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Market Overview - August 2023

Market Overview

Global markets delivered a strong performance in July, maintaining upward momentum as a further recovery in risk-on sentiment bolstered flows into most regions, especially emerging markets (MSCI World: +4.7%, MSCI Emerging Markets: +5.8%). The CNN Fear & Greed Index, a measure of sentiment/mood, has moved into "extreme greed", which also shows that market participants are very optimistic. Investors remain upbeat about the prospect of a US Federal Reserve rates pause and the US avoiding a deep recession. Inflation readings have improved significantly, following an aggressive series of rate hikes (500bps over the past 18 months), but the labour market has thus far remained strong. The Citi Bank Economic Surprise Index for US has reached multi-year highs, alleviating recession fears. In addition, expectations for further stimulus out of China (MSCI China +7.7%) in the second half of the year provided an additional boost to global equities.

US markets rallied, with the S&P 500 locking in gains of ~4.8% (at the time of writing) amid a positive performance across most sectors as opposed to being dominated by tech stocks, as seen in the prior months. The 2Q23 earnings season provided a positive boost to markets and generally upbeat economic data provided further support. The most recent GDP reading (2Q23: +2.4% q/q, higher than 2% in the previous period and well above market expectations of 1.8%) showed that the US economy remains resilient despite experiencing one of the most aggressive rate-rising cycles in 40 years. Hiring has slowed but remains strong and the unemployment rate is still close to a record low. In terms of policy movements, the US Federal Reserve pushed through a widely anticipated 25 basis point interest rate hike at the July meeting, raising its benchmark borrowing costs to the highest level in over 22 years. Fed Chairman, Jerome Powell's, messaging was balanced, noting that inflation has moderated somewhat but still has a way to go to meet the Fed's 2% target. While any future monetary policy decisions will be data driven, expectations that the Fed is close to peak rates or has already reached the end of the cycle have strengthened further.

In the Euro Area, the Stoxx 600 (+3.4%) also benefitted from the change in sentiment, however, upside potential was weighed on by weak economic data and ongoing concerns surrounding sticky inflation numbers. The European Central Bank (ECB) raised interest rates by 25 basis points last week (as expected), marking its ninth consecutive rate hike. ECB President, Christine Legarde, noted that inflation is still expected to remain high for an extended period despite the recent slowdown. The ECB is committed to following a "data-dependent approach" for future rate decisions and said that rates would be set at sufficiently restrictive levels for as long as necessary to bring inflation back to its 2% target. Lagarde's statement removed wording that explicitly said that rates will be hiked again. Hence, investors interpreted this as a sign that the ECB could pause if inflation continues to come down and the European economy weakens further. Thus far, ECB officials have implemented a 425-basis point increase in rates since July 2022 - the fastest tightening pace in its history.

The JSE (All Share Index: +5%, +11.4% in USD terms) benefited from the positive performance seen in global markets, with expectations for further stimulus out of China being supportive of local commodity exporters. Fading concerns surrounding local political issues and structural headwinds continued to fade, providing further thrust. The "mighty ZAR" has seen a solid recovery as well (appreciated ~6% against the USD) and was among the top performers in the emerging market basket. The South African Reserve Bank (SARB) kept the repo rate unchanged at a 14-year high of 8.25% during its July meeting, matching expectations, and marking a pause in its tightening cycle after ten consecutive hikes. The decision came after recent CPI data showed that inflation slowed further in June to its lowest rate in 20-months at 5.4% and within the SARB's 3% to 6% target range. Reserve Bank governor, Lesetja Kganyago, noted, however, that this was not necessarily the end of the hiking cycle but said that future Monetary Policy Committee (MPC) decisions would be data dependent.

