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Market Overview - September 2023

Market Overview

Global markets swung into the red in August with the MSCI World Index and MSCI Emerging Markets Index trading down around 2.2% and 5.4% respectively towards the end of the month. Sentiment was mainly dominated by two key themes, namely the rate hike path in the US and weaker-than-expected growth in China. While market participants are of the view that recent stimulus measures introduced by the People's Bank of China (PBoC) are relatively conservative, Chinese authorities have promised to step up policy support and accelerate government spending as the post-Covid-19 economic growth trajectory has continued to disappoint the market.

US markets were under pressure for most of August but saw some reprieve towards the end of the month, with the S&P 500 trading down 1.5% at the time of writing. Policy speculation remained at the forefront, with US Federal Reserve Chair Jerome Powell's speech at the Jackson Hole Symposium reaffirming that the Fed remains hawkish. While any further action will be data dependent, Powell was clear that the Federal Open Market Committee (FOMC) is "prepared to raise rates further if appropriate" and intends "to hold policy at a restrictive level" until the inflation outlook is sustained at around the 2% level. The US economy remains resilient and hence policy rates are expected to remain elevated for the remainder of 2023 and into the first quarter of 2024. However, recent labour data showed a decline in US job openings, which could be a sign that the jobs market is softening after remaining incredibly resilient despite slowing economic growth and restrictive monetary policy. The market is currently pricing in a 11.8% probability of a hike in September, a 39.1% chance of a hike in November, and a much higher likelihood that cuts could start as early as March next year.

Moving over to the Asia Pacific region, the Chinese market (MSCI China Index: -8%) remained under strain and was one of the worst performing within the emerging market basket. Economic data releases from the world's second largest economy have generally been softer than expected, confirming that additional intervention is required not only on the monetary front, but in the form of extra fiscal thrust as well. Monetary authorities have already beefed-up support through a range of measures including the reduction of short- and medium-term lending rates, injecting liquidity into the economy, and support for the local currency. Analysts are now expecting a cut in reserve requirements in the fourth quarter and a possible (long-term) interest rate cut this year. Recent pledges made by the finance minister and the chairman of the National Development and Reform Commission sparked notions that Chinese authorities may be becoming more proactive in fiscal intervention in the economy. The health of the Chinese economy is of vital importance to the global growth outlook and demand for commodities.

The JSE (All Share Index: -4.4%, -8.6% in USD terms) tracked global peers lower as investors remained focused on the key issues dominating global markets. The rand experienced large swings against the greenback (a function of US dollar strength and general weakness among commodity producer currencies, amplified by general risk-off sentiment), breaching the R19 to the dollar mark earlier in the month, but has since strengthened to around R18.68/dollar. In terms of local economic data, CPI was lower than expected at 4.7% in July from 5.4% in June. The slowing in inflation closer to the 4.5% target, should support gradually lower inflation (and interest rate) expectations over time but monetary policy in the US, adverse risk sentiment should China's prospects not improve, and SA's fiscal outlook worsening, may suggests that local rates will remain restrictive going into 2024, when potential easing comes into the narrative.

Economic data overview

The US Federal Reserve will maintain a restrictive stance until inflation reaches the target range

Flash estimates showed that the S&P Global Composite PMI for the US decreased to 50.4 in August, below expectations. The latest reading indicated the softest pace of expansion in private sector activity since February, with a contraction in the manufacturing sector accompanied by lower service sector output. Although annual inflation picked up to 3.2%, this was still lower than the forecasted figure of 3.3%. Retail sales in July increased 3.2% y/y, compared to the 1.6% rise a month before. This was well ahead of expectations. Back in June, the US trade deficit improved to $65.5 billion (consensus: deficit of $65 billion), as imports edged 1% lower y/y, while exports dipped marginally by 0.1% y/y. The unemployment rate in July decreased to 3.5%, slightly better than expectations. At the recent Jackson Hole Economic Symposium, Fed chair, Jerome Powell, suggested that further rate hikes are still necessary to manage sticky inflation, and that while the central bank would continue to evaluate all available signs before making a certain decision, it seems likely that rates will be held steady at the next meeting in September. The central bank remains committed to achieving its inflation target of 2%.

The European Central Bank's (ECB) rate hike pushed interest rates to its highest level since 2008

On a preliminary basis, the HCOB Eurozone Composite PMI decreased to 47 in August, compared to 48.6 a month before. This was below expectations of 48.5. This reading is indicative of the sharpest contraction in private sector activity since November 2020. Services output fell for the first time since December 2020, while manufacturing output contracted at the second-strongest pace over the past eleven years. Retail sales in June were down 1.4% y/y, compared to expectations of a 1.7% decline. A trade surplus of €23 billion was recorded in June, compared to consensus estimates of a $18.3 billion surplus, as imports tumbled 17.7% y/y and exports inched 0.3% higher. The unemployment rate in June stood at 6.4%, below market estimates of 6.5%. Consumer price inflation for July came in at 5.3%, in line with consensus expectations. The ECB raised its key interest rates by 25bps to 4.25%, the highest since 2008, as expected. Speaking at the Jackson Hole Economic Policy Symposium, ECB President, Christine Lagarde, said that interest rates in the Euro Area will remain high as long as necessary to slow the still-high inflation.

