Market review
This quarter saw a sharp rebound of the JSE, with a total return of 6% for the Swix, led by a snapback of beaten-up resources stocks, which were up 18% and financials up 6%. This has been a global phenomenon led by emerging market bonds (up 11%). SA government bonds were up almost 12% in dollars, followed by a partial recovery of emerging market currencies and equities. Once again we see the phenomenon whereby extreme risk aversion is followed by a normalisation in prices, but in order to benefit from this one needs to remain stoic when the chips are down and focus on valuation first and foremost.
Investors who heavily sold financial stocks after the announcement that the Minister of Finance would be replaced unexpectedly in December changed course. Within the financial universe, Short-term Insurers, led by Santam after posting good numbers, was the leading component, up 27% during the quarter. Banks, which in December suffered their heaviest daily sell-off since the Rubicon speech, rebounded some 13%. Life Insurers also did well (up 6%) but they were not as heavily impacted by the December events as the banks due to greater diversification of revenues. Listed property returned 10% in the period, also rebounding after selling off as badly as the banks in December.
The current economic and political uncertainty has certainly fuelled some capital allocation decisions from corporate South Africa. We have seen a continuous trickle of offshore expansions, focused mainly on developed markets with FirstRand recently stating that they would scale up in the UK. On the other hand, we are likely to see some local divestitures. The most notable ones are Barclays plc, which announced that they would be disposing of close to 40% of ABSA, and Old Mutual plc, which decided to relinquish control of Nedbank and break up the group to unlock value.

What SIM did
The SIM Financials Fund returned a total of 5.2% for Q1'16, benefitting from the strong rebound in SA banks mentioned above, which comprised over 30% of the fund.
In the course of the quarter, we diversified somewhat out of SA banks and SA life insurers, which had a combined weighting in the fund of more than 60%. We achieved this mainly by selling completely out of Discovery, which we considered the most expensive SA life insurer, and Nedbank given that we already own a material weight on a see-through basis given the fund's weighting in Old Mutual.
We used some of these proceeds to add to Reinet, an investment holding company which trades at a 25% NAV discount and diversifies the fund into what is predominantly a defensive tobacco asset. We initiated a significant allocation to listed property as these also sold off in December and again in January. This includes local listed property such as Growthpoint and additions to UK listed property as these had sold off dramatically on Brexit fears (Britain exiting the EU) so we had an opportunity to buy these at sharp discounts to NAV.
We also added to offshore asset managers and insurers trading at sharp discounts to book value and/or high dividend yields. Overall, we estimate that the fund now has a 12% exposure to foreign businesses with hard currency exposure (not counting hybrids like OML and Investec which have SA and foreign exposures; in this case the see-through foreign exposure is closer to 20%).

Outlook
South Africa faces some further specific issues, namely stagflation and a potential credit downgrade with policy makers scrambling to re-establish credibility after the December cabinet reshuffle. This has undermined consumer confidence, which is at 15-year lows and the current account deficit at 5% of GDP is taking longer than expected to respond to the weak rand. South Africans are also bracing themselves for the impact of the crippling drought, which will require close to 0.5% of GDP in maize imports and will catapult food inflation into the double digits. The key issue now remains when Moody's, which has South Africa's sovereign rating two notches above junk, will downgrade us by one notch in line with the other rating agencies.
Over the longer term, South African businesses are likely to continue to focus on the African continent as a vector for growth, especially in financial services. A more positive story remains Sanlam's $375m acquisition of North African operator Saham, which will provide it with access to new African markets. Africa will become increasingly important in the lives of a streamlined Old Mutual, an ABSA sans- Barclays and a reinvigorated Standard Bank.

Market Review
The quarter was dominated by speculation around the timing of an interest rate increase in the Unites States, heightened global growth concerns and a concerning increase in terrorist activities by the Islamic State (IS). Against the backdrop of global growth concerns commodity prices continued to decline with Iron Ore falling 31%, Brent Crude losing almost 24%, Palladium 16%, Nickel 12%, Copper 8%, Gold 5% and Platinum 4%.

At the Federal Open Market Committee (FOMC) meeting in October, Fed chair Janet Yellen dropped the reference to global economic activity potentially having an adverse impact on the US economy, clearly influenced by the steady growth in consumption and a reasonable labour market. Despite this, uncertainty hinged on every data point emerging from the US until the actual rate rise in December when the US Federal Reserve finally raised its lending rate, ending months of speculation. It raised its benchmark lending rate by 25bp to between 0.25% and 0.50%, its first upward adjustment since 2006.

