Global developed equity markets were broadly stronger in the third quarter of 2019 (S&P500: +1.7%; MSCI Europe: +2.5%; Japan TOPIX: +3.4%) despite a continued slowdown in economic data. In the United States, the US Federal Reserve (Fed) cut interest rates in both their July and September meetings as consumer confidence data and economic growth showed signs of easing. Longer duration US bonds recorded a historical rally which led to the curve completely inverting in August culminating in all bond maturities yielding less than the Fed Funds Rate. Similarly, weak economic data in Europe forced the European Central Bank’s hand in resuming a fresh round of quantitative easing and further cutting interest rates into negative territory.

Emerging equity markets felt the impact of a stronger US Dollar, soft economic data and continued trade tensions between the US and China. The MSCI Emerging Market index declined during the quarter by 1.9% with South Africa’s All Share Index dropping by 11.2% (in USD terms). While global events weighed on the local equity market, endogenous factors such as a deteriorating fiscal environment, worsening debt profile and structural constraints (such as Eskom) continue to impact South Africa’s equity performance. Furthermore, increasing prospects of a sovereign credit downgrade from Moody’s in the fourth quarter of 2019 is likely to weigh heavily on investor risk appetite and the direction of returns over the short term. Against this backdrop, SA equity valuations are at their lowest level since 2012 with the JSE All Share now trading on a 12x forward PE multiple compared to 18x recorded in late 2015.

In line with global trends, SA defensive equities outperformed cyclical stocks during the quarter despite some reversal in September. SA Financials and Resources performed particularly poorly returning 6.8% and 6.4% respectively, while the local industrial index fared better at 2.5%. Precious metals continued to benefit from macro tensions with local platinum and gold mining producers gaining 106% and 65% year-to-date.

The Northstar SCI Equity Fund outperformed the local equity market during the quarter returning 4.3%, ahead of the JSE Capped SWIX index, which was down 5.1% for the same period. The fund benefitted from an overall defensive stance with a large overweight position to outperforming consumer goods stocks, in particular beverages (AB InBev, Distell) and tobacco (BAT and Reinet Inv). These showed resilience in a difficult global environment. Left field contributions came from several out of favour consumer and industrials, most notable of these being Woolworths and AECI, which performed well against a difficult local economic backdrop.

Whilst we admit that local equity valuations have collapsed to the extent that these are more supportive of improved future returns and consequently, we are finding better entry points into a number of companies, we continue to harbor some concerns, the primary one being that we expect further corporate earnings downgrades which we believe will moderate return expectations over the short term. We believe this effect will be pronounced in the SA consumer and industrial space which are unlikely to show signs of recovery in the absence of significant structural reforms and improved political will.

It's an interesting environment with tail events (both to the upside and downside) taking place in various areas of the market - this offers opportunity, but also results in extreme manager relative performance differences. There are effectively two camps of managers, those participating in the 'trend' or momentum area of the market, which means heavy resource exposure and then those less exposed to resources due to concerns around capital preservation. The unique market structure in South Africa (where 21% of the JSE All Share index is constituted by commodity exposure) lends itself to binary outcomes and tail events for market participants. What is also worth noting is that the center of the market - good businesses that are non-resource based has been in limbo.

South African equities have been a mixed bag in 2019, outperformance (albeit with extreme volatility) of commodity companies has dominated (resources are 21% higher year to date) the market while domestically focused companies have underperform both in terms of share price performance (the local financial index has gained 5% year to date and the industrial index is down 5.8%) and with respect to their earnings trajectory. Certain local stocks look cheap - although not many, there are a grouping of SA companies where free cash flow yields are elevated and ratings are no longer high, but earnings projections are dismal as underlying economic growth in the system is vacant. Contrast this to commodity businesses where ratings are high when applying normalized earnings but profitability levels are also elevated as spot prices for certain commodities have exceeded market expectations. It is also true that capacity is being well managed amongst the mining giants, helping to control supply in tight markets caused by supply disruptions.

The resource story and the level of bullishness by managers invested within that space becomes more questionable when the demand side of the equation is thoroughly interrogated. Chinese investment spending growth peaked in 2003 and has been falling ever since, year on year growth is now under 8%, having been closer to 20% between 2003 and 2013. Air pollution regulations and Chinese interventions to stimulate the economy have certainly played a meaningful role in buoying commodities, but the extent of appreciation of share prices, driven by spikes in physical metal prices to levels significantly higher than the marginal cost of production, makes for vulnerability. We remain underweight commodities which is consistent with our quality at a reasonable price philosophy. This is hurting performance from an allocation perspective - we are not exposed to a sector of the market going parabolic, but we are redeeming ourselves by continued positive selection effects - our stock picking within the rest of the market is adding value.