Economic data overview

The US Federal Reserve has adopted a less aggressive stance as inflation continues to taper

Flash estimates showed that the S&P Global Composite PMI for the US decreased to 52.0 in July, from a final reading of 53.2 a month before. The latest reading indicated the softest pace of expansion in private sector business activity since February, with service activity growth easing to a five-month low, and manufacturing output levels remaining relatively unchanged. Retail sales for June increased 1.5% y/y, lower than expectations (1.6%). In May, the trade deficit narrowed to $69 billion, in line with market forecasts, as imports and exports declined 2.3% and 0.8%, respectively. The unemployment rate in June decreased to 3.6%, in line with market expectations. Annual inflation declined to 3%, the lowest since March 2021, compared to 4% in May and expectations of 3.1%. The Fed raised the target range for the federal funds rate by 25bps, in line with expectations, bringing borrowing costs to the highest level since January 2001. Policymakers also said they will continue to monitor the implications of incoming information for the economic outlook and would be prepared to adjust the stance on monetary policy as appropriate if risks emerge that could impede the attainment of inflation and employment goals. The Fed resumed the tightening campaign after a pause in June, while noticing the economy has been expanding at a moderate pace, job gains have been robust in recent months, and the unemployment rate has remained low, while inflation remains elevated.

Future rates hikes will be data dependant according to recent commentary from the ECB

On a preliminary basis, the HCOB Eurozone Composite PMI decreased to 48.9 in July, compared to 49.9 a month before. This was below expectations of 49.7. Retail sales in May was down 2.9% y/y, compared to forecasts of a 2.7% decline. A trade deficit of €0.3 billion was recorded in May, compared to forecasts of a $7.6 billion deficit, as imports tumbled 12.8% and exports declined 2.3%. The unemployment rate stood at 6.5%, in line with market estimates. Consumer price inflation for June came in at 5.5%, in line with consensus expectations. The European Central Bank (ECB) raised its key interest rates by 25bps during its July meeting, a ninth consecutive rate hike, saying inflation is still expected to remain too high for too long despite the recent slowdown. This brought the rate on main refinancing operations to 4.25%, the highest since October 2008, and the rate on the deposit facility to an over 22-year high of 3.75%. The ECB has also committed to following a "data-dependent approach" to future rate decisions and said that rates would be set at sufficiently restrictive levels for as long as necessary to bring inflation back to its 2% target.

The BoE is expected to raise rates to 5.25% at the upcoming meeting as high inflation persists

Initial reports showed that the S&P Global/CIPS UK Composite PMI fell to 50.7 in July, missing market expectations of 52.4. Retail sales decreased 1% y/y in June, compared to forecasts of a 1.5% drop. In May, the trade deficit widened to 6.58 billion as exports declined 2.6% and imports fell 3.1%. Above market expectations, the unemployment rate came in at 4%. Annual inflation in the UK dropped to 7.9% in June, slightly below market expectations. The Bank of England (BoE) raised the bank rate by 50bps in June 2023, marking its thirteenth consecutive rate increase. Policymakers have also pledged to deliver further rate hikes if the ongoing inflationary pressures persist. The BoE began hiking rates nearly a year and a half ago, making it the first major central bank to take such action and resulting in the fastest policy tightening in over 30 years.

Generally soft economic data out of China bolsters expectations for further stimulus

China's composite PMI slipped to 52.5 in June, from 55.6 a month before. This was the sixth straight month of growth in private sector activity but the softest pace since January, with the service sector expanding the least in six months, while manufacturing grew for the second month in a row. Retail sales slowed 3.1% y/y in June, falling short of the market consensus. Below market forecasts, the country's trade surplus increased to $70.6 billion in June. Urban unemployment stood at 5.2% in June. China's annual inflation unexpectedly flattened in June, missing market expectations and May's figure of a 0.2% rise. The People's Bank of China (PBoC) maintained lending rates at the July fixing after the central bank earlier in the week kept its medium-term policy rate unchanged despite further signs of stalling economic recovery that may call for more stimulus.

