Macro

The third quarter saw the US Federal Reserve explaining its way out of tapering, a theme that dominated for most of the quarter but ran out of steam in the latter part of the period as the Fed announced a delay in the much expected tapering of its QE3 programme. It cited a tightening in economic conditions but was probably also factoring in the fiscal drag expected from the imminent budget debate in Congress. Larry Summers, the Fed governor designate, stepped out of the running leaving Janet Yellen, who is known to be less hawkish, as the most obvious candidate.

Military action against Syria was averted by Russian intervention, which led to the Syrian authorities agreeing to the hand over and destruction of its chemical weapons. Germany's Angela Merkel scored a record victory in the elections, a vote of confidence in her handling of the financial crisis. There was the senseless and tragic outcome of the Al Shabaab attack on the Wesgate Mall in Kenya. In the US, the quarter ended with a standoff between the Republicans and the Democrats on the budget resulting in a partial shutdown of the US government. Some sparks of light emerged from economic data out of the UK and Euro-zone, with the latter emerging from the longest recession in 40 years for continental Europe, albeit only just. Chinese growth in the second quarter came in at 7.5%, down on the 7.7% in the first quarter, causing commentators to speculate that China may miss its 7.5% target for the year, prompting some (mild) stimulus measures.

Developed market interest rates remained unchanged through the period but there have been some moves in emerging market economies that have felt the burden of softening currencies in the wake of tapering fears. Indonesia, Turkey and Brazil raised rates during the quarter. Brazil, a country experiencing a very similar economic dynamic to SA, raised interest rates by 50 basis points (bps) each month, resulting in a 150bps upward move to 9.5% during the quarter. Since its tightening cycle began in April this year, it has hiked its benchmark lending rate by 225bps in an attempt to fight inflation (largely imported as the Brazilian real has, along with the rand, been one of the worst performing currencies this year).

Locally, industrial action dominated, as the mining sector and various industrial sectors entered into wage negotiations. The fallout from this resulted in BMW shelving its expansion plans in SA. The rand weakened slightly (-1%) against the dollar during the quarter. Year to date the currency has shed 15.5% against the dollar. SA's twin deficit issue looks set to remain for some time, which is likely to keep pressure on the currency. The SARB left rates unchanged through the period as expected. But the consumer remains stressed, as indicated by increasing bad debt costs in the unsecured portfolios of lenders.

Hard commodity prices rallied during the quarter but broadly remain down for the year to date.

Sector Review

The JSE SWIX delivered a return 11% for the quarter on a total return basis. The Resource Index was the standout performer during the quarter, bouncing off its lows and returning almost 20%. Year to date, however, resources is still the worst performing sector on the JSE (-1%). Industrials (+11%) performed in line with the broader market and is still clearly the top performing sector for the year to date, boasting a 26.5% total return. Financials (+7%) underperformed for the period and remains an underperformer for the year to date.

Within Financials, banks (+12%) outpaced insurers (+5%) in the quarter. Year to date though it is still the insurers (+20%) that are ahead of the banks (+7%).

At a stock level, JSE (+21%) was the top performing counter during the period, followed by Nedbank (+19%), Peregrine (+19%), PSG (+18%) and Zeder (+18%). Discovery (-3.5%) was the worst performer, followed by Barclays Africa Group (-3%), Santam (-1%), Liberty (-1%) and Sanlam (+2%).

The Fund had a strong quarter, delivering a positive return of 9.8% and outperforming the Financials Index (+6.9%). Year to date the Fund has returned +13.5%, nicely ahead of the 11.4% Index return. On a rolling 12-month basis, the Fund has returned just over 26%, while the Index has returned around 22%. On a relative basis, the Fund has done well versus the peer group in each of the above periods.

The main contributors to this performance in the period were FirstRand, Nedbank, Standard Bank, Old Mutual and Investec. Detractors were Barclays Africa Group, Discovery and Santam.

