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Wood for the Trees | September 2023
12 October 2023

As we are all aware, trees don’t grow to the sky and markets don’t go up in a straight line. If you were not aware of this, the market’s performance in September definitely demonstrated it.

The S&P 500 finished down more than 5% in September bringing its YTD return to a still respectable 11.3%. The main driver of the market correction can be put down to the realization that rates are going to be higher for longer. Jerome Powell and the Fed are finally getting their message across that they are serious about bringing inflation down to 2% and won’t stop until such time as that occurs.

At the September FOMC meeting, Fed chairman Powell, rightly said “the most important question at this point is not whether an additional rate increase is needed this year or not, but rather how long we will need to hold rates at a sufficiently restrictive level to achieve our goals”. The penny seemed to drop for investors, and we began to see expectations adjust.

Initially, we saw interest rate futures quickly push out expectations for the first rate cut to July and reduced the number of expected cuts in 2024 from 5 to 3; suggesting a 2024 exit rate of 4.75%.

Graph, High probability rate path

10-year Treasury yields ramped 70bps to 4.80% by the end of September. Given the fact that the U.S. 10-year yield is used as the discount rate in determining stock valuations this increase in yields put pressure on stock values.

The 10-year Treasury yield moves back to levels last seen prior-2007 is very interesting and offers some useful insight into future expectations for the economy and markets.

The 10-year yield can be broken down into various components – inflation expectations and real yield. As is demonstrated in the chart below, inflation expectations have been steady at around 2.3% for much of the last year; thus the recent move up in treasury yields is completely down to a pick-up in real yields.

Graph, 10-year Treasury yield broken down into various components – inflation expectations and real yield

Real yield is essentially the premium investors require to lock up their money for a period of time. While the Fed have indicated that they think the neutral rate – rate that neither stimulates nor contracts the economy – is between 1-2%, many factors contribute to the magnitude of the premium investors demand:

    • Higher growth expectations. Markets are essentially pricing in a soft landing.
    • Treasury supply has risen sharply and will keep rising. This is a very real factor. Net Treasury issuance so far this year is already the second highest on record. Many market-watchers expect supply to continue growing rapidly next year as current issues expire and the need to fund growing fiscal deficits intensifies.
Graph: Treasury supply has risen sharply and will keep rising.
    • Uncertainty around U.S. solvency and/or political stability is higher. In the U.S. sovereign credit downgrade in August, Fitch blamed “a steady deterioration in standards of governance”; raising fears that political dysfunction might someday cause a missed bond repayment. As an explanation for a higher risk premium, this is hard to believe. Unless, and until a payment is missed, investors will probably look through hypothetical U.S. credit risk.

So, as equity markets adjust to this step change in bond markets, it is important to note that equity markets can and have performed in an environment where bond yields range between 5-6%. Over the last 30 years there have been 4 occasions where Fed fund rates have been between 5-6% for a period of 9 months or more. In all these periods the S&P 500 delivered returns of between 16-30%.

Stable rate cycle with fed fund rate with more than 5%

So, no need to be afraid of higher-for-longer rates. Focus on companies that are executing their strategy, pay a reasonable price, and you stand a good chance of seeing solid returns over the investment period.

In this month’s letter, we take a look at Nike and why we are building a position in this world class company. Additionally, given the continued nervousness around the state of the SA consumer, we pull together the latest data points to ascertain the current status quo. Finally, with continued weakness being experienced in the PGM markets, we reflect on our recent portfolio decision regarding Impala Platinum.

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By the Numbers

Global equity markets fell victim to the notorious September Effect as major indices closed lower; S&P 500 (-5.4%, +11.3% YTD), Nasdaq (-5.7%, +33.3% YTD), Stoxx Europe (-1.8%, +4.7% YTD), FTSE 100 (+2.3%, 2.1% YTD), Emerging Markets (-4.4%, -1.0% YTD), and Hang Seng (-4.1%, -9.0% YTD).

Energy was the top performing sector this month as the price of brent oil crossed $95 a barrel; namely BP (+8.3%), Shell (+7.6%), Valero (+7.5%), Exxon (+5.8%), and CNOOC (+4.4%).

