Global Markets

The S&P 500 delivered a total return of 7.7% over the last three months, 10.6% year to date and 14.4% since its February lows. Unfortunately, this strength is not shared broadly, with European, Australasian, Far Eastern (EAFE) and Emerging markets (EM) returning in US dollar 1.4% and -0.9% for the quarter and -1.0% and -7.4% year to date.

A spate of news flows from across the globe is currently driving markets. America’s trade war against what seems to be the rest of the entire world remains an ongoing concern for investors. This has led to some participants betting that China will increase their current stimulus programme in the coming months. Trump also made another enemy in Opec, publicly calling them out to reduce oil prices by increasing supply. At the same time, focus was on the Federal Open Market Committee, which raised rates again - the third this year - and reaffirmed a hawkish outlook going into 2019 and beyond. It would seem as if another hike in December is almost assured.

Additional to this, the laundry list of potential market headwinds is quite long: with the yield curve that is flattening; disruptive mid-term elections; peak margins; increasing corporate leverage; problems in emerging markets; and a stock market trading at record price-to-sales.
Despite this litany of concerns, we think none will cause the transition from market risk to a market problem. Despite the best efforts by bears, international equities are so far rather resilient. MSCI World is up 5.9% year to date, outperforming bonds by 700bp, on a total return basis. The performance, however, is quite US centric, but it is notable that even accounting for the latest Italy setback, Eurozone equities are also holding up relative to fixed income this year, with the MSCI Eurozone at 0.7% against bonds at -0.7%. The general market expectation is that there would be further gains into yearend, as the US dollar is potentially peaking, the US business cycle remains well supported, and there is some stabilisation in emerging markets/Eurozone activity evident. Fundamentally, growth drivers are also far from exhausted. Although the yield curve has flattened, stocks have never peaked before the yield curve inverted. The current yield curve shape is consistent with double-digit S&P500 returns over the next 12 months.

Emerging market (EM) equities have performed poorly in 2018 and were at the recent low point down as much as 20% from January highs. Our best view is that EMs are flattening out as they tend to have a strong inverse correlation to the US dollar, which could be peaking out.

Prospects for the rand and other EM currencies have swung as they have moved from being some of the most promising asset classes this year to becoming the worst-performing asset classes in the first half of the year, largely due to tailwinds from the global economy turning into headwinds.

South Africa

After a dismal first quarter growth print of -2.2%, the second quarter GDP print was again negative at -0.7%, plunging the economy into a technical recession. Domestic demand remains weak, down almost 4% with some rebound in exports by 14% helping. Companies continue to run down inventories, detracting from GDP.

In the third quarter of 2018 the FTSE/JSE All Share Index (ALSI) posted a rand total return of -2.17%. The last three months were anything but easy, especially with the quantum of the downward moves of some of the equity prices. It is also extraordinary how intraday volatility has picked up and the fact that more than 60% of the ALSI constituents saw a more than 5% intraday move during this period. SA Resources and SA Financials outperformed in the third quarter with total returns of 5.2% and 2.8% respectively, while the SA Industrials sector was the drag on the index, shedding 7.8% over the same period. The All Bond Index (ALBI) was virtually flat with a total return of 0.8%, whilst the SA Listed Property index (SAPY) returned - 1.0% over the same period. Year to date, the ALSI has posted a total return of - 3.8% versus the ALBI’s 4.8% and -22.2% for the SAPY. SA Resources (21.0%) have severely outperformed SA Financials (-6.8%) and Industrials (-11.8%) since January 2018.

South Africa remains on a low growth path. The aftershocks of State Capture and policy uncertainty persist, constraining confidence and investment. Structural economic reforms remain slow in coming, though the finalisation of the Mining Charter before the end of the year marks an important milestone.

South Africa needs growth in order to arrest further fiscal, socio-economic and credit ratings decline. Moody’s review of the sovereign’s ratings around middle October is unlikely to deliver any surprises (no change to its stable outlook or its Baa3 rating), though we think there is a chance the review could be delayed until after the 24 October medium-term budget.