FirstRand was up 16% for the quarter on a total return basis after producing a solid set of results for the year to June, with earnings up 20% and, with the dividend, growing 33%. Nedbank gained 19% during the quarter on a less impressive results performance for its six-month period to June, with earnings and dividends up 13%, impacted by an increase in its credit loss ratio in its retail portfolios and a large single loss in Business Banking. Standard Bank increased almost 10% during the period, outperforming the Financial Index. Its results for the six-month period to end June were up 10% and its ROE declined slightly. Old Mutual saw earnings up 8% in Sterling (22% in constant currencies) for its interim period to June, with strong client cash flows. Its wealth management business is getting some traction but it is early days yet. Investec was up 7% during the period, performing in line with the Financial Index. The company hosted a pre-close presentation for its interim results to end-August, which pointed to a disappointment.

While its SA businesses are performing reasonably, its UK and Australian banking businesses have performed poorly on weaker activity levels and further restructuring initiatives.

Discovery (-3.5%) derated during the period, following a run that saw it rated at a very significant premium to its embedded value. Barclays Africa Group (-3%) produced an uninspiring set of results for the six months to end June. Revenue growth is the challenge for the bank going forward as it revealed a 12% decline in its customer base. Santam (-1%) had a tough six months to June, with natural disasters and the weaker rand having an adverse impact on profits. It is relatively well positioned and we expect underwriting margins to normalise going forward.

Actions taken during Q2

During the quarter, we added to Santam and African Bank and lightened our positions in Old Mutual, Discovery, Intu properties and Investec.

Outlook

Our outlook for the next 12 months remains quite subdued, with our economists looking for global GDP growth of around 3%. We expect SA GDP growth to average 2% in 2013, and 3% in 2014. We expect CPI to average 5.9% in 2013, ending the year at 5.7%. Should the dollar rand exchange rate remain around current levels, we would expect interest rates to remain on hold through the next 12 months. However, should the currency weaken materially from these levels on a sustainable basis, we believe the SARB would be compelled to raise interest rates, which would constrain growth further.

Should income growth continue to disappoint, the targeted government debt consolidation will be difficult to achieve, which might result in the National Treasury increasing taxes and constraining economic activity.

Domestic manufacturing PMI fell into contraction territory in September. Our economists don't expect robust growth from manufacturing in 2013. The SARB leading indicator remains soft, which doesn't bode well for growth prospects.

We expect final consumption expenditure of SA households to grow at around 2.5% in real terms over the next 12 months, tracking compensation growth. Private sector fixed investment spending is likely to remain subdued as the marginal rate of return points to moderate growth going forward, which would also suggest soft employment growth.

We remain true to our investment philosophy and expect to deliver superior returns over time.

Macro

The quarter will probably be remembered for the concerns around the slowing of QE3 in the US and the stranglehold placed on Chinese banks as its central bank squeezed overnight liquidity causing interbank rates to spike. The release of the minutes of the April Federal Reserve meeting implied that the Fed was ready to consider slowing its bond repurchase programme ($85bn per month) if economic conditions continued to improve. This spooked the markets. US 10-year treasury yields rose 65 basis points (bps) during the quarter to 2.5%. The Chinese administration is attempting to curb excessive lending and redirect funds to more productive areas of the economy. Interbank lending rates have since stabilised but remain higher than historical levels.

Locally, events that probably had the most impact on financial markets were revelations by African Bank on the state of the unsecured lending market and the disappointing GDP growth numbers for the first quarter of the year. This, coupled with the withdrawal of funds from all emerging markets as a consequence of anticipated tapering on QE3, resulted in the downhill slide of the currency.

African Bank acknowledged that it had been surprised by the deterioration in the quality of its debtors' book and had to significantly bolster provisions and increase write offs. Fortunately we have been cautious on the micro-lending space and have not taken a meaningful position in the Fund.

SA's GDP growth of 0.9% for quarter one was well below a consensus expectation of around 1.6%. The rand lost close to 7% against the US dollar during the period, sending local investors scrambling for rand-hedge counters, while local consumer counters and banks underperformed. Global macro data broadly remain soft.

