Global Markets
The S&P 500 delivered a total return of 7.7% over the last three months, 10.6% year to date and 14.4% since its February lows. Unfortunately, this strength is not shared broadly, with European, Australasian, Far Eastern (EAFE) and Emerging markets (EM) returning (USD) 1.4% and -0.9% for the quarter and -1.0% and -7.4% year to date.

A spate of news flows from across the globe is currently driving markets. America’s trade war against what seems to be the rest of the entire world remains an ongoing concern for investors. This has led to some participants betting that China will increase their current stimulus programme in the coming months. Trump also made another enemy in Opec, publicly calling them out to reduce oil prices by increasing supply. At the same time, focus was on the Federal Open Market Committee, which raised rates again - the third this year - and reaffirmed a hawkish outlook going into 2019 and beyond. It would seem as if another hike in December is almost assured.

Additional to this, the laundry list of potential market headwinds is quite long: with the yield curve that is flattening; disruptive mid-term elections; peak margins; increasing corporate leverage; problems in emerging markets; and a stock market trading at record price-to-sales. Despite this litany of concerns, we think none will cause the transition from market risk to a market problem.

Despite the best efforts by bears, international equities are so far rather resilient. MSCI World is up 5.9% year to date, outperforming bonds by 700bp, on a total return basis. The performance, however, is quite US centric, but it is notable that even accounting for the latest Italy setback, Eurozone equities are also holding up relative to fixed income this year, with the MSCI Eurozone at 0.7% against bonds at -0.7%. The general market expectation is that there would be further gains into yearend, as the US dollar is potentially peaking, the US business cycle remains well supported, and there is some stabilisation in emerging markets/Eurozone activity evident. Fundamentally, growth drivers are also far from exhausted. Although the yield curve has flattened, stocks have never peaked before the yield curve inverted. The current yield curve shape is consistent with double-digit S&P500 returns over the next 12 months.

Emerging market (EM equities have performed poorly in 2018 and were at the recent low point down as much as 20% from January highs. Our best view is that EMs are flattening out as they tend to have a strong inverse correlation to the US dollar, which could be peaking out.

Prospects for the rand and other EM currencies have swung as they have moved from being some of the most promising asset classes this year to becoming the worst-performing asset classes in the first half of the year, largely due to tailwinds from the global economy turning into headwinds.

South Africa After a dismal first quarter growth print of -2.2%, the second quarter GDP print was again negative at -0.7%, plunging the economy into a technical recession. Domestic demand remains weak, down almost 4% with some rebound in exports by 14% helping. Companies continue to run down inventories, detracting from GDP. helping. Companies continue to run down inventories, detracting from GDP.

In the third quarter of 2018 the FTSE/JSE All Share Index (ALSI) posted a rand total return of -2.17%. The last three months were anything but easy, especially with the quantum of the downward moves of some of the equity prices. It is also extraordinary how intraday volatility has picked up and the fact that more than 60%of the ALSI constituents saw a more than 5% intraday move during this period. SA Resources and SA Financials outperformed in the third quarter with total returns of 5.2% and 2.8% respectively, while the SA Industrials sector was the drag on the index, shedding 7.8% over the same period. The All Bond Index (ALBI) was virtually flat with a total return of 0.8%, whilst the SA Listed Property index (SAPY) returned -1.0% over the same period.

Year to date, the ALSI has posted a total return of -3.8% versus the ALBI’s 4.8% and -22.2% for the SAPY. SA Resources (21.0%) have severely outperformed SA Financials (-6.8%) and Industrials (-11.8%) since January 2018.

South Africa remains on a low growth path. The aftershocks of State Capture and policy uncertainty persist, constraining confidence and investment. Structural economic reforms remain slow in coming, though the finalisation of the Mining Charter before the end of the year marks an important milestone.

South Africa needs growth in order to arrest further fiscal, socio-economic and credit ratings decline. Moody’s review of the sovereign’s ratings around middle October is unlikely to deliver any surprises (no change to its stable outlook or its Baa3 rating), though we think there is a chance the review could be delayed until after the 24 October medium-term budget.

The economy should drag higher in the second half of the year as we shake off the worst impact of agriculture after good rains and companies re-stocking ahead of the Christmas season. We remain on track for 1.3% economic growth in 2018, which would be a sub-par outcome, but the second-half growth numbers should look more decent, up 3% off a low base. Consumer confidence is holding up after reaching record highs at the beginning of the year but business confidence remains in the doldrums.

Performance

FTSE/JSE RAFI Top 40 Index managed to return 0.72% and thereby outperforming the FTSE/JSE RAFI by a healthy margin. On a 12-month rolling basis the FTSE/JSE RAFI Top 40 Index outperformed the FTSE/JSE Top40 Index by 5.06%.

The relative outperformance for the quarter was mainly attributable to the index’s underweight position in Naspers and overweight position in Steinhoff and Sasol. Steinhoff is still part of the index as the FTSE Rafi Index series is based on multiple specific fundamental factors in order to calculate the fundamental weighting as per ground rules. The data used to determine this is taken over the prior five years. The company was retained within the Rafi indices and will only be revaluated in the March 2019 Rafi Index review, which will incorporate any restated reports (on the assumption they have published the reports by then).

The major detractor from relative performance was the portfolio’s overweight positions in MTN and Gold Fields, which returned -17.5% and -30.5% respectively. This index only rebalances once a year, in March.

Conclusion

In South Africa, the sentiment pendulum has swung from optimism, with the new political administration driving business and consumer confidence higher, to disappointment about the latest macro-economic drivers (GDP), which has dampened expectations of a solid economic recovery. Either way, economic mood swings tend to be exaggerated. Also, the expectation that President Ramaphosa will, in one fell swoop, reverse years of neglect and maladministration is unrealistic.

