What a strange world we live in! Can US equities, which are by most observers perceived to be quite expensive by historical standards, be the safest haven around? The way asset prices have been behaving, one could be excused for wondering… Despite global manufacturing indicators such as purchasing managers’ indices and manufacturing confidence remaining positive (albeit at levels below where it started the year), emerging market (EM) currencies and assets have been under relentless pressure, while in the developed world equities continued to outperform everything else and within that universe the US remained the star. In the last 10 years, post the global financial crisis, US equities outperformed the MSCI World ex USA Index by more than 6% p.a. In the last year that outperformance increased to almost 15% and in the last quarter it accelerated to almost 30% (on an annualised basis). Although the US technology sector greatly contributed to this outperformance, it was not the exclusive driver. Even the S&P 500 ex Technology Index outperformed the MSCI World ex USA Index by roughly 5%, 10% and 23% annualised over 10 years, one year and three months respectively.

In our previous two quarterly reports we highlighted that EMs did not do themselves any favours, with a couple of self-inflicted crises that sowed doubt about EMs. However, EMs generally are in much better shape than historically when broader EM crises developed and we believe that market movements against EMs have been overdone. However, our exposure to EM equities continued to disappoint, with continued underperformance of EMs during the quarter accentuated by underperformance from our chosen solution.

We also previously made the case for global equities to continue outperforming global fixed-interest assets, on the back of interest rates rising slowly (given high debt levels) and earnings support. And in this context the US has been the poster child, with earnings rising strongly to support equity price performance. However, the accelerating nature of US outperformance and the level of earnings growth that would be required to support valuations, are starting to concern us. Does that mean US equities are due for a correction as many commentators claim? It might be, but it is not certain - such an event is near impossible to predict. As long as earnings show positive growth, a US equity correction might remain a rainless dark cloud, but in our opinion, it is a cloud that at least warrants carrying an umbrella or a raincoat. Consequently, in the last quarter, we started adding some protective structures to the foreign equity portion of the portfolio and will continue to do so into any continued equity market strength.

In US Dollar terms only equities gave a positive performance for the quarter (with the MSCI World Index up 5%), while property, bonds and cash all delivered marginally negative returns. But the continued broader EM currency weakness saw the Rand weaken about 3% in US Dollar terms, lifting the performance of all foreign assets into positive territory and also above the best of what was available locally. After six months of continued weakness, the Rand reached levels above what fundamental drivers would suggest it should be at and when near R15/$ we started bringing some money back to SA to redeploy in attractively priced local assets. For this we had to trim back our foreign equity position a bit. We do find it very difficult to be very aggressive on the repatriation trade, however, since when things really went wrong for emerging markets in the past the Rand had sometimes blown out to levels in excess of R20/$ when expressed in current value terms. So, we’ll rather bring back more aggressively during times of more substantial currency weakness.

We continued to avoid global fixed-interest assets. It is difficult to find a scenario where these provide any form of real return in the foreseeable future, given that developed market bonds are offering low or negative prospective real yields and, in addition, their yields are more likely to rise than fall due to the quantitative easing policies of central banks coming to an end.

We reduced the previously held exposure to a basket of developed market real estate investment trusts (REITs) and added the proceeds to a diversified portfolio of attractively priced real assets (property, renewable energy, infrastructure, utilities) where long-term contracts are in place for income to rise with inflation. These assets should over time exhibit lower correlation to equity markets, while providing attractive real returns that should rival that of equities.

On the local front, all assets but cash experienced another quarter of lacklustre returns. Fixed-interest assets delivered marginally positive returns of less than 1%, whereas growth assets lost some ground with property down by 1% and equities down 3.3% (FTSE/JSE All Share Index). It has now been almost four years during which all local assets gyrated around a trend return defined by cash and where no compensation was awarded for incurring volatility in the other asset classes. During that time the other asset classes all got cheaper and, in our opinion, they are all priced for returns in excess of their respective expected long-term returns.

Towards the end of the quarter bond yields started approaching levels last seen prior to the ANC elective conference, with prospective returns from bonds rising to around 4% in real terms. The risk of further downgrades to our credit rating has indeed increased again and hence the rise in yields could be justified, with the ever-present risk of another spike upwards in bond yields being a constant threat to local bond investments. However, at levels where bonds offer real returns of 4% and more, we deem the returns adequate compensation for the increased risk. Property, on the other hand, is offering a very competitive yield and a material slowdown in the sector’s distribution growth will be required for the asset class not to outperform local fixed-interest assets. And after a prolonged period of low returns, combined with recent weakness, local equities have become the most attractively priced it has been in a few years.