In the U.S. treasury yields rose alongside a growing realization of the Fed’s stance of rates being higher-for-longer. A notable gainer was Splunk (+20.9%) after Cisco announced its intention to acquire the software company. In contrast, First Republic Bank (-34.5%) fell after a report from U.S. banking regulators showed management vulnerabilities prior to its failure in May. Airlines were also lower as the price of oil rose; United Air (-16.3%) and American Airlines (-14.0%).

UK and Eurozone inflation dropped lower than expected and their respective central banks kept rates unchanged. Some of the movers this month include financials like HSBC (+9.1%) as rates may remain higher-for-longer. Mining shares Glencore (+12.1%) and Anglo American (+8.6%) were also up with investors seeing potential as China’s step-by-step economic stimulus is laying the foundation for a recovery in the dragged down sector. Ocado (-23.9%) and Zalando (-23.8%) fell after analysts downgraded the online stores on concerns of lower growth. Luxury names like Burberry (-14.2%) were also lower on demand concerns. 

Turning to Emerging Markets, incoming data from China shows the consumer remains steady, while deterioration is mainly isolated to the property sector. However, there was optimism in the property sector as some debt restructuring plans got approved; Sunac China (+113.9%), SH Zhangjiang (+42.4%), and Oceanwide (+37.7%). On the other hand, electronic components and Apple-related supply chain stocks fell; Delta Electronics (-24.4%), Sunny Optical (-15.6%) and AAC Tech (-15.0%).

Graphs on international market performance; USD, Japan, UK, Europe, Hong Kong, Emerging Markets
Graphs on international market performance; USD, Japan, UK, Europe, Hong Kong, Emerging Markets

NIKE – Just did it

We have recently taken a position in a company who undeniably has one of the most recognizable logos in the world – Nike.

Apparel and footwear have been one of the most out-of-favour sectors this year. This is due to expectations of consumer softness, inventory issues, and uncertainty around the strength of the recovery in China.

Nike’s share price has fallen over the past few months and is down 19.3% year-to-date, and down 46% from all-time highs.


Given the soft share price performance, valuation has pulled back to 24x on a P/E basis, providing a 20% discount to its historical average. A discount like this cannot be ignored for a world class company.

This pullback in share price has created the perfect buying opportunity for this best-in-class retailer.

Graph: Nike share price

Consumer Challenges but Nike Wins Market Share

 The challenging macroeconomic environment has caused some softness in discretionary spend and cast a cloud of doubt over the health of the consumer. In Nike’s most recent earnings call with investors, management eased concerns and reiterated the strength of the consumer. Nike CFO Matthew Friend noted, “We continue to see consumer demand for our brands and for our products to be very, very strong. Sport is growing and the consumer is proving to be resilient.”

A recent topic of conversation has been around the resumption of student debt repayments in the U.S., which could potentially put pressure on consumer spending in apparel and footwear. Scratching below the surface, you find that this decline in consumer spending is more likely to be aimed at fast-fashion apparel and less on athletic wear. J.P. Morgan’s September 2023 Cost of Living Survey substantiated this, with 63% of consumers noting that casual and athletic wear rank first in the prioritized apparel category. The report said, “This underscores the expanded Total Available Market (TAM) opportunity for sportwear/athleisure, representing 35.4% of total U.S. apparel and footwear spending versus 43.1% pre-pandemic, with Lululemon and Nike top multi-year beneficiaries.”

The U.S. apparel market reached $1.53 trillion in 2022; so, the above-mentioned increase in TAM represents an additional $117.81 billion in revenue. And with Nike being the largest athletic company in the world, they stand to benefit from this trend.

While current conditions continue to put pressure on the retail space, it appears to be more of a short-term blip than a long-term headwind. 

Inventory Issues in the Rearview Mirror

 Across the retail industry, there have been concerns around the inventory glut that arose after the pandemic. The excess inventory led to markdowns and promotional activity that pressured operating margins. This extended into the wholesale channel, with retailers such as Footlocker and Dick’s Sporting Goods battling with excess inventory and subsequently reducing their replenishment orders.

