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Managed Share Portfolios

Market Overview - October 2023

Market Overview

Global markets remained under pressure in September, with the MSCI World Index (-4.2%) and MSCI Emerging Markets Index (-3.5%) falling deeper into the red as investors continued to assess the prospect of higher interest rates and a looming US government shutdown as divisions among US lawmakers have put the federal government at risk of a partial shutdown. US treasury yields edged higher as well, once again approaching 16-year highs and pushing the dollar to a 10-month high, amid speculation that the Federal Reserve will keep policy restrictive into next year, or longer. The ICE BofA MOVE Index, which tracks expected bond volatility, recently hit a monthly high.

US markets experienced a sizable sell-off towards the end of the month, with the S&P 500 trading down 4.5% at the time of writing. Investors continued to assess commentary from US Federal Reserve officials, with the repeatedly hawkish tone continuing to dampen sentiment despite the widely anticipated pause at the September meeting - the Fed kept the target range for the federal funds rate at a 22-year high of 5.25% to 5.5%, following a 25bps hike in July. The world's largest central bank, however, signalled that there could be another hike on the cards this year. Projections released in the FOMC members' interest-rate expectations dotplot showed one more increase this year, followed by two cuts in 2024. Policymakers now see the fed funds rate at 5.6% this year, the same as in the June projection, while it is seen higher at 5.1% in 2024, compared to 4.6% seen in June. Twelve of the 19 Fed officials forecast another hike this year and there were fewer cuts forecast for next year. The market is now pricing in another hike this year - either in November or December, and the timing of the first cut has now been pushed to the third quarter of next year. The Fed lifted GDP growth forecasts as well and lowered unemployment projections - highlighting the bank's expectations of a soft landing amid better-than-expected economic resilience, and in turn, upside risks to interest rates.

Moving over to the Asia Pacific region, the Chinese market (MSCI China Index: -4.9%) also remained in the red but saw some reprieve after a slew of economic data showed signs of a slight recovery in August - both industrial production (strongest pace of expansion in factory activity since February) and retail sales grew ahead of expectations, showing some resilience in the world's second largest economy. This could be an indication that the country's recent pro-growth policies are proving to be effective, with market participants now expecting to see a notable improvement in the Chinese economy towards the latter part of the year. However, concerns about China's beleaguered property sector (which accounts for roughly a quarter of China's economic growth) were exacerbated after trading in China Evergrande Group was suspended, again. This resulted in Chinese property developer stocks falling to levels last seen in 2011.

The JSE (All Share Index: -2.3%, -2.9% in USD terms) mimicked the downward trajectory seen among international peers as investors continued to monitor key global developments. In terms of local policy announcements, the South African Reserve Bank (SARB) kept its key repo rate steady at 8.25% during its September 2023 meeting, as anticipated, but emphasized that the fight against inflation was not yet over. Policymakers cited concerns about the continued depreciation of the rand and the ongoing pressures on inflation as the key drivers behind the decision - hence, a restrictive stance will be maintained until data affirms that price stability has been attained. Meanwhile, the SARB revised its inflation forecasts, with inflation for 2023 now projected to average 5.9% (prior: 6.0%). Simultaneously, policymakers raised growth forecasts slightly for this year to 0.7% (prior: 0.4%), in line with better-than expected 2Q23 GDP data. This indicated the resilience of the productive side of the economy despite ongoing structural constraints, notwithstanding energy and logistical issues, which continue to threaten the economic outlook.

Economic data overview

The US Federal Reserve paused, but maintained a hawkish rhetoric

Flash estimates showed that the S&P Global Composite PMI for the US decreased to 50.4 in August, in line with expectations. This marks the fourth consecutive month of declining PMI and signalled the weakest overall performance since February. Retail sales in August increased 2.5% y/y, compared to the 2.6% rise a month before - this was below expectations In July, the US trade deficit widened less than expected to $65 billion, as exports were up 1.6% and imports increased 1.7%. The unemployment rate in August rose to 3.8%, above market expectations. The annual inflation rate accelerated for a second straight month to 3.7% in August from 3.2% in July, above market forecasts of 3.6%. The Federal Reserve kept the target range for the federal funds rate at a 22-year high of 5.25% to 5.5% in its September 2023 meeting, following a 25bps hike in July, and in line with market expectations, but signalled there could be another hike this year. Projections released in the dot-plot showed the likelihood of one more increase this year, then two cuts in 2024.