Consequently, we continued to add to our position in local bonds, maintained our moderately high exposure to local property and added to our local equity exposure. That does give us above average exposure to growth assets and should the period of cash outperformance continue, our chosen position will put pressure on performance. However, we don’t claim to have superior skill in timing the market and as valuationanchored investors we believe in channelling money to assets that offer value, since over time these should deliver superior returns.

Economic indicators continue to indicate synchronised global growth, with positive signals from a broad range of cyclical indicators such as purchasing managers’ indices, consumer sentiment, commodities and consensus GDP numbers. This is resulting in continued positive earnings revisions, which is further supported by actual GDP and earnings announcements. Given that this is happening while global policy rates are either kept stable, or raised very modestly, growth assets continue to see support and in the past quarter, growth assets again delivered strong returns, especially in emerging markets where there should be much benefit from synchronised growth.

It is difficult to find a high probability scenario under which developed market bonds will provide any form of real return in the foreseeable future. These bonds are offering low or negative prospective real yields and, in addition, their yields are more likely to rise than fall, due to the quantitative easing policies of central banks coming to an end. The low prospective returns from foreign fixed-interest assets continue to support valuations of foreign growth assets, despite them looking expensive by historical standards on most traditional measures. As long as global interest rates remain low or rise slowly and earnings don't contract, the current pricing levels for equities can be rationalised and hence could be maintained, with equities likely to continue delivering superior returns relative to fixed-interest assets. For this reason, we have retained a moderately high position in foreign equities and continue to avoid global bonds.

The US equity market is expensive in our opinion. US companies have, on average, also become riskier during the last few years as they issued debt to buy back stock. European equities remain cheaper on various valuation measures. We therefore continue to have a bias towards Europe within our global equity allocation. We have added a bit of exposure to emerging markets, which should continue to gain from the synchronised global growth. We also retained a small exposure to a select basket of developed market real estate investment trusts (Reits). This is due to a lack of attractively priced alternative investment opportunities. The properties we own typically have an average dividend yield of around 6%, which is fair if a real return of about 4% is required.

In the local markets we experienced much volatility due to a combination of a surprise, yet sobering medium-term budget speech, a further credit downgrade and the ANC elections. The equity market was also rocked by the Steinhoff saga and impacted by a significant see-saw move in Naspers. By mid-quarter the rand was significantly weaker and bond yields had spiked, but post the ANC elections these had turned around and bonds ended the quarter almost at the same yield to where they started, while the rand ended up much stronger.

Equities, on the other hand, had a strong start to the quarter, helped by a buoyant Naspers and the weaker currency. However, the asset class gave back some of those gains in the second half of the quarter, with Naspers pulling back by 15% from its peak and Steinhoff losing more than 90% of its value. Despite the latter-half weakness, both equities and property still strongly outperformed the local fixed-interest markets over the quarter, with gains of 9.6% and 6.3% respectively, against the 2.2% of bonds and 1.8% of cash. Due to the strength of the rand, local markets generally outperformed global markets, with even global equities - the best of the offshore assets with a 5.5% US dollar return from the MSCI World Index - being down 3.3% in rand terms.

We continue to see good returns on offer from just about all local fixedinterest assets, based on an increased risk premium applicable to South Sanlam Namibia Balanced Fund April 2018 interest assets, based on an increased risk premium applicable to South African investments. These prospective returns are higher than the longterm historical returns generated by local fixed-interest assets and we continue to hold a moderate position in local fixed-interest assets. Given that shorter-dated credit instruments offer returns that are similar to longer-dated government bonds, but with much lower volatility, we have deemed it prudent to divide exposure between these two investment options.

During the first half of the quarter, bond yields rose strongly and bonds became more attractive, but still faced the risk that political developments could push yields even higher (and prices even lower). Over the period of the ANC elections we implemented a derivative structure to provide additional exposure, but with reduced downside to bonds, in case of a bond rally. When a strong rally did occur in the week after the ANC conference, we closed out the structure and locked in the gains, capturing the bulk of the positive move in the bond market.