Nike was not immune to these pressures. However, this quarter saw an improvement with inventory destocking, as total inventory units were down double-digits against revenue growth of 2%. Management also voiced their confidence with inventory levels, “Looking at inventory. We continue to feel very good about our position.”

Inventory levels appear to be moving in the right direction with operating margins normalizing. Management has guided to an improvement in gross margins of approximately 100bps, as a result of improved markdowns and lower ocean freight costs. 

Nike Getting its Mojo Back in China

 China has been a contentious point as macroeconomic headwinds and a short-lived rebound have disappointed analysts. Hence, it was a key concern for investors heading into the most recent earnings release at the end of September. Even though revenue in China was slightly lower than expected, management cooled investors’ concerns during the earnings call. CEO John Donahoe mentioned that he feels good about the market and Nike’s position – “Sport is back in China. You can just feel it. And that gives us great confidence about the future and the Chinese consumer in our segment regardless of the macroeconomic outlook there.”

A recent call with a retail director based in China gave an optimistic update on luxury and sporting goods. Key takeaways were that store traffic is at record levels, and while consumers are spending a bit less, they are sticking with well-known established brands. These top athletic brands are performing well with the power of huge sport stars and influencers backing the brands.

While we still expect some volatility and softness in China in the near term, if the company can continue to navigate the headwinds effectively, then it could be on the cusp of getting its mojo back in China. 

Valuation at an Attractive Entry Point

 A discounted valuation is not the sole reason to own a stock. You need to have a catalyst that has the potential to drive valuation higher or back to historical levels. Encouragingly, in Nike’s most recent report, earnings surpassed expectations causing the market to react positively to the news and upgrade earnings estimates. With inventory issues behind them and margin expansion potential going forward, we except Nike’s earnings growth to return to the high teens.

It is this dynamic that gives us confidence that we have seen the bottom in the earnings cycle which will lead to multiple expansion going forward.

Using an average multiple of 30x and a projected FY25 EPS of $4.58, you get a price target of $137.39, which represents over 40% upside from current levels.

Using an average multiple of 30x and a projected FY25 EPS of $4.58, you get a price target of $137.39, which represents over 40% upside from current levels.

In the near term, trends may remain weak as we navigate through negative sentiment and return to a more normalized environment. We believe the pessimistic narrative will change dramatically for this best-in-class retailer.

Nike has a strong brand and international presence, as well as being supported by a growing appreciation for health and wellness. It also goes without saying, that events like the 2024 Paris Olympics and the Rugby World Cup boost demand and sales as Nike boasts the best athletes.

Go bokke!

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By the Numbers

September was yet another tough month for equities, resulting in the JSE ALSI shedding 3.43% slightly better than the main global markets.  The weakness was broad-based, led by Industrials (-5.0%) then Financials (-4.9%), Property (-4.3%), Retailers (-1.3%), while Resources were flat for the month.

Spar rallied 10.5% following an announcement by management of its plans to exit the loss-making Polish operation. Management also suggested that some of the operational challenges that were faced in the South African business seem to be resolved. Apparel retailers Truworths (+8.6%) and Mr. Price (+6.1%) also recorded solid gains. On the flipside, Richemont (-12.7%) and MTN (-10.8%) weighed on industrials, together with retailers Shoprite (-10.0%), Woolworths (-9.9%) and Clicks (-8.3%).

Transaction Capital weighed on the Financials, shedding a further 35.3% this month following a trading update and the announcement of the departure of its CEO. Although FirstRand released a strong set of results for their 2023 financial year, the share sold off (-14.1%) following an article that rumored further expansion in the UK business. Hosken Consolidated and Nedbank also shed 12.5% and 7.2% for the month, respectively. On the other hand, better-than-expected interim results saw Capitec gain 6.3%.

Despite  management teams continuing to report improving fundamentals, the property sector stocks remain under pressure. MAS Real Estate was down -24.1% following results earlier in the month, as investors became concerned about the outlook given uncertainties about residential developments and liquidity sources given local market constraints. Growthpoint (-12.1%), Nepi (-9.9%) and Emira (-8.2%) were also down for the month, while SA Corporate on the other hand was up 9.0%.