The Bank of Japan (BoJ) guided for a moderate recovery in the economy amid pent-up demand

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Early estimates showed that the Jibun Bank Composite PMI reading in July was 52.1, unchanged from a final 52.1 in the prior month. This was the seventh straight month of growth in private sector activity but remained at the softest pace since February amid lingering global economic uncertainty, with the services sector growing for the 11th straight month while manufacturing activity contracted for the sixth time so far this year. Retail sales for June increased 5.9% y/y, in line with expectations. Japan recorded a trade surplus of ¥43 billion in June. This was better than an estimated deficit of ¥46.7 billion. The unemployment rate stood at 2.6%, in line with forecasts. Annual inflation edged to 3.3% in June, missing market forecasts of 3.5%. The BoJ kept its key short-term interest rate unchanged at -0.1% and that of 10-year bond yields at around 0% at its July meeting by unanimous vote but decided to make its yield curve control policy more flexible amid efforts to improve the sustainability of stimulus policy. The board added that the 0.5% ceiling on yield movements was a reference point rather than a rigid limit. Meanwhile, the BoJ viewed the economy as likely to recover moderately, supported by pent-up demand. Regarding inflation, the y/y rate of CPI is likely to decelerate, on the waning effects of past rises in import prices. The board mentioned it will continue expanding the monetary base until inflation exceeds 2% and stays stably above the target. The committee reiterated it will take extra easing measures if needed.

In South Africa, inflation dropped to a 19-month low with a recovery in risk-on sentiment globally providing further uplift in the local market

The SACCI business confidence index fell to a nine-month low of 106.9 in May, while the leading business cycle indicator dropped 1.7%, as sentiment in South Africa was impacted by lower trade volumes, fewer inbound tourists and a weaker rand compared to other major trade and investment currencies. Retail sales contracted 1.4% y/y, marking the sixth consecutive decline in retail activity and slightly worse than market expectations of a 1.1% decrease. SA recorded a trade surplus of R10.2 billion, well ahead of forecasts (+R6 billon). Mining production decreased 0.8% y/y, against expectations of a 1.4% increase. Growth in manufacturing production slowed to 2.5% but was still better than expectations (+2.3%), as industrial activity stood firm despite load-shedding headwinds. The value of recorded building plans passed in SA's larger municipalities declined 2.8%.

The composite PMI edged higher to 48.7 (May: 47.9), as new business intakes fell at a softer pace, with companies benefitting from reduced levels of load-shedding. Manufacturing PMI, however, decreased to 47.6 amid weaker domestic demand and a downturn in exports. Total new vehicle sales increased 8.3% to 46 810 units as the second-hand market remained tight. Consumer price inflation (CPI) dropped to a 19-month low of 5.4% (consensus of 5.6%) and is now just within Reserve Bank's target range of between 3% and 6%. This was mainly due to a slowdown in the rising costs of food, household content, clothing and transport. Core inflation edged lower to 5%, while producer price inflation (PPI) slowed to 4.8% (compared to 7.3% a month before) amid weaker growth in various raw material prices.

The SARB left its benchmark interest rate unchanged at 8.25% during its July meeting, in line with expectations. This was the first pause in its hiking cycle since policy implementation, however, Reserve Bank Governor, Lesetja Kganyago, warned that it was not necessarily the end.