China grew at 6.9% yoy in Q3 versus the 7% it achieved in the first two quarters of the year. The bulk of the growth in Q3 was driven by consumption spend, which is where it wants to swing the economy in the medium to long term. The United States grew 2.0% yoy in Q3, a slowdown from the 3.9% achieved in Q2, but was broadly in line with expectations. The main reason for the slowing was the slowdown in inventory accumulation, which points to expectations of low growth. However, consumer spending grew at a healthy pace of 3.2% (was 3.6% in Q2).

The United Kingdom grew at 2.1% in the third quarter with the strong currency inhibiting exports.

The Eurozone grew at an annualised 1.2% in Q3 slowing from the 1.6% delivered in Q2. Mario Draghi announced an extension of the bond repurchase programme to March 2017, but kept the rate of repurchase at €60bn per month, which seemed to disappoint markets. Japan adjusted its Q3 growth rate up from a decline of 0.8% to growth of 1.0% annualised after adjusting for investment activity, technically taking the economy out of recession territory.

India recorded growth of 7.4% yoy in Q3.

Brazil's economy declined by 4.5% yoy in Q3. Inflation rose to 10.5% in November and Moody's warned that it may downgrade Brazil on concerns around its governability. Its minister of finance has since resigned.

China's manufacturing sector is still weakening - the Caixin Manufacturing PMI in China dropped to 48.2 in December from 48.6 in November, its tenth straight month of slowdown.

Broadly, flash PMI data continue to indicate that emerging markets remain weak while developed markets are in moderate expansion. November was a dark month on the geopolitical front across Europe, the Middle East and Africa. The spate of attacks started on 31 October when a Russian airliner carrying 224 passengers and crew was brought down over the Sinai province. IS claimed responsibility for the crash which killed all on board. On 12 November two suicide bombers killed 43 people in a southern suburb of Beirut, Lebanon, with IS claiming responsibility. The following day Paris, France experienced a number of attacks in the form of shootings and suicide bombings by IS, which killed 129 and injured 300. In Nigeria 41 people were killed in two separate explosions set by Boko Haram.

Brussels was in lock-down for a period of four days towards the end of November on fears of an imminent terrorist attack. Schools, businesses, events and public transport were all shut down.

A bomb blast at a luxury hotel in Mali's capital killed 20. In Tunisia a suicide bomber killed 12 troops in the presidential guard. A bombing of a hotel in Tunisia killed several people.

In December a couple killed 14 people in San Bernardino California in an attack that was apparently inspired by the Islamic State. Retaliation has been swift. France declared war on IS. Russian and French air forces carried out coordinated attacks on IS positions. The mastermind behind the Paris attacks was killed in a police raid in a Paris suburb five days after the attack. The IS leader in Libya was killed in an air strike. Jihadi John, the infamous IS member from Britain was killed in a drone strike. In December the British House of Commons voted in favour of air strikes against ISIS in Syria.

In Africa the move by the Nigerian authorities in imposing a $5.2bn fine on MTN's Nigerian subsidiary for failing to disconnect unregistered subscribers came as a shock. The Nigerian fiscus is clearly under pressure with oil having come off so materially since June 2014. Stanbic IBTC Holdings was also fined by the Nigerian authorities for alleged accounting irregularities. Locally, student protests around tertiary fee increases disrupted universities throughout the country early in the quarter, with the President eventually declaring that there will be no increases in fees in 2016.

South Africa's manufacturing PMI collapsed to 43.3 in November from an already weak 48.1 in October. In its November meeting the SARB raised the repo rate by 25bp on supply side inflation concerns. Arguably one of the most relevant events in the quarter in a local context was the dismissal by President Zuma of Finance Minister Nhlanhla Nene early in December and the announcement of his replacement, David van Rooyen, a whip of the standing committee on finance and whip of the economic transformation cluster and former Executive Mayor of Merafong Municipality.

This followed the sovereign downgrade by rating agency Fitch, which cut South Africa's sovereign credit rating by one notch to BBB-, placing it one notch above junk status, citing the slowing economy and rising debt as the main reasons. Fitch's move merely followed that of S&P. Markets didn't take the news well as the currency and local bond prices slid significantly. Banks had their biggest down day in 20 years post this event. In a move to restore confidence former Finance Minister Pravin Gordhan was reappointed to the position which saw the ZAR and bond prices stabilise, although at a lower level.