The economy should drag higher in the second half of the year as we shake off the worst impact of agriculture after good rains and companies re-stocking ahead of the Christmas season. We remain on track for 1.3% economic growth in 2018, which would be a sub-par outcome, but the second-half growth numbers should look more decent, up 3% off a low base. Consumer confidence is holding up after reaching record highs at the beginning of the year, but business confidence remains in the doldrums.

Performance
The FTSE/JSE All share Index (ALSI)) delivered a return of -2.17%, which was better than that of the SWIX index, which realised -3.34%. The return difference could mainly be attributed to the weight differences in Naspers, BHP Billiton, Richemont and to a lesser extent Aspen. The underweight in Sasol, FirstRand and Sanlam negated some of this relative outperformance.

Your portfolio performed in line with its benchmark. The difference in your return relative to its benchmark was mainly due to our optimised model portfolio marginally underperforming the SWIX Index. Trading costs, as well as market impact due to rebalance trades, also influenced performance. Our optimised portfolio holds between 135 and 140 shares out of a possible 160 plus shares at an ex-ante active risk of around 10 basis points.

Conclusion

In South Africa, the sentiment pendulum has swung from optimism, with the new political administration driving business and consumer confidence higher, to disappointment about the latest macro-economic drivers (GDP), which has dampened expectations of a solid economic recovery. Either way, economic mood swings tend to be exaggerated. Also, the expectation that President Ramaphosa will, in one fell swoop, reverse years of neglect and maladministration is unrealistic.

The JSE trades on a forward PE of around 13x, which relative to its long-term historical average, is not expensive.

Market overview

What a volatile start for global markets during the first three months of 2018!

A pull-back in technology-driven shares, rising trade tensions and fears over higher rates and inflation led to a volatile first quarter of 2018 for the S&P 500 Index. Following a 10% correction from its January highs and rallying back 8% by early March, the index suffered another 5% pullback in the last few weeks, ending the month of March down 2.5% on a total return basis and losing 0.8% over the last three months (first negative quarter since the third quarter of 2015). The S&P 500’s correction of just over 5% in the first week of February was a reminder that rising bond yields are likely to cause much anxiety on the path to normalisation.

While stocks were the worst-performing asset class in March, they finished the first quarter in the middle of the pack, beating both long-term Treasuries (-3.2%) and investment-grade corporate bonds (-2.2%) but lagging cash (+0.4%), gold (+2.5%), WTI oil (+5.3%) and the US Dollar Index (-0.7%).

Forgotten was the fact that the US implemented the biggest tax reform in three decades to drive the corporate income tax rate from 35% to 21% and boost investment spending and productivity. The US is also encouraging corporates to repatriate some $2.5 trillion held offshore - but the impact on the US dollar should be limited as it is over 10 years and already held in dollars. The market, however, reminisced that the 1986 tax reform programme led to the considerable weakening of the greenback.

While recent data globally are mixed, credit impulse numbers and various leading indicators do suggest that growth expectations may still have room to drift lower. This could mean that downside risks for equities, yields and broader commodity prices are increasing, but in general the market positioning is much cleaner now and has probably priced in this ‘news’, leaving scope for a bounce.

While February and March are historically weak, April is a seasonally strong month (+1.2% average total return since 1928, the third-best month of the year).

South Africa

The JSE battled two opposing forces this quarter. On the one hand the ‘Ramaphosa effect’ drove some SA Inc. stocks to new highs, while the ‘Viceroy effect’ led to a slew of rumours impacting a number of companies. The recall of the former president attracted elusive foreign flows to the JSE, which flowed mainly into local retailers and banks, up 22%, a very narrow part of the market viewed as representative of the SA economy.

The Budget also served to quell investor concerns. Fiscal consolidation is back on track with government debt now peaking at 55% of GDP - better than the mid-term budget scenario where debt was forecast to balloon. The GDP outlook has improved slightly from 1.1% to 1.8% and prospective revenue has improved thanks to a 1% increase in the VAT rate and enforcement of a strict expenditure ceiling.