A derating of local property over the last three years took place despite property's resilient growth in dividends, which has kept pace with inflation and was much stronger than dividend growth from equities. Furthermore, approximately 35% of JSE-listed property companies’ earnings are now from outside South Africa, with a skew towards euro exposure, a currency that still seems cheap against the rand on a purchasing power parity basis. Given the increased political uncertainty in SA during the previous quarter, listed property companies with a South African rental income stream became cheaply priced. The three largest and most liquid SA Reits (Growthpoint, Redefine and Hyprop), which derive 80% of their earnings from SA, offered an average dividend yield of about 8%. Even with very modest distribution growth - well below our assumption for longterm inflation - these counters were priced to deliver real returns in excess of what we require from SA listed property companies. We therefore built on our position in SA listed property by buying a blend of these three stocks.

We have added to our exposure to South African equities. Companies with a South African earnings base (i.e. financials and retailers), have rerated given the outcome of the ANC elective conference in midDecember. Naspers now makes up about 25% of the Swix Index. According to our analysis, Naspers was trading at 34% below its fair value at quarter end. If we exclude Naspers, then the forward P/E of the market is about 13.5 times. Based on this, the SA equity market is fairly priced in the context of globally repriced equity markets. This is supported by a bottom-up valuation of the Swix, where we aggregate the fair values of its constituents as calculated by the SIM analysts.

No discussion of equities for the past quarter would be complete without reference to the terrible loss experienced in Steinhoff. Although we had exposure to the share and hence suffered a loss of almost one percent of fund value as a consequence, this illustrated again the benefit of having a diversified portfolio to reduce the impact of such a negative event.

Risks
Global real yields have dropped substantially after the 2008 financial crisis. We remain unsure whether this is a temporary phenomenon, due to central bank policies of quantitative easing, or whether this is more permanent due to globalisation and demographic changes. Even if temporary, we can't predict the rate of normalisation.

Assets are currently priced as if real yields are going to remain low for a prolonged period and we can express a rationale for such based on global debt levels. On a relative basis, growth assets are priced to global debt levels. On a relative basis, growth assets are priced to continue giving the type of outperformance (over fixed-interest assets) that they have historically given. The risk does lie in a more rapid normalisation of pricing levels (to historical average values) that would detract from growth assets' relative returns.

South African assets have rerated given the outcome of the ANC elective conference. To what extent the management of the country will improve given the change in leadership remains to be seen. A lot of good news has been priced in, even though the government’s financial position remains precarious.

Overview and Asset Allocation

Economic indicators continue to indicate synchronised global growth, with positive signals from a broad range of cyclical indicators such as purchasing managers’ indices, consumer sentiment, commodities and consensus GDP numbers. This is resulting in continued positive earnings revisions, which is further supported by actual GDP and earnings announcements. Given that this is happening while global policy rates are either kept stable, or raised very modestly, growth assets continue to see support and in the past quarter, growth assets again delivered strong returns, especially in emerging markets where there should be much benefit from synchronised growth.

It is difficult to find a high probability scenario under which developed market bonds will provide any form of real return in the foreseeable future. These bonds are offering low or negative prospective real yields and, in addition, their yields are more likely to rise than fall, due to the quantitative easing policies of central banks coming to an end. The low prospective returns from foreign fixed-interest assets continue to support valuations of foreign growth assets, despite them looking expensive by historical standards on most traditional measures. As long as global interest rates remain low or rise slowly and earnings don't contract, the current pricing levels for equities can be rationalised and hence could be maintained, with equities likely to continue delivering superior returns relative to fixed-interest assets. For this reason, we have retained a moderately high position in foreign equities and continue to avoid global bonds.

The US equity market is expensive in our opinion. US companies have, on average, also become riskier during the last few years as they issued debt to buy back stock. European equities remain cheaper on various valuation measures. We therefore continue to have a bias towards Europe within our global equity allocation. We have added a bit of exposure to emerging markets, which should continue to gain from the synchronised global growth. We also retained a small exposure to a select basket of developed market real estate investment trusts (Reits). This is due to a lack of attractively priced alternative investment opportunities. The properties we own typically have an average dividend yield of around 6%, which is fair if a real return of about 4% is required.