We feel comfortable that the businesses within our portfolio have sustainable and enduring franchises that are best equipped to survive the ongoing economic malaise occurring in South Africa. Our work has focused on margins of safety with financial and operational robustness. Until the underlying fundamentals within the economy change, conservatism will remain our approach.

The local equity market enjoyed a fourth consecutive month of positive returns in March 2019 after a particularly weak 2018, which saw the local bourse decline by 8.5%. During the first quarter of 2019 the JSE All Share Index gained +7.9% driven by a strong rally in SA Resources (+17.8%) and a rebound in SA Industrials (+7.4%). The large cap index returned +8.5% during the quarter while the small and mid-cap indices continued to underperform returning respectively -3.4% and 2.8%.

Despite improving local returns, South African equities underperformed global emerging and developed markets by respectively 5.4% and 8.2% in USD terms. While global equity and credit markets enjoyed a strong rally in 2019 on the back of improved sentiment around US/China trade relations and a more dovish US Federal Reserve, South African specific issues weighed heavily on local returns. In this regard, Moody’s latest update notes that if continued low GDP growth rates persist during the medium-term and elevated debt levels are not curbed the sovereign would likely be downgraded to Junk status.

The Northstar SCI Equity Fund performed well during the quarter returning +5.4%, ahead of the JSE Capped SWIX index, which recorded a gain of +3.9% during the same period. Although the fund’s significant underweight position to SA resources continued to hurt its performance relative to the resource-heavy JSE all share index, we remain prudent as a result of our weak outlook for the sector. The fund benefitted during the quarter from a strong performance in core positions such as British American Tobacco (Q1 2019: +30%), Anheuser-Busch (+27%), Reinet Investments (+13%) and an overall underweight position to SA retailers, who continued to experience losses as the state of the SA consumer has not seemed to show improvement. Whilst we admit local equity valuations are looking more supportive, particularly in the industrial space, we remain cautious as a result of a weak outlook for the sector. The fund continues to be overweight a number of stocks in the consumer goods and financial sectors, which we expect to outperform over the medium term.

We expect global markets to remain volatile as geopolitical tensions simmer but see the Fed’s renewed dovish stance as constructive for equity markets over the short term despite reasonably high valuations. From a South African perspective, we see the faith of the equity market tied to the outcome of the local general elections in May 2019, which are likely to create volatility and significant opportunity for investors.

The third quarter of 2018 has been another turbulent period for the local equity market with the JSE All-Share TR Index declining by 2.2%. Emerging equity markets have dramatically underperformed their developed counterparts as the impact of geopolitical tensions between the US and China and negative growth revisions in China and Europe were felt by global markets. In South Africa, while the SARB refrained from raising interest rates, the Rand rebounded by +3.7% in September as President Ramaphosa unveiled an economic plan aimed at reviving the economy. The JSE Industrial Index however declined in September by 7.7% recording its worst monthly performance since 2009 as stocks such as MTN (-18%), Aspen (-35%) and Blue Label (-50%) tumbled during the quarter. The selloff has been widespread with few areas of the market escaping bar the SA resource index which continues to be the exception returning +5.2% during the quarter and +21% year-todate.

The Northstar SCI Equity Fund marginally underperformed the local bourse, declining 2.5% during the quarter. The fund has performed well in 2018 by avoiding several hazards (Steinhoff, Resilient / Fortress, Aspen) and holding three of the top five best performing JSE stocks this year (Sasol, BHP Billiton and Mondi). Sound stock picking compensated for the fund’s low weighting in the only performing area of the market: SA resources, which we acknowledge may continue to do well over the short term, but broadly speaking, we do not believe to be a high quality industry. The only mining stock in the fund is BHP Billiton, which unlike most of its global counterparts has displayed consistency of performance through various cycles on the back of superior asset quality and capital allocation from a highly competent management team. We see better opportunities in the SA industrial space, particularly in the out of favour mid-cap space, which has drastically underperformed the market over the past 3 years. Confirming our view that stock picking can offset some of the concentration bias on the JSE, the fund enjoyed meaningful returns from several non-resource positions including Old Mutual (+14.5%), Super Group (+14%), Reinet Investments (+10.1%) and Bidcorp (+8%).

We expect global markets to remain volatile as geopolitical tensions simmer impacting trade agreements and the US maintains its interest rate hiking course. From a South African perspective, weak Q2 2018 GDP numbers are likely to be a low point of the cycle and in the absence of political shocks we expect the economic environment to gradually improve. The fund is currently well diversified, conservatively positioned and invested in high quality businesses that we expected to perform well through the cycle. We are now finding good opportunities in the market, particularly in the mid-cap space, which is now starting to offer compelling value.