Sector Review
The FTSE/JSE All Share Index gained 1.7% in the quarter on a total return basis. Industrials returned 6.6%, while Financials lost 3.3% and Resources declined 19.2%.

For the year the All Share returned 5.1%, led by Industrials with a total return of 15.3%. Financials returned 3.9% while resources returned a negative 37%. Within Financials, Life Insurers (+1.5 %) handsomely outperformed the Banks (- 12.9%) in the quarter. Real Estate Investment Services was the top performing sector within Financials with a total return of 12.5% for the quarter. This was followed by General Financials with a return of 4.3%. The other sub sectors within the Financials space produced negative returns: Non-Life insurance (-16.2%), REITS (-4.3%) and Equity Investment instruments (-0.1%).

The performance in Life Insurance was driven by Old Mutual (+4.6%) and Sanlam (+1.2%), offset by weak returns from Liberty (-8.8%) and MMI (-7.5%). The stellar performance by Real Estate Investment services was driven by solid performances from Tradehold (+41.5%), New Europe Properties (+27.0%), Rockcastle (+19.3%), Stenprop (+17.7%) and Capital and Counties (+12.9%).

The performance within General Financials was driven by strong performances from Transaction Capital (+25.3%) and Brait (+18.8%) and a solid return from Investec (+5.3%).

Banks were driven lower by a weak performance across the board except for Capitec (+8.2%). The returns of the others were: Standard Bank (-15.9%), Barclays Africa (-15.7%), Nedbank (-14.2%) and FirstRand (-11.8%).

At a stock level it was the ZAR hedges and offshore property counters that stood out with Transaction Capital (+25.3%) being the exception. Brait (+18.8%), IAP (+18.6%), Capital and Counties (+12.9%) and Intu (+8.6%) were among the top performers. Alexander Forbes (-22.5%), Niveus (-16.4%), Santam (-16.2%), HCI (- 16%) and Standard Bank (-15.9%) were among the worst performers in the month.

The fund returned a negative 3.8% in the quarter (after costs), underperforming the Financials Index, which declined 3.3% (before costs) in the period. For the year the fund returned 0% (after costs) while the Financials Index returned 3.9% (before costs). The most material driver of underperformance in the quarter was the overweight position in the banking sector. The fund's underweight in Brait, Capital and Counties and Intu also contributed to the underperformance. The Banks are looking attractive on forward PEs of around 7x and dividend yields of 7% to 9%. Life Insurers are also offering value. The fund is well positioned in both of these sectors.

Actions taken in Q4
Transactions in the period were predominantly around the management of cash flows.
Outlook
SA bond yields have opened up. This has implications for funding costs for the fiscus, as well as for banks. The fiscus may seek to recoup some of this through higher personal taxes, which has negative implications for disposable income, which in turn is negative for credit loss ratios for banks and lapses for insurers. Banks will also run higher funding costs as a result of this and possibly as a result of increased competition for deposits as clients may choose to move deposits offshore. The banks liquidity position is already impacted by more stringent liquidity requirements amid a shrinking savings pool in SA.

The weaker ZAR will most likely result in higher inflation, which in turn could mean a more aggressive interest rate cycle than originally anticipated. This is negative for banks. The consumer environment locally remains constrained.

The consumer is over indebted and job growth is very subdued. Advances growth has taken place primarily in the corporate space and we see this trend continuing in the medium term. Banks will continue to compete aggressively for primary customers, which will likely keep pressure on fees. Life insurers will probably continue to see a slight uptick in lapses in the middle to lower end of the market as the consumer struggles to adjust.

Our outlook for the next twelve months is very uncertain. The start to the year in equity markets globally has been the worst in decades. Locally the drought has intensified and maize prices are currently well above import parity. The ZAR has weakened even further into the New Year and bond yields are spiking again. The threat of a further sovereign downgrade to junk is a meaningful overhang.

Our economists are looking for global GDP growth of below 3%. We have downgraded our expectations for SA GDP growth to 0% (from 1% to 1.5%) in 2016. We expect food inflation to move well into double digits in the year, pushing our estimate of CPI to an average of more than 6% in 2016 based on the currency converging to fair value by the end of June 2017.

We expect final consumption expenditure of SA households to grow at around 0.5% in real terms over the next twelve 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. SA banks are predominantly a domestic play and the subdued outlook locally is negative for bank earnings. We remain true to our investment philosophy and expect to deliver superior returns over time.