Market review

Global markets, up 5% in US dollars this quarter, have remained buoyed by the $1.7 billion central bank injection this year and 13% increase in earnings growth. Global growth is strong at 3.5%, accompanied by low unemployment and improved consumer and business confidence. The current bull run in global equities is near the strongest in history, yet global valuations are only near the trough levels of 2003. Moreover, prospects for earnings are the most positive in nearly five years. On the face of it, the outlook appears serene, but on most historical measures the US seems to be on the expensive side while other regions prove to be cheaper.

History has shown us that the toughest month in the calendar year for the Dow Jones is October, which has coincided with emerging market (EM) currency sell-off since early September. The question is whether this should be a cause for concern, as in the grander scheme of things these are small moves as EM currencies are still up 5% vs the US dollar year to date (YTD). Most importantly for SA investors, the rand has declined versus the greenback and has wiped out most of this year’s currency gains. There have been four main drivers for the rebounding of the dollar: 1) mainly that US inflation is likely to move higher over the coming months, suggesting a December hike by the Fed; 2) reversing quantitative easing from October; 3) President Trump’s overhauled plans on tax reform, including cutting the corporate tax rate to 20%; and 4) Chancellor Merkel’s reduced majority in the German elections. We believe that right now we are in ‘EM giving back some of the strong gains of 2017’ territory. But moves in the dollar are something to watch in the immediate future.

In South Africa, apart from the ongoing movie between the US and North Korea, there isn’t much that moved the SA market in September. This could change as the ANC presidential race heats up into December.

We are seeing some recovery in real economy data, with the increase in electricity demand and positive vehicle sales growth being good examples; there are nonetheless signs of slightly positive GDP growth after negative growth in Q1. South Africa has never been in recession when global growth has been in excess of 2.5%. We continue to see GDP growth averaging below 1.0% in 2017 and between 1% and 1.5% in 2018, with downside risk particularly next year, should the political environment sour further. Nevertheless, the fact that the economy has managed to climb out of recession in Q2 is likely to allay some fears and, in our view, should bode in favour of the currency (at least in the short term). That said, South Africa has fared well bearing in mind that 60% of the JP Morgan Global Bond Index is now un-investable. The term premium in SA bonds is the highest among emerging markets, showing that the pricing of our bonds is at extremes now. The risk of S&P downgrading our local bonds to junk is high but it could take a while before South Africa gets removed from the World Government Bond Index In Q3 2017, the FTSE/JSE All Share Index (Alsi) posted a rand total return of +8.9% versus -0.4% for Q2 and +3.8% for the first three months of the year. This has been the best quarterly performance since Q3 2013 (+12.5%). This performance was boosted by the +17.8% total return from SA Resources (-7% in Q2). SA Industrials and SA Financials showed similar improvements in performance in Q3 of about 5%. The FTSE/JSE All Bond Index (Albi) underperformed equities, returning +3.7% (+1.5% in Q2).

The Alsi’s YTD total return of +12.6% has outperformed all other asset classes (SAPY +8.2%, Albi +7.8%, Cash +5.6%). SA Industrials (+17%) outperformed SA Resources (+12.4%) and Financials (+4%). Although this appears to be good absolute returns, the South African market underperformed that of its emerging market peers. A large contributing factor was the net outflows in local equities of US$5.6 billion against the inflows into emerging markets of US$63 billion YTD.

The Alsi’s forward price/earnings (P/E) ratio rerated by about 3.5% during the last three months as the metals rally and rate cut expectations boosted equities earlier in the quarter.

Performance and portfolio actions
For Q3 2017, the Alsi realised a very good return of 8.9%, outperforming the FTSE/JSE Shareholder Weighted All Share Index (Swix)’s return of 7% by 1.9%. This was one of the best returns of the general equity indices that we track. Year to date the Alsi is also comfortably above the Swix.

The large outperformance for the quarter was mainly attributable to the index’s relative overweight in Anglo American (AGL), BHP Billiton (BIL) and Richemont (CFR), which all managed very good returns over the last quarter. The index’s relative underweight position in Steinhoff further enhanced this outperformance. The relative underperformance in Naspers negated some of this outperformance.

During the quarterly rebalance in September we re-optimised the portfolio back to its stated 6 to 8 basis points tracking error relative to the benchmark. We track the index with about 130 shares out of a possible 160 plus. The fund performed in line with the Alsi.

Conclusion
The main question facing investors, as in Q3, is whether valuations and positioning point to a tactical pullback from risk. We think the general market view currently is that it would probably not. This year’s equity rally has been driven by earnings growth, not multiple expansion; while the pace of this growth might slow, stocks should still out-earn bonds. It is difficult to see a plausible catalyst that could upset valuations in risky assets for the rest of 2017. If we contrast the fortunes of overseas markets to our local one, it is clear that investor confidence is an important behavioural factor driving investment markets. Companies which have delivered results below expectation are being marked down heavily and a number of former darling stocks have suddenly been found wanting.