The European Central Bank (ECB) hiked interest rates for the tenth consecutive time

On a preliminary basis, the HCOB Eurozone Composite PMI rose to 47.1 in September, compared to 46.7 a month before. This was above expectations of 46.5. However, the latest PMI reading still indicated a significant monthly decline in business activity at the end of the third quarter, primarily driven by a steep contraction in the manufacturing sector. Meanwhile, the rate of decline in services activity eased slightly. Retail sales in July were down 1% y/y, compared to expectations of a 1.2% decline. A trade surplus of €6.5 billion was recorded in July, compared to estimates for a €20 billion surplus, as imports tumbled 18.2% y/y and exports fell at a softer 2.7% y/y. The unemployment rate in July stood at 6.4%, matching consensus expectations. Consumer price inflation for August came in at 5.2%, slightly lower than expectations. The ECB hiked interest rates for the tenth consecutive time in September (compared to expectations for rates to remain unchanged) and signalled that it is likely done tightening policy as inflation has started to decline but is still expected to keep rates high for as long as needed.

The Bank of England (BoE) held rates steady, adopting a wait-and-see approach

Initial reports showed that the S&P Global/CIPS UK Composite PMI fell to 46.8 in September, missing market expectations of 48.7. Retail sales decreased 1.4% y/y in August, compared to forecasts of a 1.2% drop. In July, the trade deficit shrank to £3.45 billion from £4.79 billion in the previous month, as exports rose 1.8% y/y and imports dropped 0.2% y/y. In line with market expectations, the unemployment rate came in at 4.3%. Annual inflation in the UK dropped to 6.7% in August, below market expectations. 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 policy tightening in nearly two years, following the central bank's unprecedented 515bps hikes. Policymakers have reiterated their commitment to tightening policy further if deemed necessary

Resilient data out of China sparks hope for an improvement in economic growth over the latter part of the year

China's composite PMI slipped to 51.7 in August, from 51.9 a month before, in line with forecasts. This was the eighth straight month of growth in private sector activity but the softest pace since January, as a softer expansion in services activity was only partly offset by a renewed, albeit mild, increase in factory production. Retail sales increased 4.6% y/y in August, quickening from a 2.5% growth in the prior month and exceeding market estimates of 3%. Below market forecasts, the country's trade surplus slumped to $68.36 billion in August compared to the previous month of $78.65, as exports dropped more than imports amid persistently weak demand from home and abroad. The surveyed urban unemployment inched down to 5.2% in August. China's consumer prices rose 0.1% compared with market forecasts of a 0.2% gain and after the first drop in over two years of 0.3% a month earlier. The People's Bank of China (PBoC) maintained lending rates at the September fixing, as policymakers assessed the impact of previous easing measures, including an interest rate cut in August and a recent reduction in the reserve requirement ratio for banks. China's economy showed some signs of improvement in August, particularly in industrial production and retail sales. Inflationary conditions also improved after the country slipped into deflation earlier this year. However, the overall outlook for the economy remains uncertain, amid weak overseas demand and a property downturn.

The BoJ maintained an ultra-loose policy stance

Early estimates showed that the Jibun Bank Composite PMI reading in September fell to 51.8, from a final reading of 52.6 in the prior month, flash data showed. While pointing to the ninth straight month of expansion in private sector activity, the latest result marked the softest growth since February, highlighting the economy is struggling to maintain a strong recovery. Retail sales for July increased 6.8% y/y, exceeding market consensus for a 5.4% growth. Japan's trade deficit decreased sharply to ¥930.5 billion in August, against market expectations of a shortfall of ¥659.1 billion. The unemployment rate unexpectedly increased to 2.7% in July. Annual inflation edged lower to 3.2% in August from 3.3% in the prior month, pointing to the lowest reading in three months. The Bank of Japan (BoJ) kept its key short-term interest rate unchanged, in line with market expectations, and mentioned that it would patiently continue with monetary easing and respond to developments in economic activity. The committee reiterated it will take extra easing measures if needed, while being aware of rising inflation expectations.

