Our positioning
It is likely that the developed market central banks’ quantitative easing policies are coming to an end. The US Federal Reserve will begin to unwind its US$4 trillion balance sheet from this October, at a rate of R50 billion per month.

As explained in previous commentaries, we believe that assets in general, and US equities in particular, are overvalued. This overvaluation might be due to the quantitative easing programme of the developed market central banks.

We remain underweight global bonds and marginally underweight risky assets given current valuations. We believe that all these assets did benefit from the quantitative easing policies.
Local investments:
Local equities
During the quarter we changed our position in SA equities from underweight to neutral. Given estimates of earnings growth, the SA equity market currently trades at a 15 times one-year forward earnings (PE) multiple.

Naspers now makes up 21.2% of the SWIX Index. If we exclude Naspers, then the forward PE of the market is about 13. (According to our analysis Naspers is currently trading 25% below its fair value.) Based on this the SA equity market is fairly priced.

According to a bottom-up valuation of the SWIX, where we aggregate the fair values of its constituents as calculated by the SIM analysts, SA equities are approximately 25% undervalued. This is because of: 1. improved earnings prospects of the resources companies given higher commodity prices; 2. the derating of companies with domestic earnings; and 3. an increase in the valuation of Naspers, given earnings surprises from Tencent, which is its largest holding.

Local bonds
We retained an overweight position in conventional bonds, as the approximately 3% real yield on offer is attractive if compared to the domestic bonds of similarly rated countries. Inflation is under control and well within the inflation target band.

Inflation-linked bonds
Ten-year inflation-linked bonds (ILBs) currently offer an attractive real yield of 2.50%. For this reason, we retained the overweight position in ILBs during the quarter.

Unlike conventional bonds, ILBs protect against unexpected inflation and are therefore considerably less risky. SA ILBs are also attractively priced relative to developed market ILBs.

Local listed property
We have a neutral holding in listed property. We believe that JSE-listed properties are fairly valued at a current one-year forward dividend yield of 7.1%. Approximately 35% of JSE-listed property companies’ earnings are 7.1%. Approximately 35% of JSE-listed property companies’ earnings are now from outside South Africa.

Global investments:
On a purchasing power parity basis, the trade-weighted rand is back at about fair value. Against the euro and British pound, the rand remains overvalued while it continues to be undervalued versus the US dollar.

Global equities
Global equity markets are expensive according to our valuation methodologies. For the US market, in particular, valuation measures such as Tobin's Q ratio (EV/replacement value), stock market capitalisation to GDP ratio and the Shiller PE ratio are all at about 1.5 times their standard deviation above their long-run average values.

Even though European equity markets have performed well relative to the MSCI World Index, using valuation measures such as forward PE, Shiller PE and price-to-book ratios, Europe is still about 15% cheap. We therefore retain our overweight Europe position in our global equity portfolio.

Global bonds
We retained our underweight position to global sovereign bonds. We would require a premium above long-run global inflation assumptions of 2% before considering investing in developed market government bonds.

Global property
We retained an overweight position to our global property basket. Currently the properties we own have an average dividend yield of 5.5%. This is fair if a real return of about 4% is required.

Risks and opportunities ahead
Geopolitical risk has increased as the hostility between North Korea and the US escalates. However, it seems as if the financial markets are assigning a very low probability to a full-scale war between the US and North Korea. The price moves of financial assets are muted in response to war-mongering events such as new North Korean missile and nuclear tests, or new verbal threats.

South Korea and Japan are embroiled in the dispute between North Korea and the US. Both countries are important participants in the world economy.

Overview
Our positioning During 2016 global political uncertainty rose considerably. In Europe the Brexit vote and the Italian referendum caused uncertainty with respect to the future of the European Union and Britain’s role within the EU. The election of Donald Trump as the US president has further increased uncertainty due to his proposed policies, some of which are impractical or ambiguous.

It is considerably easier to determine asset prices in an environment of political and economic stability. The value of assets depends on the future cash flows that they can generate, discounted by the time value of those cash flows - the risk free rate. The future cash flows of companies, for example, are more uncertain in a political environment that is rapidly changing. Typically we would require a higher risk premium or discount when buying assets to compensate for the increased risk. This is not something we are seeing in the pricing of international assets. Instead they have become more expensive.

Local investments:

Local equities
We retained our underweight position in South African equities. The historical price to earnings (PE) ratio of the South African equity market is above 20. Given the increase in commodity prices, the earnings of the resources companies are expected to make a significant recovery. If this materializes it should bring the PE to below 15 by year-end. However, this is still above our estimate of a fair PE of 12 to 13, given our long-run real required return of 7% for South African equities.

