Macro review

In the US, economic growth remained robust and this ultimately overshadowed simmering concerns around the escalating US.China trade war. Stability in growth and employment figures allowed the Federal Reserve (Fed) to enact its widely anticipated increase in the federal funds rate by 25 basis points. The committee dropped its long-standing description of monetary policy as eaccommodativef and reaffirmed its outlook for further gradual hikes into 2019. Data released in September showed wages to be growing at the fastest rate since 2009, while additions to non-farm payrolls remain above 185 000 on a three-month average. As yet, industrial activity indicators show little impact from the trade wars.

In Europe, worries over trade wars and potential US tariffs on cars were a feature of the period. On the economic front, Q2 2018 growth was revised up to 0.4% quarteron- quarter, compared to the initial estimate of 0.3%. Forward-looking activity indicators continued to point towards expansion, albeit at a more subdued pace than at the start of 2018. The Flash Eurozone PMI Composite Output Index (1) for September fell to a four-month low of 54.2. Eurozone inflation was estimated at 2.1% for September, up from 2% in August. There was no change in policy from the European Central Bank who reiterated that interest rates would remain on hold eat least through the summer of 2019.

In emerging markets, there was little progress in bilateral trade negotiations and China responded with tariffs on $110 billion of US goods. Meanwhile, Chinese macroeconomic data disappointed. Turkey experience a sharp sell-off in the Lira, as geopolitical tensions with the US exacerbated ongoing concerns over its wide current account deficit, above-target inflation and central bank independence. South Africafs macro backdrop deteriorated as global liquidity tightened given the economyfs twin deficits, and Q2 2018 GDP growth disappointed, slowing to 0.4% year-on-year. Mexico saw positive general elections and an agreement with the US on NAFTA renegotiation. Despite ongoing risk of new US sanctions, Russia benefited from crude oil price strength.

Global and local market review

The MSCI World Index posted a Dollar total return of 5.1% (+1.9% for Q2 2018), once again outperforming the MSCI Emerging Markets Index (-0.9% in Q3 2018 vs - 7.9% in Q2 2018). In the US, despite political uncertainty and trade concerns, the US equity bull market became the longest in history on 22 August, and advanced in Q3 2018 to significantly outperform other major regions. Over the quarter, the information technology and healthcare sectors were boosted by a slew of robust earnings. Eurozone equities posted a modest gain in Q3 2018 with the MSCI EMU (European Economic and Monetary Union) Index returning 0.4%. Energy and industrial stocks were among the leading gainers. The FTSE/JSE All Share Index fell 0.8% amid Brexit uncertainty and a tempering of the global growth outlook, as a result of the escalating trade war between the US and China. Although trade tensions continued to escalate during the quarter, the Japanese stock market ended September above its recent range to show a total return of 5.9% for the quarter.

Emerging market equities lost value in what was a volatile Q3 2018, with US Dollar strength and the US.China trade dispute weighing on risk appetite. China underperformed as the US implemented tariffs on a total of $250 billion of Chinese goods, some of which are set to increase in January, and threatened tariffs on a further $267 billion of goods. There was little progress in bilateral trade negotiationsand China responded with tariffs on $110 billion of US goods. Turkey was the weakest index market amid a sharp sell-off in the Lira. South Africa also underperformed. The market is vulnerable to global liquidity tightening given the economy’s twin deficits, and Q2 2018 GDP growth disappointed, slowing to 0.4% year-on-year. SA Resources and SA Financials outperformed in Q3 2018 with total returns of 5.2% and 2.8% respectively, while the SA Industrial sector was the drag on the index, shedding 7.8% over the same period.

Portfolio performance, attribution and strategy

Global trade uncertainties and other geopolitical risks once again weighed heavily on investor minds over the prior quarter. This resulted in rotation between the Momentum/Growth and Value strategies during the quarter as the slope of the yield curve gyrated. Short interest in the Price Momentum strategy globally has stabilised near historical average, suggesting it is not as crowded anymore. The Momentum strategy’s macro risk has also declined recently, and it has become more defensive to credit risk. Additionally, the performance of the Price Momentum strategy started to diverge from the Growth strategy as they become much less correlated.

In South Africa, both the Price Momentum and Earnings Momentum strategies have endured a tough quarter. With broad equity indices down in absolute terms over the period, these cyclical strategies are expected to experience some underperformance. Whereas previous quarters saw Earnings Momentum (a subcomponent of Headline Momentum) and Price Momentum exhibit divergent performances, during Q3 2018 we saw synchronised underperformance, as investors disregarded companies with positive earnings sentiment. Typically, however, the Earnings Revisions strategy encompasses a more defensive component, and we expect Earnings Momentum to fulfil its role going forward in our overall Momentum strategy.

As an overall factor the Momentum strategy struggled during Q3 2018 relative to the FTSE/JSE Capped Shareholder Weighted Index (Capped SWIX). The strategy’s positive contributions to performance was largely attributed to high-scoring Momentum stocks such as Assore (ASR), Capitec (CPI) and African Rainbow Minerals (ARI). In terms of underperformance contributors, these included overweight positions in Naspers (NPN), Clicks (CLS), Standard Bank (SBK) and Imperial (IPL), and underweight positions in MTN and Old Mutual (OMU).