The Bank of England (BoE) will ensure that bank rates remain sufficiently restrictive as core inflation remains sticky

Initial reports showed that the S&P Global/CIPS UK Composite PMI fell to 47.9 in August, missing market expectations of 50.3. Retail sales decreased 3.2% y/y in July, compared to forecasts of a 0.5% drop. In June, the trade deficit shrank to £4.8 billion from an upwardly revised £7.7 billion in May, as exports remained flat m/m and imports fell 3.9%. The unemployment rate came in at 4.2%, above market expectations. Annual inflation in the UK dropped to 6.8% in July, in line with market expectations. The BoE raised the policy rate by 25bps, marking the fourteenth consecutive rate increase, also in line with market expectations. The decision was spit 6-3 in favour of the 25bps hike, with two members voting for a 50bps hike, and one preferring a pause. The BoE noted that rates are now in restrictive territory, and that it intends to make sure that the bank rate is sufficiently restrictive for as long as is needed for inflation to return to the 2% target. The central bank now expects inflation to fall to around 5% by year end.

Chinese authorities are expected to be more proactive in terms of fiscal intervention

China's composite PMI slipped to 51.1 in July, from 52.3 a month before, and below forecasts of 52. This was the lowest reading since December 2022. The outcome was underpinned by a contraction in factory activity for the fourth straight month, and the lowest expansion in the service sector in seven months. Retail sales increased 2.5% y/y in July (+3.1% y/y in June), far below market consensus of 4.5% growth. Ahead of market forecasts, the country's trade surplus increased to $80.62 billion in July as exports fell more than imports amid persistently weak demand from home and abroad. The surveyed urban unemployment inched higher to 5.3% in July. China's consumer prices fell 0.3% y/y into deflationary territory, coming in below market expectations and June's figure of 0%. The PBoC cut its one-year loan prime rate (LPR) by 10bps to 3.45%, a record low, while the one-year medium-term lending facility rate was slashed by 15bps. However, the five-year rate was maintained at 4.2%. The PBoC has promised measures to release more liquidity for the economy, as it seeks to strike a balance between stimulating the ailing economy and stemming further weakness in the yuan.

Japan has a positive economic outlook, with the moderate recovery being supported by pent-up demand

Early estimates showed that the Jibun Bank Composite PMI reading in August was 52.6, up from a final reading of 52.2 in July, flash data showed. This was the eighth straight month of growth in private sector activity, and the sharpest increase in three months, with the services sector driving growth for the third straight month in a row, while manufacturing activity contracted for the third month running. Retail sales for June increased 5.9% y/y, in line with market consensus. Japan also unexpectedly recorded a trade deficit of ¥78.73 billion in July, against market expectations of a ¥24.6 billion surplus. The unemployment rate fell to 2.5%, in line with consensus expectations. Annual inflation stood at 3.3% in July, missing market forecasts of 3.1%. The Bank of Japan (BoJ) kept its key short-term interest rate unchanged, in line with market expectations. The BoJ decided to make its yield curve control policy more flexible amid efforts to improve the sustainability of stimulus policy. The bank's outlook on the economy is positive, with a moderate recovery expected amid pent-up demand. The board has reiterated its goal of expanding its monetary base until inflation exceeds the 2% target.

In South Africa, inflation dropped to a two-year low amid a slowdown in food, transportation and fuel costs

The SACCI business confidence index improved to 108.8 (though the leading business cycle indicator edged 0.1% lower) in June, but thereafter dropped to 107.3 in July as the higher cost of borrowing continued to weigh on sentiment locally. Retail sales contracted 0.9% y/y, slightly worse than expectations of a 0.2% decrease, but this was much better than the 1.6% drop the month before. SA recorded a trade deficit of R3.5 billion, which was well below forecasts of a R11.9 billion surplus. This was due to an 8.6% decline in exports amid lower shipments of vehicles and transport equipment, mineral products, precious metals and stones, as well as base metals.

