The Northstar Income fund performed well over the quarter with a 2.3% return vs. the benchmark return of 1.8% and the strategic benchmark return of 2.0%.

The strongest attributors to outperformance have been the overweight position in short duration inflation linked corporate bonds (39bps), marginal overweight to fixed corporate bonds (25bps) with predominant holdings in high yielding shorter durations and a purchase of a longer dated maturity after the market pullback in July, and the underweight property holding providing positive attribution (15bps).

Conversely, the portfolio’s underweight foreign cash and bonds holdings (7% vs. 15%) resulted in a negative attribution of 50bps. The net result has been a 30bps outperformance of the strategic benchmark, which in its own right, performed well.

Shorter duration fixed bonds reached full value during the quarter, prompting a reduced exposure to maturities below 7 years. Post the riskoff dynamics in July, the 10 year to 20 year maturity valuations improved somewhat, which motivated a small purchase. The net effect has seen the fixed bond weighting being reduced further with a lower contribution to overall duration vs the fixed component in the strategic benchmark.

Inflation linked bond yields have continued to rise as inflation concerns have dissipated and nominal bond yields, particularly in the longend, have remained elevated. There is a strong argument that real yields, particularly around the 5 year maturity point are becoming attractively valued on an absolute basis, despite declining inflation expectations. As such, the inflation-linked weighting in the portfolio has been increased from 20% to 26% over the quarter.

Property stocks have continued to selloff, specifically those with a predominant exposure to the local economy which is struggling and puttng constraints on consumer spend and hurting the retailers. Vacancy rates continue to rise across all sectors and are becoming elevated, specifically in the office space where poor business confidence is causing tenants to downsize and the industrial space where tenants are opting for shorter leases and lower rentals stemming from electricity supply issues and increased business failures. Based on the number of building plans passed, there is a major concern that the market may be in oversupply, however the total amount of buildings completed is lagging significantly, which may mitigate this outcome. In the interim however, investors are demanding higher yields as rental growth softens, debt costs rise, operating costs rise and balance sheets weaken. We remain underweight property.

The foreign currency and bond exposure remains underweight vs the strategic benchmark weighting as a result of the Rand trading at around 20% undervalued on a purchasing power parity basis vs the US dollar. The rand has only traded at weaker levels 10% of the time historically, which took place during exogenous events such as the Global Financial Crisis and Nenegate. Other valuation methodologies also point to an undervalued rand, which supports our underweight position.

Despite the attractive Rand valuations, the portfolio maintains its 8% foreign currency weighting (post monthend). This holding should perform well in the event of a deteriorating Government debt trajectory (post MTBPS), poorly received Eskom turnaround plan, potential negative change in outlook from Moody’s and or any other poor news relating to local politics, ongoing trade tensions, challenging Brexit outcomes and a slowing global economy for example.

On an after-cost basis, the Northstar Income fund remains positioned to deliver a strong real return, coupled with a very low risk of capital loss.

The Northstar Income Fund performed well over the last quarter with a 2.6% return vs. the benchmark return of 1.8%. The fund performance relative to the benchmark also compares favorably over 1 year (9.7% vs. 7.3%) and 3 years (8.3% vs. 7.4% annualised). Over the last 3 years, the Northstar Income Fund has displayed low risk characteristics with a maximum drawdown of 0.46% and a standard deviation of 1.3%. In addition, the portiolio's current holdings have a weighted average credit rating of Aa2. Over the last 3 years, the Northstar Income fund has realised an annualised real return of 3.6%.

During the quarter, the portfolio has been underweight listed property (1.1% vs. the strategic benchmark weighting of 5%) which has been a small detractor to returns, with the sector returning 4.5%. On an absolute basis, the foreign cash and bond holdings detracted from returns as a result of the USD and other developed market currencies weakening by +/2% vs the ZAR. Conversely, the portfolio's overweight positions in fixed and inflation linked corporate bonds contributed 1.22% and 0.91% respectively. The balance of returns were achieved with holdings in NCDs and floating rate notes which each contributed 0.41%.
Global factors have been the primary driver of local fixed income pricing over the last quarter. Global inflation remains benign and growth is waning, which has prompted central banks to consider lowering interest rates. As a result, global investors have dropped their return requirements and driven yields lower. Despite South Africa's deteriorating debt profile, dire growth prospects and lackluster policy improvements, local yields have been too attractive to ignore. Consequently investors have been comfortable buying the R186 (SA 7½year maturity) on yields of 9.35% all the way down to around 8%.