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

The RMB/BER Business Confidence Index improved to 33 during 3Q23 (compared to 27 in the previous quarter), however, sentiment remains generally cautious as high interest rates and inflation continue to weigh. The leading business cycle indicator on the other hand, edged 0.1% higher in July, following an upwardly revised increase of 0.2% a month before. Retail sales contracted 1.8% y/y (slightly worse than the forecasted 1.2% drop), reflecting the adverse impacts of the tight monetary environment. The trade balance amounted to a surplus of ~R16 billion, well ahead of expectations of a ~R1.3 billion deficit. This was driven by a 4.6% rise in exports (amid higher shipments of vehicles and transport equipment and agricultural produce) as well as a 7.6% decline in imports.

Mining production slumped 3.6% y/y in July, against expectations of a 0.5% increase. This followed an upwardly revised increase of 1.3% in the previous month. Growth in manufacturing production dropped to 2.3% y/y, behind expectations (+4.4%). This marked the fourth consecutive monthly increase in industrial activity, albeit at a slower pace. Composite PMI rose to 51 in August (compared to 48.2 a month before), pointing toward the first expansion in private sector activity since February, as a result of stronger output. This was evidenced by the uptick in manufacturing PMI to 49.7 (July: 47.3). Total new vehicle sales improved 5.3% to 45 679 units as the second-hand market remained tight. The value of recorded building plans passed in SA's larger municipalities slumped 17.3% y/y, in stern contrast to the 14.7% increase a month before.

As expected, consumer price inflation (CPI) in August was marginally higher at 4.8% due to increased housing and utility costs (including electricity, water and other municipal services). Nevertheless, CPI remains within Reserve Bank's target range of between 3% and 6%. Core inflation (which excludes the price of food, non-alcoholic beverages, fuel, and energy) was also at 4.8%. 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 yet done.

Market Outlook in a nutshell

Local

• Despite the ongoing infrastructure constraints, the local economy has performed better than expected. The second quarter data showed resilience in the productive sectors, coupled with job creation, the continued corporate-sector replacement cycle, and investments in alternative sources of energy. These have offset the impact of an ailing consumer as real wage compression and rising debt service costs dampen spending power. Furthermore, global activity has also surprised positively. A resilient US economy and the recovery in China, albeit laboured, should support exports, and limit the negative impact of energy-related imports on growth. Nevertheless, overall activity should remain weak as leading economic indicators still suggest soft growth in the near term. Confidence indices have improved compared to the prior quarter, but not enough to suggest improved spending and broad-based investments. These indicators should continue to be weighed on by persistent inflationary pressure, elevated political risks, and hawkish monetary policy. Overall, the improved starting point has resulted in an upward adjustment to our GDP growth forecast and we now predict growth of 0.7% in 2023, from 0.2% previously. Weak fundamentals mean growth rises gradually to 1.8% in 2026, not robust enough to reduce unemployment and enable a more inclusive economy.
• Recent headline inflation data benefitted from positive base effects from last year's strong lift in prices. However, reflation in energy and still-elevated food inflation should test the resolve of wage and price setters. So far, the passthrough of elevated operating costs has been less severe than initially expected, and weakening consumer fundamentals should generally weigh on pricing power. While this suggests a delay in margin rebuild, it does also pose upside risk to inflation as workers and businesses experience extended pressure. We currently forecast average headline inflation of 5.9% this year, before tediously falling to the SARB's preferred target of 4.5% by 2026.
• Monetary policy is currently restrictive but an uptick in energy inflation in the coming months should reduce real interest rates. This, along with a possible lift in Fed rates before the end of the year and adverse risk sentiment, poses upside risk to repo. Therefore, global inflation and funding risks suggest that policy should at least remain restrictive - with pressure to keep the real repo rate around 2.5%. This also suggests that the cutting cycle that we anticipate from the middle of 2024 should 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 in October 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, but the opposite has occurred. We believe that the loosening of financial conditions in recent months 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 other developed markets, particularly in the 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 PBoC ease monetary policy conditions further by slashing several different interest rates. However, continuing weakness in coincident to lagging economic data, particularly sluggish consumption expenditure amid pre-payment of mortgages by locals, highlights a potential confidence issue in the broader economy. 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.
• 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.

