Despite more clouds gathering on the horizon of global growth prospects during the third quarter of 2018, global equity market participants preferred to focus on continued strong profit growth numbers out of especially the US to register very strong returns over the period. The MSCI All Country World Index returned 4.3% over the quarter, almost matching the year-to-date number of 3.8%. At the same time, investors have had to adjust their interest rate expectations for the US upwards, as was discussed in a few of our earlier quarterly reports. This was in response to a US economy continuing to surprise on the upside in terms of growth and the sustainability thereof.

Going forward we will continue to monitor escalations in the trade war dialogue primarily between the US and China. Up to now the market has chosen when it becomes concerned about developments, and hence one should exercise judgement when headline-grabbing pronouncements are being made. As we argued in the prior quarter, we think the bigger issue that investors need to focus on is the process of interest rate normalisation playing out in the US. Ten-year yields in the US have moved from 2.9% at the end of June 2018 to 3.1% at the end of September 2018 and have subsequently moved to over 3.2%. Investors should be reminded that in Europe the process of interest rate normalisation has barely started, hence we continue to advise exercising caution when calibrating expectations for equity market returns over the next few years.

Another notable development over the last three months has been the increased cost of capital in emerging market equities. This subset underperformed their developed market complex by 6% over the quarter, on top of an underperformance of almost 10% in the prior three month period. This has meant that over most periods emerging markets have now underperformed developed markets, with the US equity market continuing to be the stand-out performer over the last decade. Emerging market currencies shared in this adjustment, with the Russian ruble, South African rand and Indian rupee all depreciating by around 12% during 2018. The Turkish lira is down almost 37%, but we view this as mostly self-inflicted as the political regime continued to alienate foreign investors with illogical and, at times, contradictory actions. Developed economies' currencies generally depreciated only slightly against the US dollar over the quarter (around 2%).

Healthcare was the best performing sector this past quarter, with information technology again registering a strong performance. Laggards were energy (after a very strong second quarter), utilities and real estate. Since the start of the year consumer staples (in line with higher long bond rates), financials (slightly more perplexing given the higher interest rate expectations), materials (concerns over emerging market growth prospects) and telecommunications (also higher interest rates) have been laggards, with information technology by far the best performer and healthcare a clear second.

The fund performed marginally worse than the benchmark over the quarter, resulting in a poor last twelve months, and an average last two years. Over three years we are marginally ahead of the benchmark and since inception we are still behind. Fundamental stock picking again disappointed, notably JD.com, L Brands, Aspen and Intu. The tobacco sector also continued to sell off, hurting the fund's performance. Notable winners over the quarter included Blackstone (a long-term winner with more upside in our opinion), Spirit (subsequent to quarter-end we have exited this position), Advance Auto Parts (a strong positive contributor over the last twelve months) and Charter Communications (after a poor start to the year).

We often reflect on positions in the fund that detracted from performance, which should highlight the learning process with which we approach investments. In this commentary, we thought it appropriate to discuss Advance Auto Parts in more detail. Advance is the second largest retailer in the auto parts sector in the US and sells both to the do-it-yourself customer as well as the professional mechanical workshop. We initially invested in this stock in August 2017 after we met the new management team at a conference in the US. This team was brought in to fix a business that was cobbled together through acquisitions, and which had failed to deliver on the promised cost savings and the integration benefits. At the time their operating margin was about half that of the industry leader, and the new team had concrete plans to partially close the gap. At the same time, unusual weather had also adversely impacted industry sales, and there was lots of speculation about Amazon making a stronger push into the category. We thought the weather issue was temporary and believed that the category was less attractive to an online retailer than generally believed. While the management team has yet to deliver on their promise to increase margins, a more normal winter has seen industry volumes pick up again. The Amazon threat has also subsided, with the result that the stock has been our biggest contributor to alpha over the last year. Given that the margin improvement still needs to be delivered (arguing for a degree of implementation risk), we have reduced our position to less than half of what it was at its peak. We continue to see some value in the stock and are watching the execution of the turnaround fund closely.

The second quarter of the year created even more uncertainty after the turbulent first quarter. Investors' minds were increasingly occupied by the growing prospect of an intensifying trade war between the US and its major trading partners. President Trump and his administration seem intent on even turning long-term allies into enemies, with their erratic but ongoing comments about putting America first with regards to trade. This has led to a series of tit-for-tat reactions from predominantly China, but even countries like Canada and trading blocs such as the European Union have resorted to reactive measures to try and drive home the fact that the US should behave in a responsible way in a global trading village. While one can contextualise these measures as relatively small in a global trading context, investors have been spooked as it is difficult to predict if and when these irrational actions will stop. In addition, down the line these actions have a direct impact on monetary policy and, as such, create more uncertainty.