In the local markets we experienced much volatility due to a combination of a surprise, yet sobering medium-term budget speech, a further credit downgrade and the ANC elections. The equity market was also rocked by the Steinhoff saga and impacted by a significant see-saw move in Naspers. By mid-quarter the rand was significantly weaker and bond yields had spiked, but post the ANC elections these had turned around and bonds ended the quarter almost at the same yield to where they started, while the rand ended up much stronger.

Equities, on the other hand, had a strong start to the quarter, helped by a buoyant Naspers and the weaker currency. However, the asset class gave back some of those gains in the second half of the quarter, with Naspers pulling back by 15% from its peak and Steinhoff losing more than 90% of its value. Despite the latter-half weakness, both equities and property still strongly outperformed the local fixed-interest markets over the quarter, with gains of 9.6% and 6.3% respectively, against the 2.2% of bonds and 1.8% of cash. Due to the strength of the rand, local markets generally outperformed global markets, with even global equities - the best of the offshore assets with a 5.5% US dollar return from the MSCI World Index - being down 3.3% in rand terms.

We continue to see good returns on offer from just about all local fixedinterest assets, based on an increased risk premium applicable to South African investments. These prospective returns are higher than the longterm historical returns generated by local fixed-interest assets and we continue to hold a moderate position in local fixed-interest assets. Given that shorter-dated credit instruments offer returns that are similar to longer-dated government bonds, but with much lower volatility, we have deemed it prudent to divide exposure between these two investment options.

During the first half of the quarter, bond yields rose strongly and bonds became more attractive, but still faced the risk that political developments could push yields even higher (and prices even lower). Over the period of the ANC elections we implemented a derivative structure to provide additional exposure, but with reduced downside to bonds, in case of a bond rally. When a strong rally did occur in the week after the ANC conference, we closed out the structure and locked in the gains, capturing the bulk of the positive move in the bond market.

A derating of local property over the last three years took place despite property's resilient growth in dividends, which has kept pace with inflation and was much stronger than dividend growth from equities. Furthermore, approximately 35% of JSE-listed property companies’ earnings are now from outside South Africa, with a skew towards euro exposure, a currency that still seems cheap against the rand on a purchasing power parity basis. Given the increased political uncertainty in SA during the previous quarter, listed property companies with a South African rental income stream became cheaply priced. The three largest and most liquid SA Reits (Growthpoint, Redefine and Hyprop), which derive 80% of their earnings from SA, offered an average dividend yield of about 8%. Even with very modest distribution growth - well below our assumption for longterm inflation - these counters were priced to deliver real returns in excess of what we require from SA listed property companies. We therefore built on our position in SA listed property by buying a blend of these three stocks.

We have added to our exposure to South African equities. Companies with a South African earnings base (i.e. financials and retailers), have rerated given the outcome of the ANC elective conference in mid- December. Naspers now makes up about 25% of the Swix Index. According to our analysis, Naspers was trading at 34% below its fair value at quarter end. If we exclude Naspers, then the forward P/E of the market is about 13.5 times. Based on this, the SA equity market is fairly priced in the context of globally repriced equity markets. This is supported by a bottom-up valuation of the Swix, where we aggregate the fair values of its constituents as calculated by the SIM analysts.

No discussion of equities for the past quarter would be complete without reference to the terrible loss experienced in Steinhoff. Although we had exposure to the share and hence suffered a loss of almost one percent of fund value as a consequence, this illustrated again the benefit of having a diversified portfolio to reduce the impact of such a negative event.
Risks
Global real yields have dropped substantially after the 2008 financial crisis. We remain unsure whether this is a temporary phenomenon, due to central bank policies of quantitative easing, or whether this is more permanent due to globalisation and demographic changes. Even if temporary, we can't predict the rate of normalisation.

Assets are currently priced as if real yields are going to remain low for a prolonged period and we can express a rationale for such based on global debt levels. On a relative basis, growth assets are priced to continue giving the type of outperformance (over fixed-interest assets) that they have historically given. The risk does lie in a more rapid normalisation of pricing levels (to historical average values) that would detract from growth assets' relative returns.
South African assets have rerated given the outcome of the ANC elective conference. To what extent the management of the country will improve given the change in leadership remains to be seen. A lot of good news has been priced in, even though the government’s financial position remains precarious.