Weekly Market Report

6 June 2023

Global Report

Does the Global Financial Sector Offer Good Value for Investors?

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Local Report

The SARB Financial Stability Review on 29 May 2023.

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Market Indicators

Global and Local Indicators.

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Global Report

By Carel la Cock

The global financial sector, comprising a diverse array of financial companies, plays a crucial role in the health and development of modern economies. As one of the largest investable sectors globally, it presents numerous opportunities for investors seeking income and capital growth. The recent challenges faced by institutions like Silicon Valley Bank and Credit Suisse, have retail investors scratching their heads; is now a suitable time to increase exposure to the global financial sector?

Financial companies serve as the backbone of the global economy, providing essential services such as banking, insurance, asset management, and financial advisory. Their performance is often seen as a barometer of economic health, as the financial sector tends to thrive when the economy is doing well and suffer when the economy is struggling. Financial services stocks comprise large portions of world indices. The UK has traditionally been a financial powerhouse with 15% of the FTSE 100 comprising of financial stocks. The Euro STOXX contain 10% while the tech-heavy S&P 500 has 10%. Globally the financial sector makes up 15% of the MSCI World Index. Therefore, even for passive investors, the exposure to the sector can be significant.

Following the recent collapse of Silicon Valley Bank and Signature Bank in the US and the last-ditch rescue deal for Credit Suisse by UBS, some financial institutions are trading at historic low valuations both in absolute and relative terms, offering longer-term opportunities for investors. Despite US regulators and their counterparts in Europe moving swiftly to contain any systemic risk, investors have been dumping banking stocks with pessimistic zeal. However, multinational banks remain well capitalised and in a far better shape than during the global financial crisis in 2008.

One way for investors to tap into the potential of the global financial sector is through actively managed portfolios, such as the Polar Capital Global Financials Trust (PCFT). The PCFT aims to generate a growing dividend income along with capital appreciation by identifying the best investment opportunities in the world of financials. In a recent report, Nick Brind and George Barrow, co-Fund Managers at PCFT Financial, note that the global financial sector has strong forward earnings estimates and structural growth opportunities.

PCFT has a large weighting to banks at around 50% of the trust, but low exposure to the small and mid-size market capitalization US banks, which have seen the bulk of the recent sell-off. One of the reasons for the March mini-banking crisis was the “soft-touch” regulation following from the Trump administration. Smaller US banks will face more stringent regulation in the coming years, which will compress profit margins.

First quarter results from the large US multinational banks were encouraging. JPMorgan beat analysts’ forecasts and guided a 10% increase in full year net interest income expectations. They were clear winners from the mini-banking crisis and reported higher period end deposits compared to lower bank deposits for US banks overall. The impact of higher funding costs was most acute for smaller banks squeezing interest margins by 13 basis points in contrast to large banks who saw margins expand by seven basis points. Furthermore, non-performing loan ratios remained constant in the quarter, but shadows loom over the industry’s exposure to commercial real estate (CRE). While most of the downside risk in CRE lies in office and retail, it comprises a much smaller percentage of the overall loan book, compared to multi-family apartment blocks and warehouses.

Key holdings in the PCFT trust include JPMorgan, HDFC Bank, Chubb, Berkshire Hathaway, HSBC Holdings, Bank of America, Visa, AIA Group and Mastercard. Exposure to banks and the insurance sector is just over 70%, making up the bulk of its assets while there is bias towards North America (39%) and Asia Pacific (22%), geographically. PCFT is down nearly 9% year to date, trading at a 10% discount to net asset value (NAV), lower than its average over the last 12 months, while its NAV is down only 4% year to date. It has underperformed its benchmark the MSCI World Financials, but the value of a quality manager to navigate these turbulent times in the financial sector should not be discounted.

PCFT has been a key holding in our portfolios for many years; at current historic low valuations in the banking sector and optimistic longer-growth prospects there is a compelling case for increasing exposure at these levels.

Local Report

By Gielie Fourie

INTRODUCTION: This week we examine the SA Reserve Bank’s (SARB) Financial Stability Review (FSR) published last week, 29 May 2023. The FSR is an impressive document highlighting several serious risks to South Africa’s financial stability. It is available on the SARB’s website and on the SARB’s YouTube channel, which you can view here. The FSR’s candid and thorough analysis confirmed our recent resolve to adjust our own investing strategy. Below are some pointers from the FSR.

GOVERNMENT’S NEUTRAL STANCE ON RUSSIA: During her recent visit to South Africa in January 2023, the US Secretary of the Treasury, Janet Yellen, provided the following warning to South Africa: “My main message is that we take very seriously these sanctions that we’ve placed on Russia in response to its brutal invasion of Ukraine. Violation of those sanctions by local businesses or by governments –– we would respond to it quickly and harshly and we certainly urge that there be compliance with those sanctions.”