Over the last three months the FTSE/JSE All Share Index (ALSI) posted a total return of -6.0%. This has been its worst quarterly performance in eight years (Q2 2010: -8.2%). SA Industrials were the worst performer, returning -8.0% (Naspers and British American Tobacco, which were both down more than 15%). SA and British American Tobacco, which were both down more than 15%). SA Resources lost 3.8% (rising global uncertainty) and SA Financials lost 3.6%. The FTSE/JSE All Bond Index (ALBI) outperformed with a total return of 8.1% (helped by Moody’s keeping SA’s sovereign credit rating unchanged), while the FTSE/JSE SA Listed Property Index (SAPY) has shown the largest underperformance, -19.6% (negative press on Resilient group of companies).

Of the equity sectors, the top first-quarter performance came from Non-life Insurance (+24.4%), Fixed Line Telecoms (+10.0%) and General Retailers (+9.2%). The worst performance came from Real Estate Development and Services (-31.2%), Software (-30.5%) and Household Goods (-29.0%).

The ALSI has derated year to date and is now trading at a forward price-to-earnings ratio (P/E) of between 14.5 and 15 times (16.8 historic) versus the long-term average of 12.6 times. But ex Naspers we are at 13.5 times versus the long-term average of 12.3 times.

Portfolio and performance review

The ALSI (-6.0%) managed a better return than the FTSE/JSE Shareholder Weighted Index (Swix), which was down -6.76% in the first quarter. The main reasons for this were the relative overweight dual-listed companies such as BHP Billiton, Anglo American, Richemont and a lower exposure in Naspers, which was down over 15% during this period.

The negative returns for the first quarter was mainly due to industrial stocks, down 8%, as the strong rand and choppy global markets weighed on stocks with global footprints. British American Tobacco and Naspers were both down over 15%. The Ramaphosa effect was noticeable with banks, up 24%, apparel retailers, up 9%, and small cap stocks, down slightly. Resources stocks were down around 4% with heavyweight Anglo American up 10%, while the platinum index came under pressure, down some 27%, with Impala Platinum falling out of the Top 40 Index after retreating 27% on the back of poor results.

The difference in your portfolio’s return from its benchmark was mainly due to our optimised model portfolio underperforming the ALSI as well as trading costs and market impact related to the rebalance and cash flow trades.

Conclusion

Volatility has once again become the dominant factor in financial markets globally, exemplified by the VIX fear index experiencing its biggest daily spike in history during the quarter. There are growing concerns that global businesses may be subject to new regulation and be the target of tariffs if a US-China trade war escalates. Political risk is dominating fundamentals and we now have progressed into a new era where central banks are not the backstop supporting financial markets.

In South Africa, the sentiment pendulum has swung from pessimism to optimism with the new political administration driving business and consumer confidence higher with expectations of a solid economic recovery being discounted. Either way, economic mood swings tend to be exaggerated. Also, the expectation that President Ramaphosa will, in one fell swoop, reverse years of maladministration and corruption are unrealistic.

Market review

For the first time on record, global equity markets rallied in all 12 months of a year. The MSCI All Country World Index (ACWI) rallied 21.6% in 2017, which is one of the strongest years since 2009. Consistent with previous economic upturns, the US lagged the global index somewhat while Emerging Markets (EM) (+34.3%) and Asia Pacific ex Japan (+33.5%) led the pack. At the beginning of 2017, global macroeconomics and earnings were improving and the policy was accommodative and, analysing the current environment, it seems as if the same attractive set-up for equities exists at the start of 2018.

While tax reforms in the US should provide a big boost to 2018 earnings growth, there are several reasons to expect it to be a headwind in subsequent years, due to the fact that higher returns should incentivise additional competition, which then should have a negative impact on margins over time. The stronger growth could also result in more aggressive Fed tightening, which could eventually weigh on overall economic growth.

The yields on the US 10-year rose marginally from 2.33% to 2.40% over the quarter, but for a brief period when they touched 2.5%. However, the curve flattened aggressively as shorter maturities sold off in anticipation of the December rate hike and continued tightening of monetary policy by the Fed in 2018. Yields on German bonds rallied slightly from 0.46% to 0.42%.