Inflation across developed markets is anticipated to remain below 2%, with the exception of the US where consumer prices may reach 2.1% in 2020. Despite multi decade low unemployment of 3.7%, the Fed has signaled potential rate cuts, on the back of a slowing economy and benign inflation pressures. The ECB is likely to follow suit, with Mario Draghi indicating the need for monetary stimulus in the event of no improvements in the economy. These concerns are reflected in the depressed consensus GDP forecasts, with developed markets set to grow at 1.6% in 2020, post the 2% plus growth during the last 3 years. The US has been performing well with growth of 2.9% in 2018, however US real GDP is expected to slow to 1.8% over the next couple of years. Growth in Europe and the UK is likely to be even more subdued. Conversely, growth in Eastern Europe and emerging markets is expected to remain reasonably buoyant.

On the local front, severe electricity supply disruptions, weak business confidence, policy uncertainty, escalating debt, increased debt costs, an overtaxed consumer and ongoing corruption resulted in a sharp decline of 3.2% in real GDP for Q119. With no quick fixes in sight, SA growth is likely to muddle behind other emerging market peers with anticipated growth of 1.8% vs. the 4.8% average for emerging markets over the next couple of years.
On a forward looking basis, local inflation is expected to average 5%, which is comfortably within the target band 3% to 6% set by the SARB. In addition, the SARB remains an independent body with a clear mandate to ensure price stability. Should developed markets embark on further monetary stimulus, it is reasonable to expect the SARB to do the same. Room for SARB action however, will remain restricted given the wide range of alternative investment destinations offering better growth opportunities with even lower inflation rates.
On this basis, the Northstar Income Fund maintains a broad range of fixed income assets with the aim of achieving a reasonable real return over time. The fixed bond weighting is being reduced as yields decline. Likewise, global currency exposure is being marginally increased as the Rand approaches fair value, to ensure sufficient capital protection in the event of any unforeseen South African or emerging market related risk event. The inflation linked bond weighting has been increased marginally above the strategic level, as 5year real yields have cleared handsomely above our hurdle rate. The balance of capital, realised from reduced fixed bond exposure, has been allocated to a range of NCDs and floating rate notes, resulting in overall lower portfolio duration.

The Northstar Income Fund returned 8.6% for the year vs. inflation of 4.1%, the benchmark (STeFI Call x110%) 7.2% and the strategic asset allocation return of 6.8%.

All asset classes held within the portfolio made positive contributions over the 12 months. Fixed bonds were the largest contributor with 5.2% followed by floating rate notes 2.5%. Inflation linked bond holdings also made a positive contribution of 0.9%, despite the index being down 3.1% over the period. Local property holdings, NCDs, foreign cash and US bond exposure also made small positive contributions.

Relative to the Northstar Income Fund’s strategic benchmark, the largest attributors were fixed bonds, followed by inflation-linked bonds and then NCDs. Listed property also added positive alpha. Being underweight foreign cash and global bonds however detracted from relative returns. The Northstar Income Fund added 1.8% alpha relative to the strategic asset allocation benchmark.

The fixed bond exposure in the Northstar Income Fund has been reduced as yields reach fair value. Under current conditions, we estimate the front-end of the curve to be expensive (R208 & R2023) and longer dated bonds (R186, R2030, R213 etc) to be undervalued, with a fair-value 1 year exit yield of 8.3% for the R186. The interest rate outlook is positive for fixed bonds, with inflation forecasts moderating more than expected and developed markets (lead by the US) taking on a dovish tone and indicating a neutral stance on the future direction of interest rates.

The inflation-linked bond weighting has been gradually increased over the 12 months, with a bias for shorter dated maturities on real yields above 3%. Although 3% real yields are very attractive on an outright basis, their prospective nominal returns look muted relative to the returns from fixed bonds with the same maturity. Currently the R186 (fixed bond which matures in 2026) is set to deliver an 8.6% return whereas the R210 (inflation linked bond maturing in 2028) will only outperform the R186 if inflation averages above 5.5% for the period to maturity. Inflation-linked bonds however, do offer a great deal of protection in the event of the central bank not being able to maintain price stability.