SECONDARY SANCTIONS: Numerous media articles published over recent months have highlighted the growing challenges posed by South Africa’s efforts to maintain its neutral stance on the Russia-Ukraine war. Remarks on 11 May 2023 by the US Ambassador, Reuben Brigety, to South Africa, could change perceptions about South Africa’s neutrality, which could build up to a point where it triggers secondary sanctions being imposed on South Africa. The diplomatic fallout resulting from the comments by the US Ambassador led to a sharp sell-off in the South African rand and its worst-ever level against the US dollar, trading at R19.51 to the US dollar on 12 May 2023. Secondary sanctions, in a nutshell, is the risk the government is taking with a “neutral stance” which most commentators interpret as code for “pro-Russian”.

NO MORE SWIFT: The FSR warned that should the risk of secondary sanctions materialise, “the SA financial system will not be able to function if it is not able to make international payments in USD. It could lead to a sudden stop to capital inflows and increased outflows.” Over 90% of South Africa’s international payments are processed by the Society for Worldwide Interbank Financial Telecommunication system, or Swift. “Exclusion from Swift would make such payments impossible. That would make it almost impossible to import things like oil and portable electronics and wheat and lots of other things that South Africa’s economy and society need but don’t produce”, the FSR’s lead author, Herco Steyn, was quoted as saying.

GREYLISTING: The effect of the recent FATF greylisting was relatively muted as expectations had largely been priced into financial markets. However, the potential implications for the South African economy are severe. Even in the absence of formal secondary sanctions, counterparts to South African financial institutions could put institutions under intensified scrutiny and decide to reduce their exposure to South Africa as part of their own risk management processes. A return to normality will depend on the speed and effectiveness with which South Africa can address the findings that led to the greylisting.

TYPICAL SA VULNERABILITIES: In South Africa, idiosyncratic factors continued to weigh on domestic financial sector resilience and overall economic growth prospects. The most notable country-specific vulnerability is the increasingly detrimental and widespread ramifications of an insufficient and unreliable electricity supply, while concerns over the deteriorating South African rail and port infrastructure networks also continue to grow.

DEBT BURDEN AND LESS FOREIGN INVESTORS: South Africa has one of the highest ratios of state-owned enterprise (SOE) debt among emerging markets. While Eskom remains the largest contributor to SOE debt, the debt burden of several other SOEs continues to weigh on the fiscus. Growing incidences of government taking over SOE debt are not helpful. Debt is naïvely moved around, while the total debt stays the same. It obviously increases the state’s debt burden, in turn further increasing the domestic financial sector’s exposure to government debt as the bulk of new issuances of government debt is nowadays being taken up by domestic investors – not by international investors as we experienced in the past. The SARB is alarmed by the dwindling appetite by international investors for new issuances of government debt. International investors would rather sell, than buy, SA debt. This structural shift is a major concern because there is doubt about the capacity of SA investors to continue absorbing new debt issuances in future.

OVERBERG ASSET MANAGEMENT’S NEW STRATEGY FOR SA FOCUSSED PORTFOLIOS: Against this background we at Overberg Asset Management continually monitor South Africa’s macroeconomic and political climate and the outlook for the future. Our slowing economic growth and lack of strong political leadership convinced us to de-risk our portfolios by conscientiously revising our investment strategy. New fixed capital investment projects within South Africa are diminishing, especially when compared to attractive offshore projects and opportunities. At the same time the investable universe of shares available on the JSE is dropping, making portfolio diversification challenging. Considering this, our new strategy will incorporate a selection of local exchange-traded funds (ETFs) that have underlying offshore exposure to different global regions and currencies.

To identify regions likely to yield favourable market returns, we will continue our global research. This research will aid in identifying regions and markets that show potential for generating satisfactory investment returns. Additionally, a portion of the portfolios will be allocated to a hedge fund. Hedge funds have been recognized as investments that consistently offer superior returns while maintaining low risk.

BOTTOM LINE: Our revised investment strategy will feature a blended mix of investments across various asset classes, aligning with the respective portfolio objectives. The implementation of this strategy will be carried out gradually over the next 6-8 months, commencing in June 2023. The new strategy is designed to enhance the protection of our investors’ wealth.

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Reference:Capital Economics – Historical bond and equity return data

The Bottom Line: Innovation and the Magic of Compounding

By Carel La Cock

The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.

Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.

After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.

Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.

As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.

Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.

Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.

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