Macro review

In the US, the third quarter saw increased political uncertainty amid rising tensions between the US and North Korea and the ongoing failure of the Trump administration to implement its policy goals. These tensions were a key factor behind the temporary rotation into lower-risk assets in August. In the wake of hurricanes Harvey and Irma, economic data and activity indicators deteriorated towards the period end. However, capital markets discounted the potential negative impact on growth as minimal, as did the US Federal Reserve (Fed) in its statement following the latest Federal Open Market Committee meeting. At this meeting, the Fed kept interest rates steady but confirmed that measures to reduce its balance sheet would begin in October, despite persistently weak inflation.

In the Eurozone region, economic data remained robust over the prior three months. GDP growth was confirmed at 0.6% in the second quarter, up from 0.5% in the first quarter. Economic sentiment rose to its highest level since July 2007, while unemployment in the Eurozone remained at 9.1% in August, which was stable compared to July, and the lowest rate since February 2009. The possibility that the European Central Bank could reduce its stimulus measures continued to be a focus for the market, as the committee kept policy rates unchanged in September. Also noteworthy was Angela Merkel winning a fourth term as the Chancellor of Germany in September. For the UK, the economy showed clear signs of slowing down, while inflation picked up, reaching 2.9% in August. During the quarter the Bank of England struck a more hawkish note with Governor Carney and a number of members of the Monetary Policy Committee openly discussing rate rises. Emerging markets saw a positive economic backdrop of steady global growth, modest inflation, US dollar weakness and a continued momentum in the Chinese economy through a pickup in commodity prices. In China, Industrial profits rose 20% year-on-year in August vs. 16.5% year-on-year in July, driven by a rebound in industrial prices. In South Africa, the South African Reserve Bank (SARB) lowered the repo rate by 25 basis points (bps) in July, yet surprised markets by keeping the policy rate steady at 6.75% in September. GDP growth momentum recovered in the second quarter to lift by 2.5% (quarter-on-quarter, seasonally adjusted annual rate) after a brief technical recession in the first quarter.

Global and local market review Global equity markets advanced in the third quarter with the MSCI World Index returning 5.0% in US dollars, and 16.5% year to date (YTD). This advance was largely driven by stable economic growth, benign inflation and positive earnings releases. Emerging market equities, however, outperformed their developed world counterparts, returning 8.0% during the third quarter and 28.1% YTD, in dollars. This streak of outperformance ended in September after eight months of positive relative performance. Top performers in emerging markets in the third quarter were Brazil (+23%), Russia (+18%) and Chile (+17%), while Pakistan (-16%), Greece (-12%) and Qatar (-7%) were the laggards. Brazil saw some reform progress and central bank easing, while Russian equities rallied as crude prices picked up and lower inflation opened the door for further interest rate cuts. In contrast, Pakistan’s market was weighed by their Supreme Court’s disqualification of the prime minister, while Greece declined amid a sell-off in banking stocks.

Year to date, South African equities (Swix) delivered a healthy 10.6%, underperforming bonds (+4.0%) and cash (+3.7%) as commodity prices rallied andrate expectations buoyed equity markets during the third quarter. Over the quarter, the Swix returned 7.0%, driven by Materials (+17.8%), while Industrials (+7.4%) and Financials (+5.1%) also rallied. Within Industrials, Naspers (15.0%) continued to outperform on the back of a strong performance in Tencent. Interest rate-sensitive sectors such as Retail and Banks also bounced early in the third quarter, around the first rate-cut in July, although the SARB surprised markets in September by keeping the policy rate steady at 6.75%. MTN (+11.2%) also drove the equity market as MTN’s new management conveyed its aspirational growth potential, while Aspen (+5.7%) rallied after announcing the AstraZeneca (AZN) deal.

Portfolio performance, attribution and strategy

Globally, the Momentum factor (particularly Price Momentum) continues to lead the race among factor performances YTD, followed closely by Quality/Profitability and Growth. In South Africa, we are starting to see an alignment with global outcomes, as Price Momentum’s strong recovery in the third quarter of 2017 has seen this factor among the leading factors in the domestic market YTD. This, after a particularly poor 2016 calendar year, has seen the Momentum factor redeem itself somewhat and recoup much of the losses it experienced last year. Earnings revisions, however, has not seen the same recovery, and continues to be tepid during 2017, given still high levels of domestic economic and policy uncertainty flowing over to uncertain corporate earnings estimates.

Notwithstanding the testing environment, our Momentum offering (which combines Price Momentum and Earnings revisions) has steadily improved its year-to-date performance relative to the Swix. Given that most of the stocks enjoying the highest earnings revision characters are hard commodities, the higher beta nature of these counters will likely influence the portfolio’s factors over the coming months.

Stock selection within the resource sector was the primary driver of positive relative performance over this quarter, where names such as Kumba Iron Ore (KIO), Exxaro (EXX), Assore (ASR), and Glencore (GLN) were the largest contributors from overweight positions. Industrial counters such as Barloworld (BAW), Naspers (NPN), both overweights, and Remgro (REM), an underweight, also lent support to outperformance. On the other hand the largest detractors were underweights in Anglo American (AGL) and BHP Billiton (BIL), and overweights in British American Tobacco (BTI) and Sappi (SAP).

At last rebalance date, we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Sappi (SAP), Old Mutual (OML) and Curro (COH) were removed, and African Rainbow Minerals (ARI) and Reinet (REI) were added. Exposures in RMI (RMI) and Kumba Iron Ore (KIO) have also been reduced while exposures to Assore (ASR) and Richemont (CFR) were increased in line with the risk objective of the fund. The biggest fundamental change in the portfolio’s positioning over the course of 2016 has been the rotation into the hard commodity stocks whose price and earnings revision signals remain strongest in our domestic universe.

We remain convinced of the factor’s medium- to long-term significance and the premium it offers in the South African capital market and remain disciplined in our implementation and extraction of the factor.