Should the environment favour fixed bonds and their yields rally below fair value, this exposure will be switched into higher yielding floating rate notes and or inflation linked bonds and listed property where valuations are supportive.

Up until recently, valuations on listed property stocks have looked unfavourable, given the deteriorating economic environment, weak consumer, declining business confidence, electricity disruptions, rising vacancies and over-supply. The result for companies, has been weaker top-line growth and reduced profitability as costs have increased and balance sheets leveraged in order to explore offshore growth opportunities. Despite this backdrop, valuations are looking more supportive, especially if economic conditions stabilise and improve.

In the interim, cash is being diverted to short-dated NCDs on yields of 8.1%. The foreign cash exposure has been marginally increased in the lead up to the scheduled Moody’s credit review and the national elections. The portfolio remains marginally underweight foreign currency, however the duration of the portfolio has decreased somewhat, reducing the risk of price shocks.

The Northstar Income fund is on a yield of 8% and operating with an effective duration of 0.9, which should mitigate the portfolio from any adverse price shocks and allow the portfolio to continue delivering a healthy real return.

The Northstar Income fund returned 1.6% for the quarter vs. 1.78% for the STeFI composite index and 1.29% for the fund’s strategic benchmark. The fund’s underweight positions to property (-3.48% return) and inflation linked bonds (0.41% return) were the primary contributors to outperformance relative to the strategic benchmark. The portfolio also benefited due to enhanced yield from credit exposures to NCDs, floating rate notes, fixed bonds and inflation linked bonds.

A number of factors have resulted in headwinds for a broad range of fixed income returns outside of US cash. The Federal open market committee continues to raise interest rates at a steady pace, with three 25bp hikes so far this year, and an expected further four 25bp rate hikes over the next 12 months. The US economy continues to power ahead (4.2% QoQ GDP Sep 2018) with core inflation breaching the 2% level in March 2018 (currently 2.2% Aug 2018) and unemployment falling below 4% (May 2018) and remaining below this level. Rising US rates coupled with the scaling back of its asset purchase program is improving the relative attractiveness of yields on US cash and putting upward pressure on longer dated US bond yields and global bond yields.

Additional factors which are negatively affecting global fixed income returns currently are: 1) the escalating trade tensions between the US and its trading partners which is rapidly translating into growth uncertainty and risk aversion in global markets, 2) emerging market risk aversion, largely initiated by the collapsing Turkish Lira as a result of US trade sanctions, raised Turkish USD debt interest payments and Turkish government influenced central bank rates 3) Italy’s rising debt concerns, 4) Brexit negotiation difficulties and 5) poor emerging market growth and spill-over into deteriorating emerging market debt metrics.

As a result of these factors, the dollar has appreciated, with US cash outperforming longer dated US bonds and global bonds over the last 12 months. The US cash relative performance has been more pronounced over the last 6 months in Rand terms (US cash has appreciated 20.1% in Rand terms), as the local currency and other emerging market currencies have weakened. Over this period, local bond yields have spiked with the R186 yield rising from 8% in April to 9% currently and reflecting a negative -3.03% return for the All Bond Index.

Over the last month, the rand has rallied from very old sold levels (USDZAR 15.5) to a more reasonable level of 14,40 USDZAR, however remains undervalued relative to the Dollar (12.10 USDZAR) based on a purchasing power parity basis. Using the same analysis for the rand vs. other major global currencies, the rand looks more reasonably valued vs the Pound and the Yen and remains undervalued vs. the Euro.

Based on current yields and prospective returns, the fund is overweight modified duration fixed bonds 2.2 vs. 1.4, underweight inflation linked bonds however lifting exposure as yields spike higher, underweight property, no exposure to global bonds, an underweight exposure to global currencies and an underweight to floating rate notes. We note that preference share yields have spiked over the last couple of months, but yet to reach levels which compensate investors for the associated lower credit quality and higher liquidity risks vs. other income yielding assets.