Market Outlook in a nutshell

Local

• The latest round of forecasts from the IMF shows continuous improvement in global growth expectations. The IMF now predicts growth of 3.0% this year, better than the previous expectation of 2.8%, but still a moderation from 3.5% last year and the pre-pandemic average (2000-2019) of 3.8%. Conversely, inflation is projected to remain above the 3.5% average recorded prior to the pandemic, despite slowing from 8.7% in 2022 to 6.8% in 2023, and 5.2% in 2024.
• Elevated global inflation, in the context of supply chain reconfiguration and climate change, will apply upward pressure to local inflation. Fortunately, a lower intensity of load-shedding as well as an El Nino impact that may be mitigated by the fading prolonged La Nina phase, which has improved soil moisture and dam levels, should assist in avoiding a further lift in input cost pressures. We preliminarily predict headline inflation of 6.0% on average this year, slowing closer to target at around 4.8% in 2025.
• The repo rate was left unchanged at 8.25% at the July MPC meeting, but the MPC asserted that this was not the end of the hiking cycle, leaving room for further responses to adverse data outcomes. An official halt to the hiking cycle would be supported by improvement in risk sentiment, a stronger rand, and continued downside inflation surprises – with inflation now within the target band. However, a further lift in inflation expectations, especially with 2024 global and local expert inflation forecasts being revised upwards, tighter monetary policy in advanced economies, fiscal slippage, and political fallouts, will keep the MPC unnerved and ready to resume the hiking cycle. For now, we foresee SA to have reached peak interest rates.
• The prevailing cost of living crisis and depressed consumer confidence point to constrained household consumption expenditure growth. In addition, net trade benefits will be restricted by logistical inefficiencies amid less supportive global activity. Therefore, we maintain our view that the ongoing replacement cycle and investments in energy supply will be the primary driver of growth this year. We preliminarily anticipate meagre average growth of 0.2% this year, higher than the -0.1% predicted previously and on account of better 1Q23 outcomes.
• Growth is predicted to lift to around 1.5% on average over the period to 2025, supported by improving global activity and easing local infrastructure inefficiencies.

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.
• At the moment, 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, this may prevent price discovery from emerging in the short-term. Similarly, it is worth noting that the Fed has articulated that they need to tighten financial conditions, but the reverse has indeed occurred.
• Against this backdrop, we believe that the loosening of financial conditions in recent months will likely embolden the Fed to tighten interest rates further as we progress into the second half of the year, as this will likely be needed to bring core inflation levels down to more sustainable levels.
• In emerging markets, it is certainly encouraging to see the People's Bank of China ease monetary policy conditions further by slashing several different interest rates. However, 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 attractive with a higher yield offering compared to most sovereign bond curves without taking on too much duration risk.

Come on Barbie, let's go party?

Greta Gerwig's much anticipated Barbie movie has surpassed lofty box office expectations, with its opening weekend grossing over half a billion United States (US) dollars worldwide. The movie had the most successful opening weekend of any film in the US so far this year and is on-track to become one of the highest grossing films for 2023 after its run-in theatres ends in a couple of months' time.

The success of the movie followed an intense marketing drive spearheaded by Warner Bros and the iconic doll maker, Mattel, that leveraged the brand equity already attached to the name, spanning experience-based events, and merchandising with Barbie branded goods taking up substantial real estate in shops across the globe.

The movie and promotional activity prior to its release has also piqued investors interest - with analysts following Barbie merchandising across clothing retailers to predict who would benefit from higher sales related to the movie's release, a new interest in experience-based companies like movie creators and distributors, as well as exploring toy makers themselves.

The global toy market

Toy companies are in a unique position where brand loyalty is substantial, and income tends to be quite steady. According to Circana, global toy sales reached $107.4 billion in 2022, posting a 1.5% growth over 2021. The compounded annual growth rate for the global toy market was 3.5% over the five-years since 2017.

The toys and games segment has four key players globally being Lego, Bandai Namco, Hasbro, and Mattel. Lego is a private, family-owned company and its success since its founding in 1932 has been unsurpassed. The next three largest companies are all listed. Tokyo-listed Bandai Namco boasts brands such as Pac-Man and Tekken, Hasbro is US-listed with its major brands including Monopoly and Transformers, and Mattel is also US-listed with Barbie and Hot Wheels dominating its portfolio.

Long term, the growth in global revenue in the toys and games market will be driven by higher disposable income in developing countries such as China, Brazil, and India, and population growth in Southeast Asia and Africa.