Mining production rose 1.1% y/y, against expectations of a 0.2% increase. Growth in manufacturing production improved to 5.5%, better than expectations (+3%). As expected, composite PMI edged lower to 48.2 (June: 48.7), while manufacturing PMI decreased to 47.3 (June: 47.6) as elevated prices, weak confidence and lingering capacity constraints weighed on overall demand. Total new vehicle sales dropped 7.3% to 43 389 units as elevated financing costs continued to weigh on consumers. The value of recorded building plans passed in SA's larger municipalities climbed 10.8%, following a sizable slump (-12%) the month before. Encouragingly, consumer price inflation (CPI) in July dropped to a two-year low of 4.7% (consensus of 5%) and sits comfortably within the Reserve Bank's target range of between 3% and 6%. This was mainly due to a slowdown in the rising costs of food, transportation and fuel. Core inflation (which excludes the price of food, non-alcoholic beverages, fuel and energy) was also at 4.7%.

Market Outlook in a nutshell

Local

• The weakness in the domestic economy highlights the binding constraint of prevailing electricity and logistics challenges, which are exacerbated by higher inflation and restrictive monetary policy. Furthermore, SA's growth prognosis is weighed on by slower global demand and trade activity. This view is echoed by the prolonged annual decline in the composite business cycle leading economic indicator, which suggests a high probability of economic weakness in the near-term. Confidence indices were more subdued in 2Q23 relative to the prior quarter, reflecting less willingness to spend on big-ticket items or make significant broad-based investments. Nevertheless, investment growth is supported by the ongoing replacement cycle and efforts to increase the supply of energy. We expect load-shedding (predominantly stages 4-6) to persist well into the 1H24, before gradually easing as private-sector energy generation comes online. Therefore, the near-term outlook is characterised by higher investment growth, which mitigates weaker household spending. In line with this, we see meagre GDP growth of 0.2% in 2023, before lifting to 1.0% in 2024, and stabilising at 1.8% in 2025 and 2026.
• Having experienced the highest annual inflation since 2009 last year, we have benefitted from base effects that have pulled inflation down in the few months to July. In particular, the food and fuel price shocks that lifted headline inflation from the middle of 2022 are pulling in the opposite direction. Underlying inflation has lifted on the passthrough of price pressures at the ports, factory gates, and retail stores, but the extent has been less severe than initially expected and weakening consumer fundamentals should generally weigh on pricing power. We forecast average headline inflation of 5.9% this year, before gradually falling to the SARB's preferred target of 4.5% by 2026.
• As inflation continues to slow, we see real interest rates climbing further above the neutral level into the middle of 2024, further restricting economic activity and amplifying the gravity pull on inflation. At that stage, the MPC would be able to initiate a cutting cycle. We predict a cutting cycle starting in July 2024, after the elections and the potential lift in the risk premium at around that time, but the consensus of analysts highlights that it could be as early as at the start of 2024. Nevertheless, the cutting cycle should be shallow, with the repo settling at 7.0%, as global inflation risks remain elevated amid weakening co- operation and climate challenges - falling in line with the higher-for-longer theme.

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.

Beauty is in the eye of the beholder: ESG ratings dispersion on the FTSE/JSE Top 40

One of the major stumbling blocks in making investment decisions within an Environmental, Social, and Governance (ESG) framework is that there remains great uncertainty among investors as to how best to measure whether a company rates highly or not when it comes to ESG factors. There is often discordance between how different ESG ratings providers rank specific companies. In this publication, we evaluate how three large ESG ratings providers score the largest 40 companies on the Johannesburg Stock Exchange (JSE) - and whether they agree with each other.

This is a critical point of investigation, as ESG ratings firms can decide the fate of an investment. Where an exclusionary approach is adopted by the investor, a poor rating may cause a disinvestment, or strike a potential new investment, and where index providers use ratings agencies to determine a company's inclusion into their ESG index, a poor rating by one chosen provider can see exclusion from the index, and ultimately see lower flows into a company's shares.

Introduction to ESG scores

For the purposes of this exercise, we made use of three scores: MSCI's ESG Rating, Morningstar's Sustainalytics ESG Risk Scores, and S&P Global's ESG Rankings. All ratings were sourced from Bloomberg as of July 2023.

An issue when comparing ratings from different providers is that they follow their own ratings frameworks - using different data sources, employing varying methodologies, and ultimately generating scores using different scales and systems, that can be challenging to directly compare. This can also lead to materially different ratings being awarded.

MSCI uses categorical ratings variables, like their approach when awarding credit ratings, while S&P Global provides a numerical ranking of 0 to 100 (with 100 being the best). Sustainalytics employs an altogether different approach, where ratings reflect ESG risk - so a higher score reflects a higher degree of material risk to which companies are exposed and there is no upper bound to how badly a company can score. Sustainalytics calculates this exposure by determining the amount of ESG that a subindustry is exposed to, dividing these into manageable risks and unmanageable risks, and adjusting for the extent to which there are shortcomings in company policies and practices. S&P Global's approach is to collect data points from companies through surveys, covering topics across each of the three ESG pillars, while MSCI collects data from company disclosure and other objective third-party datasets, giving companies the opportunity to verify data - rather than collecting it from them firsthand.