The JSE trades on a forward PE of around 13x, which relative to its long-term historical average, is not expensive.

Market overview

What a volatile start for global markets during the first three months of 2018!

A pull-back in technology-driven shares, rising trade tensions and fears over higher rates and inflation led to a volatile first quarter of 2018 for the S&P 500 Index. Following a 10% correction from its January highs and rallying back 8% by early March, the index suffered another 5% pullback in the last few weeks, ending the month of March down 2.5% on a total return basis and losing 0.8% over the last three months (first negative quarter since the third quarter of 2015). The S&P 500’s correction of just over 5% in the first week of February was a reminder that rising bond yields are likely to cause much anxiety on the path to normalisation.

While stocks were the worst-performing asset class in March, they finished the first quarter in the middle of the pack, beating both long-term Treasuries (-3.2%) and investment-grade corporate bonds (-2.2%) but lagging cash (+0.4%), gold (+2.5%), WTI oil (+5.3%) and the US Dollar Index (-0.7%).

Forgotten was the fact that the US implemented the biggest tax reform in three decades to drive the corporate income tax rate from 35% to 21% and boost investment spending and productivity. The US is also encouraging corporates to repatriate some $2.5 trillion held offshore - but the impact on the US dollar should be limited as it is over 10 years and already held in dollars. The market, however, reminisced that the 1986 tax reform programme led to the considerable weakening of the greenback.

While recent data globally are mixed, credit impulse numbers and various leading indicators do suggest that growth expectations may still have room to drift lower. This could mean that downside risks for equities, yields and broader commodity prices are increasing, but in general the market positioning is much cleaner now and has probably priced in this ‘news’, leaving scope for a bounce. While February and March are historically weak, April is a seasonally strong month (+1.2% average total return since 1928, the third-best month of the year).

South Africa
The JSE battled two opposing forces this quarter. On the one hand the ‘Ramaphosa effect’ drove some SA Inc. stocks to new highs, while the ‘Viceroy effect’ led to a slew of rumours impacting a number of companies. The recall of the former president attracted elusive foreign flows to the JSE, which flowed mainly into local retailers and banks, up 22%, a very narrow part of the market viewed as representative of the SA economy.

The Budget also served to quell investor concerns. Fiscal consolidation is back on track with government debt now peaking at 55% of GDP - better than the mid-term budget scenario where debt was forecast to balloon. The GDP outlook has improved slightly from 1.1% to 1.8% and prospective revenue has improved thanks to a 1% increase in the VAT rate and enforcement of a strict expenditure ceiling.

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 British American Tobacco, which were both down more than 15%). SA and British American Tobacco, which were both down more than 15%). SA Resources lost 3.8% (rising global uncertainty) and SA Financials lost 3.6%. The FTSE/JSE All Bond Index (ALBI) outperformed with a total return of 8.1% (helped by Moody’s keeping SA’s sovereign credit rating unchanged), while the FTSE/JSE SA Listed Property Index (SAPY) has shown the largest underperformance, -19.6% (negative press on Resilient group of companies).

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%).

The ALSI has de-rated year to date and is now trading at a forward price-to-earnings ratio (P/E) of between 14.5 and 15 times (16.8 historic) versus the long-term average of 12.6 times. But ex Naspers we are at 13.5 times versus the long-term average of 12.3 times.

Portfolio and performance review

For the first quarter of 2018, the FTSE/JSE Rafi Top 40 Index realised a return of - 2.13%, outperforming the FTSE/JSE Top 40 Index return of -6.32% by about 4.19%. For the one-year period, this index is nearly 2.5% ahead the FTSE/JSE Top 40 Index.

The large outperformance for the quarter was mainly attributable to the index’s relative underweight in Naspers and British American Tobacco. This was enhanced by overweight exposures in Anglo American and Standard Bank. Anglo American managed very good returns in March due to the mining industry performing well.

During the March annual rebalance Exxaro, Investec and Sibanye Gold were added to the FTSE/JSE Rafi Top 40 Index replacing Brait SE, Kumba Iron Ore and MMI Holdings. The one-way churn in the index was about 12.44%.

Steinhoff (SNH) is still part of the FTSE/JSE Rafi Top 40 Index series. This is the response that we received from the FTSE Russell Policy Team on the reasons why: The company should be retained within the RAFI indices and the company should be revaluated in March 2019 which will incorporate any restated reports (on the assumption they publish the reports by then). As the investigation remains ongoing, it would be premature to remove prior to the conclusion of these investigations. If removed, there is a potential that the company could be reinstated to the index at the next Annual review with a different RAFI score as we do not know what within the financials are likely to change which may impact the RAFI score.

This index only rebalances once a year, during March.

The difference in your portfolio’s return from its benchmark was mainly due to trading costs and market impact related to rebalance and cash flow trades.


Conclusion

Volatility has once again become the dominant factor in financial markets globally, exemplified by the VIX fear index experiencing its biggest daily spike in history during the quarter. There are growing concerns that global businesses may be subject to new regulation and be the target of tariffs if a US-China trade war escalates. Political risk is dominating fundamentals and we now have progressed into a new era where central banks are not the backstop supporting financial markets. In South Africa, the sentiment pendulum has swung from pessimism to optimism with the new political administration driving business and consumer confidence higher with expectations of a solid economic recovery being discounted. Either way, economic mood swings tend to be exaggerated. Also, the expectation that President Ramaphosa will, in one fell swoop, reverse years of maladministration and corruption are unrealistic.