Sector Review

The JSE SWIX returned 0.7% for the quarter on a total return basis, with industrials the top performers (+7%) followed by financials (-1.6%) and resources way behind with -11.8%. Within financials, life insurers were yet again the clear outperformers (+1%) followed by other insurers (-0.6%), general financials (- 2.5%) and banks (-6%) again lagging significantly. The Fund had a tough quarter, returning a negative 2.7%. Year to date the fund has returned 3.4%, slightly behind the 4.3% return form the Financials Index. On a rolling 12-month basis, it has returned just over 21%, marginally behind the Index, which delivered 22.1%. On a relative basis, the Fund has done well verses the peer group in each of the above periods. Discovery, which returned +7% for the quarter, Coronation (+34%), Delta (+8%), Zeder (+9%) and Intu (+6%) were the main positive contributors to Fund performance during the period, while the positions in FirstRand, which was down 10% during the quarter, Nedbank (-8%), Standard Bank (-4%), Absa (-4%) and African Bank (-45%) detracted from performance.

Discovery released its interim results during the previous quarter, which were solid and resulted in it rerating very strongly during that period. Some of that momentum continued into the second quarter and it is now looking slightly expensive.

Coronation was the top performing financial counter during the period. It reported interim results for the six months to March 2013 that confirmed the momentum of inflows and the good performance of its funds, which boosted earnings by 88%. It increased its share of retail assets to about 13%. It is clearly enjoying the benefits of the virtuous cycle that might continue for some time yet but it is expensive.

Delta Property Fund had a 50% capital raising during the period, which was telegraphed at the time of listing (November 2012) and we followed our rights here. The counter trades at a dividend yield of more than 9%. Its BEE credentials mean that its assets are heavily weighted to government-tenanted properties, with very long-term leases, low vacancies and rentals escalating contractually at 8%+ a year. We believe a track record of real (above CPI) distribution growth, combined with improving liquidity as the fund grows its assets, will aid in a rerating, offering a favourable long term expected total return.

Zeder proposed a change in the fee structure for fees paid to PSG and also sought approval for the sale of Capevin Holdings. The counter still offers value, trading at a discount to its underlying investments.

Intu Properties released its interim management statement for the first quarter during the period - overall a good result in a relative sense. Footfall was down 1% on the previous period but did outperform national footfall (-4%). On the negative side, vacancies are at 5%, up from 4% and 3% in the last two years respectively. Units being traded by administrators are also up from 1% a year ago to 3% currently. We expect distribution growth to be muted in the medium term.

The underperformance by the banks was most likely due to the numbers published by African Bank midway through the period which saw its credit risk charge increased 180bps to 14.9%. The deterioration in its debtors book had surprised management and it responded by bolstering provisions and increasing write offs, sending a shudder through the sector. FirstRand is more exposed to unsecured lending relative to the other three large banks and possibly the announced resignation of its FNB CEO contributed to the share's more than 10% decline. Nedbank also pointed to an uptick in its bad debts and stated that it is seeing more stress in the unsecured area of its business - the counter declined 8% during the period. There was no specific news from Absa and Standard bank but they too were impacted by the negative sentiment.

Outlook

Our outlook for the next 12 months remains quite subdued, with our economists looking for global GDP growth of around 3%. We expect SA GDP growth to average 2% in 2013, and 3% in 2014. We expect CPI to average 6.1% in 2013 ending the year at 5.7%. Should the rand/dollar exchange rate remain around current levels, we would expect interest rates to remain on hold through the next 12 months. However, should the currency weaken materially from these levels on a sustainable basis, we believe the SARB would be compelled to raise interest rates, which would constrain growth further.

Should income growth continue to disappoint, the targeted government debt consolidation will be difficult to achieve and might result in the National Treasury increasing taxes, which will constrain economic activity.

Domestic manufacturing PMI stalled in the first quarter from quite a robust fourth quarter last year but is still in expansionary territory (marginally). Our economists don't expect robust growth from manufacturing in 2013. The SARB leading indicator remains soft. This doesn't bode well for growth prospects.

We expect final consumption expenditure of SA households to grow at around 2.5% in real terms over the next 12 months, tracking compensation growth.

Private sector fixed investment spending is likely to remain subdued, as the marginal rate of return points to moderate growth going forward, which would also suggest soft employment growth.