Rand Cost Averaging and our behavioural biases

There is no doubt that the last three years have been volatile, and our analysis of ASISA unit trust data shows what we know to be true, which is that during times of uncertainty, and especially after market declines, we are reluctant to invest in risky assets - and often sell out at the worst times to do so.

The chart below highlights the importance of staying invested, and how time in the market compounds your initial investment. Market returns are heteroskedastic in that their volatility changes over time, and volatility clusters - meaning extreme movements are often followed by more extreme movements. While this can be stressful, it also means that during periods with extreme negative moves, you are also more likely to see extreme positive moves - so, selling out of equity markets to 'cap your losses' can not only crystallise losses, making them more difficult to recover, but it also reduces your exposure to potential shorter-term market recovery. This is further illustrated in the graph below where missing the best five days in the market over the ~21-year period would have reduced the value of your investment by almost a third.

R1000 invested in the ALSI from 28 June 2002 to 4 April 2023

Understanding the biases we are subject to is really valuable as investors, because it allows us to use objective data to formulate strategies that work to overcome them and serve us best over the long term.

Behavioural finance, the study of how our psychology influences our financial decision making, shows that we are subject to a number of these biases, some of which are

1. We are bad at forecasting the future - and are disproportionately influenced by past performance;

2. We dislike losses more than we like gains; and

3. We are subject to regret aversion - to avoid the emotional pain of making a decision that turns out to be the wrong one, so we do nothing.

The chart to the left illustrates the strategy, assuming the investor buys into FNB Growth on the last day of every month over the last year. Using RCA keeps the investor buying into the unit trust despite the decline between March and June 2022, 'averaging down' their investment cost. However, since forecasting performance over short periods is a fraught affair, we keep phasing the investment in while the price is rising.

FNB Horizons Growth 1-year Performance

As mentioned above, RCA is most useful for reducing volatility in the early stages of an investment when market moves can most impact the value of your funds.

For example, we look at all 90-day investment outcomes from investing in FNB Growth. While two thirds of the time investments have grown by 0-10% in 90 days, in 27% of the time investments have declined by up to 10% over this short period. As highlighted earlier, that can be stressful. However, it is important to keep a long-term perspective, and in the RCA strategy, rather than all your funds being invested 90 days prior and suffering these short-term losses, you have the diligence to continue phasing your investment in, now buying the same investment at cheaper prices.

90 day outcome of R10,000 in a High Equity Unit Trust

Let's compare the two strategies over a longer period of five years, looking at the performance of FNB Growth. The RCA strategy involves investing R1 000 per month x 60 months, giving a balance on 31 March 2023 of R75,982. While the fund would have outperformed this strategy over five years (more time in the market means more time for investments to grow, and compound), this would have required a lump sum investment of R52,264 in 2018, and along the way it would have resulted in some significant short-term losses, like during the Covid-19-induced market crash of 2020.

Example: Invest R1000pm in FNB Growth from March '18 - March '23

Is RCA a suitable strategy to avoiding these losses as much as possible? The graph below shows the maximum drawdowns1 of the lump sum and RCA strategies. While a lump sum investment is sensitive to entry price, a RCA strategy can result in less sensitive drawdown profiles. Because the investment account is regularly being topped up, with the 'entry price' being averaged down during period of drawdowns, the investor can experience smaller drawdowns - and less time in the red.

Maximum Drawdowns

Not only is your journey as an investor smoother, particularly over the early years of your investment, but using this strategy sets you up to form good financial habits. Investing is a long-term game, and for you to get the most benefit over the long term, it requires you to start early and invest regularly

For more information regarding your investment, please contact your Portfolio Manager directly

Regards

FNB