Although the gold miners weighed on resources (DRD -21.2%; Gold Field -14.2%; Harmony -11.0%), gains from Glencore (+8.7%), Sasol (+8.7%), Sappi (+8.7%) and Kumba (+7.7%) helped the sector end the month flat.


Graphs of the performance of different investment sectors: Financials, industrials, resources.
Graphs of the performance of different investment sectors: retailers, property

Household Finances Likely To Withstand Higher For Longer Interest Rates

Earlier this year, we highlighted our belief in the resilience of the South African consumer, stating that they were likely to weather the storm despite challenges. However, more recently, the shift in expectations for interest rate cuts has raised concerns about whether the South African consumer can sustain higher interest rates over a prolonged period. In addressing these concerns, we take a fresh look at the current state of the consumer and highlight why we continue to believe that the consumer will be able to withstand higher interest rates for an extended period.

While consumer confidence recovered from the very depressed levels reported in the first and second quarter of 2023, it remains well-below the long-run neutral reading of zero, as well as the highest reading post covid. Confidence levels remain in negative territory, signalling low willingness to spend. However, we view the improvement in sentiment as a step in the right direction.

Graph: FNB/BER Consumer Confidence Index

Delving into the confidence data reveals that consumers are more concerned about the outlook for the economy and less about their own household finances. While the latest reading shows a recovery in economic outlook confidence, a meaningful improvement towards the historic averages of -10, and further improvement in household finances is needed to drive consumer spending.

Graph: Economic and Household Finance Confidence

Taking a closer look at household finances, recent data has shown resilience in household earnings in the current year. This is reflected in employee tax receipts, which are up 8% year-to-date, tracking ahead of the Treasury’s budgeted increase of 6.2%.

Further supporting this is the relatively steady growth in gross earnings of 5.4%, which now outpaces current inflation of 4.8%. Noteworthy, consumers are starting to see growth in real wages, giving them a little breathing room at the end of each month.

Graph: Gross Earning (YOY % change)

Household balance sheets remain in good shape. While we have seen a further increase in debt service costs due to higher interest rates, household debt to disposable income remains relatively stable.


Graph: Households Debt

Savings levels have remain stable, suggesting households continue to manage their current debt obligations without having to draw on savings.


Graph: Gross savings as a % of GDP

The relatively healthy savings levels are also reflected in the excess deposit balances, which we estimate to be R138 billion at the end of July, representing 10.7% of 2022 retail sales.


Graph: Short term cash deposits

Despite ongoing macroeconomic pressures, household debt and savings rates have remained stable throughout the year, showing no significant signs of deterioration. This, coupled with the growth in real earnings, gives us comfort in the overall health of household finances. It is for these reasons that we believe the South African consumer will be able to endure higher interest rates for longer. If necessary, consumers do have a healthy savings buffer to tap into to support their household income.


Platinum Group Metals Turn Bearish

The Platinum Group Metal (PGM) miners have had a rough 2023, with the sector losing half of its value over the course of 9 months. The weakness amid widespread power shortages, weak PGM pricing and persistent inflation. The PGM basket price is the primary driver behind share price movement and its consistent devaluation has wreaked havoc on the sector. Under the higher for longer interest rate narrative the global climate is unsupportive of a recovery in the PGM basket and as such our outlook on the sector has turned bearish.


PGM Basket Pricing Tumbles

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Graph: South African PGM producers spot basket prices

The demand and supply relationship for PGMs should be simple but has proven opaque.

Supply – In Line with Expectations

The two largest PGM suppliers are South Africa (almost 90% of PGM Reserves) and Russia. South Africa has been plagued with electricity constraints which impacts the PGM miners in the form of load curtailment. One would assume production was impacted on the back of this. However, curtailment was limited to processing infrastructure with little to no impact on mining itself. The impact saw an increase in work-in-progress stockpiles but this remained a very small part of refined throughput. Overall PGM supplies from SA mines were largely in line with expectations despite the tricky operating conditions and increased operating costs.

Russia on the other hand is sanctioned against exporting PGMs. The anticipated reduction in supply has failed to materialize as Russian supply somehow manages to find its way to the market.

Between South Africa and Russia, supply has been largely normal.