It is interesting to note that Naspers now makes up 16.5% of the SWIX index. It is trading on a very high PE ratio because its price reflects a very rapid earnings growth. Excluding Naspers, the historical PE of the market drops to around 17.

Local bonds
We retained our overweight position in South African long bonds. South African long bonds are still offering among the highest local currency real yields in emerging markets. Even if inflation settles at the top end of the 3% to 6% inflation target a real return of 3% is on offer. This is particularly attractive given the low real returns available in equity markets, as well as global bond markets.

Inflation-linked bonds
We introduced a 0.5% overweight position in local inflation-linked bonds in December 2015 when their yields briefly spiked to 2.3% after the Minister of Finance was dismissed. Inflation-linked bonds rallied in the first part of 2016, but in the last quarter of 2016 the 10-year inflationlinked yield weakened to above 2%. We consider this to be an attractive real yield, as this is the real return that conventional 10-year long bonds have returned in SA over the past century. Unlike conventional bonds, inflation-linked bonds provide protection against unexpected inflation and are therefore considerably less risky. SA inflation-linked bonds are also attractively priced relative to developed market inflation-linked bonds.

The SA government is in effect in control of the rand printing press so the default risk on rand denominated SA inflation-linked bonds is low, as long as the inflation-linked component of the SA government’s total debt stays at a reasonably low level. Currently it is at 24%. There is probably more risk with the accuracy of the measurement and the measurement methodology of inflation, especially during periods of very high inflation or hyper-inflation. If this is a problem then the inflation adjustment applied to these bonds would be compromised.
We still prefer SA conventional bonds to inflation-linked bonds as is reflected in the position sizes. Implied inflation, calculated by subtracting the inflation-linked yield from the conventional bond yield, is priced to be well above 6%.

Local listed property
We have a neutral holding in listed property. We believe that JSE listed properties are slightly expensive at a current dividend yield of 6.2%. Approximately 40% of JSE listed property companies’ earnings are now from outside South Africa. We’ve retained the neutral position due to the geographic diversification of the income stream, and the fact that this is still a relatively high yielding asset class in an environment starved for yield.

Global investments:
On a purchasing power parity basis the rand is approximately one standard deviation cheap against the US dollar, while it is trading above fair value versus the British pound and the euro. We retained the underweight position with respect to our portfolios’ total offshore exposure. The interest rate differential on cash investments is at approximately 7%.

Global equities
We cut our overweight position to neutral in global developed market equities in the third quarter of last year. This is after a good eight-year run with the MSCI World Index giving an annualized return of 11% during this period.

After Mr Trump was elected as US president, world markets, and the US market in particular, rallied significantly. This might be in expectation of rising corporate profits given Mr Trump’s promised plans of cutting corporate taxes and also new infrastructure spending.

The US market is expensive on a current rolled PE of 20 and a price to book ratio of 2.8. We are of the opinion that the market is over-optimistic about Mr Trump’s policies. On a purchasing power parity basis, the US dollar is considerably overvalued versus emerging market currencies, making US companies less competitive. Furthermore, non-financial US companies have increased their financial leverage considerably since 2012 to buy back shares, with debt to assets now at record high levels of around 27%.

We did retain a neutral position in developed equity markets as real returns from competing assets were not attractive. However, with rising global bond yields we are reconsidering this decision.

Global bonds
Even though global sovereign bond yields weakened after the election of Mr Trump as president, we retained our underweight position. At a yield of about 2.4%, US long bonds offer a positive real return relative to our long-run inflation assumption of 2% for the developed world. We are concerned about long-run global inflation (see the discussion below) and would require an attractive premium above 2% before investing in developed market bonds.

Global property
We retained our overweight position in international properties via listed REITs. Our portfolio currently consists of nine companies that have properties in the USA, UK, Europe and Australasia. The average dividend yield of the portfolio is 6.0%. These REITs typically have a 40% debt to equity ratio so rising bond yields would increase their cost of funding over the longer run. However, since we do expect some growth in earnings from these property companies, especially if inflation rises, they should outperform global bonds in the long run.
Risks and opportunities ahead
We are worried that global inflation might become a problem. Commodity prices have recovered rapidly in 2016 and this has already caused corporate goods prices to start increasing in China. Also Mr Trump’s plans for fiscal stimulus, through infrastructure spend, could push up inflation. All of this should be seen in the light of the quantitative easing policies of the past few years with central banks printing money to fund rising government debt in the US, Europe, UK and Japan. US government debt to GDP has increased from 65% in 2007 to well over a 100% now.