The JSE Top 40, Rated

ATo enable better comparability between the three scores, we converted MSCI's ratings from categorical variables to numerical variables on a scale of 0 to 100, and converted Sustainalytics' risk scores to the same scale, such that a higher score also means a better ranking. The median rating from each provider was 86.5 (MSCI - corresponding to a rating of AA), 86 (S&P Global), and 54 (Sustainalytics, corresponding to a risk rating of 22.8). Even from this one data point, divergences in ratings exist - MSCI and S&P Global appear to rate the (equally-weighted) Top 40 more favourably than Sustainalytics, with its rating of 'Medium' risk.

The worst-rated companies received ratings of 29.5 (MSCI - BB), 18 (S&P Global), and 19.8 (Sustainalytics). MSCI and S&P Global both agreed that this company was Reinet Investments SCA, and although Sustainalytics does give this counter a poor score of 36.5 (with a 'risk' rating of 31.7), their worst-rated company was Bidvest Group Ltd.

The best-rated companies received ratings of 97 (MSCI - AAA), 100 (S&P Global), and 78.9 (Sustainalytics). Here, Sustainalytics and MSCI agree that NEPI Rockcastle NV take this position, while MSCI, in addition, awarded AAA ratings to Mondi PLC, Nedbank Group Ltd, Vodacom Group Ltd, and Woolworths Holdings Ltd. These companies all receive ratings of 'low' risk from Sustainalytics, to varying degrees, while S&P Global also awarded better scores to several companies not on this list. S&P Global's top scoring company was British American Tobacco plc, which was rated relatively poorly by MSCI and Sustainalytics.

Already we have seen several disagreements on individual names - but as it turns out, the Top 40, as a whole, is also rated quite differently by the three ratings providers.

Splitting each provider's ratings into four quartiles and plotting histograms can also help visualise how they have rated the Top 40.

Clearly differences exist in how each provider perceives and rates the largest companies listed on the JSE. S&P Global and MSCI see most of the Top 40 companies as ESG leaders, rating more than half the companies in their respective top buckets (AAA and AA for MSCI). S&P Global only rates one company in the bottom two buckets, the remainder receiving scores that fall in the second-best bucket. The challenge when evaluating these buckets again comes down to comparability - does a score of 70 from S&P Global align with an 'average' rating of A from MSCI? Or is it a 'leader' that would have an AA with MSCI?

Sustainalytics has a more pessimistic view, rating no companies of negligible ESG risk, and rating far fewer companies as low risk. Perhaps - with their distribution of ratings appearing much more evenly spread between high and low risk companies - it offers a more balanced view?

In terms of measures of correlation and concordance at an individual company level, Sustainalytics and MSCI appear to hold the closest views. MSCI's ESG scores are also slightly positively correlated with S&P Global's scores but shows a distinct lack of relationship with Sustainalytics' scores. Each ratings provider decidedly rates the Top 40 differently.

The dispersion in views expressed by rating providers is nothing new - we have seen these forces at play in credit markets before. After all, it is differing views that make the market. But it does ring a warning bell to investors content to rely on a service provider to provide a view: Your chosen ESG ratings provider might not hold the same view as others, and either may be wrong. As an investor, holding a stake in a company exposes you not only to equity market risks, but to ESG risks which may be company- or industry- specific. For this reason, no single score can be blindly trusted, but rather your fundamental analysis needs to incorporate the unique risks facing companies - especially during this time of increased ESG awareness.

Sources

Berg, F., Kölbel, J. F., & Rigobon, R. (2019). Aggregate Confusion: The Divergence of ESG Ratings. Forthcoming Review of Finance.

Dimson, F., Marsh, P., & Staunton, M. (2020). Divergent ESG Ratings. The Journal of Portfolio Management, 75-87.

MSCI ESG Research LLC. (2022, April). ESG Ratings Methodology.

S&P Global. (n.d.). 2023 CSA Methodology Update. Retrieved from S&P Global: https://portal.csa.spglobal.com/survey/documents/CSA_2023_ Methodology_Updates_Overview.pdf ?utm_medium=cpc&utm_source=google&utm_campaign=Brand_ESG_Search&utm_term=s&utm_ content=534418150272&gclid=CjwKCAjwloynBhBbEiwAGY25dLBQYNxq9bv4OmNc9tGDYN8zlde5Xg2oqt8

Sustainalytics. (2023). ESG Risk Ratings Framework. Retrieved from Sustainalytics: https://www.sustainalytics.com/esg-data#framework

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

Regards

FNB