Demand – Appears Healthy but Clouds Building

PGMs have many uses but the primary driver for demand is automobile production. PGMs are used in catalytic converters to reduce emissions and loadings (the quantity of PGM used in an emissions control system) together with global vehicle sales are a strong indicator of demand for PGMs.

Automobile demand is healthy and has shown significant improvement since the pandemic lows, recently recovering to 2019 levels. The pent-up demand for automobiles remains a driver of sales where countries showing a normalisation in sales are being supported by increased demand in others. The penetration of Battery Electric Vehicles (BEV) continues to gain traction and remains a headwind in time, but currently remains a small part of overall sales figure. The hydrogen economy will create demand given its intensive PGM usage. However, it remains in its early stages and analysts are not yet clear on how much demand will be created.


Graph: Global Auto sales, which have recovered and are back at levels of 2019

The supply demand dynamic is off. Analyst forecasts continue to indicate a net surplus in Palladium and net deficits in both Rhodium and Platinum in the coming years, which is supportive of pricing. Automobile demand appears healthy, and supply based on production figures appears normal, with a largely balanced market why does the basket price continue to decline? Market analysts aren’t certain as they continue to forecast a spot price increase despite the price continually moving in the opposite direction. Additional supply must be finding its way to the market to suppress pricing the way it has and what no one seems to be able to establish, is how much is still out there.

Outlook for PGM pricing

Russia is due to conduct maintenance at its various facilities in the coming months. Due to sanctions they may not be able to get the parts necessary to conduct this maintenance which could lead to reduced production from Russia. On the South African font, if low pricing persists, some mines/shafts will close as they are no longer viable. These two factors alone are not new to the market but present a real headwind for supply in the coming months, yet once again, spot pricing is not indicative of this. There is additional supply coming to the market which analysts and investors alike cannot see. Until this has worked itself through the market or demand increases significantly there will be this overhang in the market.

A strong recovery in demand seems unlikely in the current global context. Chinese stimulus packages will assist, but expectations for large stimulus packages from the Chinese government are starting to wane. The market’s view on global economic growth under the “higher for longer” interest rate narrative fails to support a strong push in PGM pricing especially as concerns of recessions come to the fore. The market is starting to price in weaker PGM prices for longer as a result.

During a recent mining indaba this was addressed by senior management at various mining houses. Some indicating significant cost control would need to take place sooner rather than later in order to protect against a basket price that remains weak for longer.

Cost Control Between a Rock and a Hard Place

The success of a mine is a balancing act between what it receives for its production in the commodities market less what it had cost that mine to extract and process that output. If the current spot PGM basket price is below the cost of that mine, the mine is making a loss. As per the graph below, some mines have moved into loss making territory at current spot prices.


Graph: 2023 PGM cost curve

To counteract this, the mine operators reassess strategies and cost control comes to the fore with capex projects curtailed and employees retrenched. The amount of cost cutting is limited with SIB (stay in business) capex largely fixed as it is an essential part in maintaining a mines integrity.

Impala Platinum Lost its Lustre

Impala finds itself in a position where several of its mines (in green above) will become loss making based on current spot prices. Our calculations show that under these conditions Impala may see negative free cash flow in FY24 and potentially FY25. Impala’s recent purchase of Royal Bafokeng has reduced its existing cash position and its capex planned for the coming year is primarily SIB limiting its ability to cut back. Given this, it is highly unlikely they will be in position to pay a dividend without a strong push in PGM pricing. A strong recovery in pricing now appears further away than originally anticipated and we must adjust our exposure accordingly.

As such we have exited from our Impala Platinum positions across our income producing mandates given our expectation for no dividend. We have a hold on Impala on our growth focussed mandates, but it is currently under review.

Closing Comments

Third quarter earnings season is about to kick-off so we will get a chance to hear how companies are doing in the current environment. Most economic indicators are suggesting the U.S. economy remains in good shape.

As we head into the final quarter of the year, the current level of bond yields is causing a change in rhetoric from Fed members, with many expressing their views that there may not be a need to increase rates further. A solid earnings season accompanied by good guidance and a Fed that is less prone to hike again in November bodes well for markets in October and a stock rally into yearend.