE underperformed its peers, and the Rand pulled back to below R18 following the 50-basis point rate hike by the MPC in the recent meeting. All sectors were down for the month except Resources. The performance in the resources sector was driven by the gold miners, where stocks were up over 20% (Goldfields +42.1%; AngloGold +39.1%; Harmony +31.1%). A mixed bag from industrials: Aspen was up 29.1%, largely driven by the improved prospects of the sterile manufacturing business; Bidvest (up 8.1%) and Anheuser (up 6.1%) also recorded solid returns for the month, while MTN and British American Tobacco were down 12% and 10.7%, respectively.

The financial sector was down 6.36% as the banking stocks came under pressure due to the global banking crisis. Absa, FirstRand, and Standard Bank shed 8.40%, 7.89% and 5.87%, respectively. Transaction Capital, however, was the biggest loser (down 59.1%) following their interim results trading update, which the market found underwhelming. The SA retail sector remained under pressure, down 3.92% for the month. Woolworths shed 16.97%, Foschini down 10.44%, and Truworths down 9.89%. The property sector was also down for the month (Sirius down 9.30%, Redefine down 4.71%, and Growthpoint down 2.83%).


Opportunity around every corner

In South Africa, investor sentiment continues to be dragged down by increasing interest rates and load shedding, which have driven higher inflation expectations. Furthermore, the global banking crisis has also weighed on sentiment. This negative sentiment is increasingly reflected in the low earnings expectations and equity valuations.

Despite all these headwinds, the South African operating environment remains resilient. However, SA equities continue to discount a much more dire economic outcome, with forward PE (Price-to-Earnings) values at a significant discount versus historical averages.

graph, 5 year PE discount

These valuation discounts created by uncertainty, provide opportunities for patient investors who are prepared to look past the short-term volatility.

Highlighting several instances where we see opportunity:

South African banks continue to produce outstanding operating results. Higher interest rates and strong loan growth (9-10%) continue to drive topline growth at an average of 14%. Credit charges are within normal ranges, with bad debt provisions remaining at levels that are significantly higher than during the Global Financial Crisis (3.5% vs 2.5%). The strong topline growth and improved cost efficiencies have resulted in earnings growth, which has driven higher return on equity (ROE) that is approaching target levels.

Despite these strong operating fundamentals, the banks continue to trade at depressed valuations. We see the potential for significant upside from current levels.

table, bank valuation based on terminal P/B and exit book values

 Retailers continue to be impacted by load shedding and cost inflation. However, as pointed out in our previous newsletters ‘SA Retail holding its own‘, the current valuations are pricing in an extremely depressed operating environment.

Looking at The Foschini Group (TFG), for example, and based on our 2023 financial year estimates, the current valuation suggests that 2024 earnings per share (EPS) will decline by 20%. To get to this number, revenues will need to decline by 22%, or we would have to see a significant decline in operating margins of approximately 20%. Given the current operating momentum, it is very hard for us to get to these numbers.


Table, showing SA retailers holding their own

This is the case for most apparel retailers, where current valuations suggest that there will be a drastic decline in revenue or margins that will impact earnings over the next 12 months. We struggle to justify a decline of this magnitude, and therein lies the opportunity.

MTN’s operations remain resilient, with revenue growth of 14%, margin expansion, and high-teens EPS growth. Its balance sheet is healthy, with debt-to-EBITDA levels at 0.8x. Despite this, MTN trades at an EV/EBITDA of 4x – a significant 20% discount to its historical average and a 30% discount to its peer group.

Aspen returned 29% in March, largely driven by improved sterile manufacturing capacity prospects. Despite this strong move, APN still trades at a discount to historical averages with a PE of 11x compared to prior average levels of between 15-18x. Earnings growth prospects continue to improve for APN, with growth for the next year forecasted to be over 15%

On the property front, fundamentals continue to improve; as noted in our note ‘SA Listed Property: Strength to Strength.’ The strong demand for space, improved rental reversions – which are starting to turn positive – and lower vacancies, are driving net operating income growth, which is translating into solid mid-single-digit dividend growth. In addition, balance sheets continue to pay down debt, and property values strengthen, driving loan-to-values lower and net asset values up.

Despite this, the property sector still trades at significant discounts to net asset value.

Graph, showing the attractive current dividend yields and large discounts to NAV, the property sector remains attractive across the board.

Given the attractive current dividend yields and large discounts to NAV, the property sector remains attractive across the board.

These are just some examples of what we are seeing out there. SA equities remain attractively valued, and it is important not to be swept away by sentiment and always to assess valuations and what is being factored in. As it stands, there are opportunities around every corner for the patient investor.

Closing Comments 

It was Ben Graham who said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” So while we are still digesting the impacts of last year’s aggressive rate hikes, we continue to focus on investing in great companies, looking to take advantage of any volatility-induced sell-offs to capitalize on attractive entry points. We are ultimately getting closer to the end of the rate-hiking cycle, which should provide a boost to equity values across the board.