Near term, merchandising opportunities and partnerships are the main growth vector for toy companies, with tie-ups across retail and entertainment providing additional revenue streams outside of the traditional manufacturing and sales of the physical toy. Lego, as an example, saw its namesake movie gross close to $468 million followed by collaborations with franchise giants including Frozen, Star Wars, Harry Potter, Spiderman, and Batman. Lego has also pivoted, quite successfully, into the so-called “kidult” market with more complex offerings like the Agricultural and Technic ranges appealing to a new market with actual buying power.

The listed players

Share price performance

Among the listed companies, Bandai Namco has comfortably outperformed the other two major toymakers over the last decade and over a five-year period. More recently, Mattel has outperformed -on the expected and realised success of the Barbie movie.

Investors have been speculating for years over a potential merger between Mattel and Hasbro and the possibility received new attention after the two companies entered into a multi-year licensing agreement to create co-branded toys and games. Hasbro is now selling Barbie-branded Monopoly games and Mattel will produce Transformers-branded UNO games as well as Transformers-branded Hot Wheels vehicles set to be released later this year and early in 2024. For now, analysts are unsure over whether this means a merger is on the cards or if this effectively shelves it for now. From our perspective, we think that a merger could be advantageous but has become less necessary for individual and shared growth (through collaborations) for the two companies.

Financial performance

Over the last five years, there have been a few major events that shaped the direction of the major listed toy companies. In the US, 2018 was an exceptionally tough year after the liquidation of Toys R Us - effectively removing one of the largest toy sellers from the lucrative US market. The going was exceptionally tough for Mattel and Hasbro who, at the time, generated ~50% of their revenues in North America. The impact was compounded for Mattel when it was announced that it lost its DC Comics license to Spinmaster later that year. The share price hit an 18-year low shortly after the announcement.

The Covid-19 pandemic initially caught toymakers off guard as supply chain disruptions and lockdowns impacted sales. The move to online channels, however, and the need for parents to provide stimulation for their children at home saw sales pick up meaningfully towards the end of 2020 - particularly in “trusted” brands. The “kidult” trend also gained momentum and demand for toys in this segment of the market also spiked. Thereafter followed a normalisation in sales. All the while toymakers have been in the process of repositioning themselves to tap into the entertainment market, with licensing agreements made and lost in the process.

Over the last five years, Bandai Namco has been the clear winner in terms of revenue growth helped by its strong gaming franchises through Covid-19, while Mattel has done the most to improve its bottom line from a deep loss in 2017 to a decent level of profitability in FY22. Looking ahead, only Mattel is expected to record revenue growth this year as the impact of the Barbie movie translates into solid merchandising and doll sales and Hot Wheels continues to perform well, while the macro-economic environment remains a constraint for other toymakers. Profitability will come under pressure across the board as input cost increases continue to bite - particularly in the context of soft revenues. An industry-wide top-line improvement is expected in FY24 with macro tailwinds. Mattel is set to report particularly strong earnings growth aided by productivity improvements, a cleaner balance sheet, a packed entertainment offering, and new licensing agreements with Disney and Hasbro.

Valuation

Consensus is broadly positive on all three stocks, with 63% of analysts holding a “BUY” recommendation on Bandai Namco (target price +13.4%), 77% on Hasbro (target price: +16.3%) and 84.6% on Mattel (target price: +15.8%).

In terms of valuation, Mattel has rerated recently but is still trading below its five-year average on an EV/EBITDA basis, while the rating for Hasbro has held steady and Bandai Namco has derated but remains elevated relative to its US peers.

We regard Mattel as best placed currently as it continues to capitalise on near-term tailwinds on top of a cleaner operating model and a balance sheet on more solid footing, enabling it to generate strong cash flows and accept new opportunities as they arise. The company also has limited gaming exposure where dynamics have deteriorated in a post-Covid world.

Disclaimer: All figures have been obtained from Bloomberg based on each company's latest financial results. Companies disclose degrees of geographic exposure in varying granularity, which may cause discrepancies, and figures obtained may be impacted by currency volatility and may not be representative of future exposures.

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

Regards

FNB