With regards to the latter issue, we remain of the view that investors are too complacent about the potential level of normal interest rates in the long term. An analysis of the yield curve shows that while the US Federal Reserve (Fed) has clearly and continuously communicated its intention to increase interest rates two more times during 2018, only half of the market believes that to be true. In addition, the market only discounts a 10% probability of further rate hikes in 2019, while the Fed has indicated its intention (all other data points being equal) to raise rates twice during 2019. We are monitoring these statistics closely, as it could affect the equity risk premium in the medium term.

Against this backdrop, the MSCI All County World Index (ACWI) returned 0.5% over the quarter, resulting in the year-to-date number still being slightly negative. Over the last year the index return was 10.7%, slightly above the three-year annualised number of 8.6% p.a. Returns in local currencies were on average more than 2% higher, but the stronger US dollar curbed reported returns in that currency. The US dollar was on average about 4%-6% stronger than most of the other major currencies. Among developed markets, Japan was the laggard by a modest margin. Given the increased concerns from investors about a possible full scale trade war, it was no surprise that emerging markets underperformed their developed counterparts by over 8%, with more than half of this number being attributed to weaker currencies. The fund has been somewhat sheltered against these moves given our decision to hedge the bulk of our emerging market currency exposures. Within the emerging market universe, Brazil was the notable underperformer, given the increasingly complex situation on the domestic political front. Over the last 12 months (and over longer time periods), developed markets have now marginally outperformed emerging markets.

Within sectors, energy was the standout performer this quarter given the stronger oil price. Financials underperformed given the trade war concerns and their potential impact on monetary policy. Telecommunication services were also weak. Over the last 12 months energy and information technology were the strongest sectors, with telecoms and consumer staples underperforming the benchmark by around 15% and 11% respectively.

Our fund slightly underperformed the benchmark over the quarter. The last 12 months have been tough in terms of relative performance, and we remain slightly behind the benchmark over the last two years, but still behind since inception. We continue to find value in the stocks we own, and in some cases have added to our positions.

Over the last quarter our most notable winners include stocks like Altice, Pershing, and Imperial Brands, which have all detracted in the past. Other positive contributors were Facebook, Alphabet, KKR and Advanced Auto Parts. Laggards included Porsche and Tata (on the back of trade war worries), Intu Properties, the airline holdings on the back of a higher oil price, and the Brazilian educational stocks as the economy continued to shrink in the face of the political and economic crisis. Our two big tobacco positions, British American Tobacco and Philip Morris, also detracted (discussed in more detail below).

In reflection on the poor outcome of the last 12 months, it is clear that some of the portfolio's larger positions have detracted meaningfully. Altice, the tobacco stocks, the US pharmacy retailers, L Brands and Tata Motors were the big negatives. In most of these cases the investment thesis still holds, and we continue to be encouraged about the prospects of these companies. The developments in the US pharmacy sector are being monitored closely, with the potential entry of Amazon in that space. Conversely, Amazon was actually our biggest positive contributor over that time.

In last quarter's report we discussed our motivation for significantly increasing the fund's exposure to tobacco stocks. We continue to do more research and have increased our conviction about the prospects for this sector in the light of continued changes in consumer preferences for the next generation products (which include both vaping and heat-not-burn products). The fund now has about 11% exposure to the sector, primarily in British American Tobacco, a stock we have worked on extensively given its dual listing on the JSE, and Philip Morris International, the owner of the iconic Marlboro brand outside of the US. Philip Morris' share price came under significant pressure after investors were disappointed with its growth in heat-notburn product sales in Japan. The sector is trading at a discount of over 30% to its historical average rating, and while we expect investor uncertainty to continue given all the relevant news flow expected over the next few years, we think patient investors will be well rewarded.

More recently, we have also introduced Mondelez to the portfolio. This branded snack and confectionary group has been punished by investors worrying about branded consumer groups' abilities to continue taking price increases in the light of the rise of in-store brands and lacklustre US-packaged food sales growth. We think the market underappreciates the fact that only 25% of Mondelez' sales are in the US, with about 40% of group sales coming from emerging markets, where its portfolio of brands is very strong and growing. The market seems to have lumped the stock with other US-centric names like Kraft and Campbell Soup where lethargic growth prospects have scared investors. In addition, the market also tends to price these stocks as bond proxies, and with the normalisation of longer-term interest rates, investors have shied away from holding consumer defensives. We consider this to be an opportunity to increase the fund's exposure to high quality holdings like Mondelez, Anheuser Busch and Reckitt Benckiser.

Whilst the headlines would suggest a more cautious stance towards equities given the level of volatility expected by the market, we continue to be excited about the prospects for the stocks we own in the portfolio.