The end of the quarter brought a number of unknowns in South Africa to the fore, leading to some sharp share price dislocations. We knew about the precarious financial position of state-owned enterprises, but did not know that it would be Steinhoff International that would make the headline as possibly one of the largest collapses in the history of corporate South Africa. We also knew that South Africa’s credit rating was on a knife-edge, but did not know that Moody’s would decide on a stay of execution. I think that we have now become accustomed to expect the unexpected when it comes to global political events.

In rands, SA equities (All Share: +21%), outperformed SA bonds (+10.2%), and cash (+7.5%). Property again had a good year with a total return of about 17.2%. The rand was also the sixth-best performing EM currency against the dollar, appreciating by 10.9%.


The local bond market endured a tumultuous ride and yields sold off more than a 100 basis points as the market anticipated a bad mini-budget and when Finance Minister Gigaba revealed the extent of the fiscal deterioration in the Medium Term Budget Policy Statement (MTBPS).

In terms of major contributions to the FTSE/JSE All Share Index’s return of 21% in 2017 in rands, Media (Naspers: +71.8%) contributed the major portion to this return. The Ramaphosa win at the ANC elective conference buoyed SA domestic-demand sectors, including Banks (+29.9%), Insurance (+37.5%), Diversified Financials (+16.2%) and Retail (+26%). The general market underweight positioning in SA domestic-demand sectors also added to the domestic stock rally into year-end. Of the sectors that realised negative returns, Consumer Durables suffered the most, given accounting irregularities (Steinhoff), followed by Healthcare.

In 2017, SA equities recorded outflows of US$2.5 billion, significantly lagging inflowsinto EM equities of US$77.2 billion. However, dissecting the flows, it appears that, excluding the outflows from dual-listed stocks, the Barclays and Vodacom sell-down, SA equities saw inflows of just more than R60 billion in 2017.

The FTSE/JSE All Share Index (ALSI) 12-month forward P/E, on market expectations, rerated by about 6% to 15.5 times in December 2017 (14.5 times in September 2017).

Market and portfolio review

The FTSE/JSE All Share Index (ALSI) had a strong close to the year, up by some 7.4% in the final quarter to end the year up 21%, delivering exceptionally strong returns against a politically and economically challenging backdrop.

Financial stocks experienced a Santa Claus rally, helped by the positive developments discussed above, up some 19% in the final quarter to end the year up over 24%. This was driven by a strengthening of the rand by some 14% against most major currencies this year and net inflows into domestic stocks. Industrials had a challenging final quarter, up only 4% as the Steinhoff International debacle weighed on sentiment, but nonetheless up by over 25.5% for the year. On a relative basis, resources stocks lagged after a bumper 2016, up just under 18% and just over 3.6% in the final quarter.

In the case of commodity stocks, the bellwether copper price was up by over 30% - an indicator of strong global demand and supply discipline, while Brent crude was up 14%, back to its 2015 levels as OPEC supply cuts kicked in.

During the FTSE/JSE December quarterly rebalance one share was added to the index with no deletions. The one-way turnover was 1.2%.

Our optimised SWIX model (using 130 shares out of a possible 160 plus) performed in line with the benchmark, therefore any difference in performance could be attributed to fund-specific cash flows.

Conclusion

Last year, the risks linked to Fed tapering and a China hard landing informed a lot of the cautious views on global equities. Cheap money found its way into alternative assets with cryptocurrencies being all the rage. This year, the risk of a China hard landing appears to have abated but there are continued concerns about the path of the US economy and future Fed actions. Emerging markets last year benefited from a buoyant global growth environment but valuations have now normalised.

A year ago, there was general apathy towards SA equities and the focus on political and economic downside risks in South Africa meant that many investors sat on the sidelines, which teed up the strong relief rally we witnessed at the end of the year. In South Africa, the danger is that too much, too soon may be expected from the new ANC leadership and, also, global risks from Fed tapering may now be underestimated.