At the last rebalance date (mid-September), we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Anglo American (AGL), Aspen (APN), Barlows (BAW), Kumba Iron Ore (KIO) and MTN were removed, whereas exposures to Assore (ASR) and Rand Merchant Holdings (RMH) were cut due to their waning strength of momentum signal. On the positive side, we added Exxaro (EXX) and Santam (SNT) based on its current strong signal, and also increased allocations to Anglo American (AGL), all in line with the risk objective of the fund.

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.

Macro review

In the US, equities began 2018 strongly, buoyed by ongoing strength in economic data, robust earnings and the confirmation of a major tax reform package. US business confidence reached an unexpected, multi-decade high in March, while GDP for Q4 2017 was revised upwards to show growth of 2.9%. The latter part of the quarter, however, saw a marked increase in volatility as investors first digested the destabilising potential of an elevated US inflation reading and the possibility that the Fed may need to become more proactive in raising interest rates, as well as escalating US-China trade sanctions, which precipitated a renewed bout of turbulence in March.

In the Eurozone, the economic backdrop remained encouraging over the three months. GDP growth for Q4 2017 was confirmed at 0.6% quarter-on-quarter. Unemployment was stable at 8.6% in January 2018. However, forward-looking surveys painted a picture of slower future growth. The composite PMI hit a 14-month low in March, albeit the reading of 55.3 still implies solid growth. European Central Bank chairman Mario Draghi reiterated that interest rates would not rise until well past the end of the quantitative easing programme. On the political front, the key event of the quarter was Italy’s election, which yielded no overall winner. Germany formed a new government after its inconclusive elections in September 2017. Angela Merkel remains as chancellor after her centre-right CDU/CSU agreed another grand coalition with the centre-left SPD.

Emerging markets saw positive returns in the first quarter despite a rise in market volatility stemming from tensions over global trade. Brazil’s former president Luiz Inácio Lula da Silva saw his criminal conviction upheld, while in Russia the central bank cut interest rates and the country’s debt was upgraded to investment grade by ratings agency S&P. In China, macroeconomic data remained broadly stable, albeit there were ongoing signs of a gradual slowing in momentum, with official PMI easing to 50.3. By contrast, there was concern in India over reported fraud at a state -owned bank.

Global and local market review

Global equity markets declined in Q1 2018 with investors unnerved first by concerns about the path of US interest rate rises and then worries over trade. US equities began the year strongly, boosted by tax reforms, but ended the quarter lower amid concerns over inflation and the impact of US-China trade sanctions. Following a 10% correction from its January highs and rallying back 8% by early March, the S&P 500 Index suffered another 5% pullback in the last few weeks, ending the month of March down 2.5% and losing 0.8% over the last three months, which was the first negative quarter since the third quarter of 2015. Eurozone equities posted negative returns as worries over US rates and trade affected other markets. Italy’s election was inconclusive but had limited impact on the equity market.

Emerging market (EM) equities outperformed, delivering a positive return in US dollars. The MSCI EM Index was up +1.5% (total returns) in Q1 2018, ahead of the MSCI World (Developed Market) Index, which was down 1.2%, the first quarterly loss in two years. 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 Tiger Brands were both down 12%). SA Resources lost 3.8% (rising global uncertainty) and SA Financials lost 3.6%. 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%).

Portfolio performance, attribution and strategy

Globally, cyclical sectors performed more strongly in January and February, when the market was focused on faster rate hikes while in March, the broader decline in risk appetites saw more defensive areas outperform. From a style perspective, this was consistent with the global Momentum and Growth factors’ correction during March, as rotation and perhaps profit-taking have dragged on a generally positive Momentum factor during 2018, primarily driven by perceived increased risk to global growth.

In South Africa, there was large consistency with global outcomes, as back-endloaded cyclical pressure over the quarter dampened an otherwise strong Momentum signal. Earnings Revisions (a sub-component of Headline Momentum), on the other hand, once again has not performed in line with Price Momentum, generating negative returns as poor earnings sentiment failed to deliver in an environment with high levels of corporate uncertainty.

As an overall factor, however, the Momentum strategy struggled during Q1 2018 relative to the FTSE/JSE Shareholder Weighted Index (Swix). The strategy’s performance was attributed on the positive side to exposure to its off-benchmark underweight positions in property stocks, including Resilient (RES), NEPI Rockcastle (NRP) and Fortress (FFB), while overweight positions in Standard Bank (SBK) and Barloworld (BAW) aided the strategy. On the negative side, cyclical exposure to Northam Platinum (NHM), African Rainbow Minerals (ARI), Kumba Iron Ore (KIO), Exxaro (EXX) and Assore (ASR) weighed on the strategy, while speculation around Capitec (CPI) fundamentals also contributed negatively.

At the last rebalance date (mid-March), we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Exxaro (EXX), Reinet (RNI) and Impala Platinum (IMP) were removed, and Harmony (HAR) and The Foschini Group (TFG) were added. Exposures in British American Tobacco (BTI) and African Rainbow Minerals (ARI) have also been reduced while exposures to Mr Price (MRP) and JSE (JSE) were added in line with the risk objective of the fund.

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.