Macro review

In the US, the third quarter saw increased political uncertainty amid rising tensions between the US and North Korea and the ongoing failure of the Trump administration to implement its policy goals. These tensions were a key factor behind the temporary rotation into lower-risk assets in August. In the wake of hurricanes Harvey and Irma, economic data and activity indicators deteriorated towards the period end. However, capital markets discounted the potential negative impact on growth as minimal, as did the US Federal Reserve (Fed) in its statement following the latest Federal Open Market Committee meeting. At this meeting, the Fed kept interest rates steady but confirmed that measures to reduce its balance sheet would begin in October, despite persistently weak inflation.

In the Eurozone region, economic data remained robust over the prior three months. GDP growth was confirmed at 0.6% in the second quarter, up from 0.5% in the first quarter. Economic sentiment rose to its highest level since July 2007, while unemployment in the Eurozone remained at 9.1% in August, which was stable compared to July, and the lowest rate since February 2009. The possibility that the European Central Bank could reduce its stimulus measures continued to be a focus for the market, as the committee kept policy rates unchanged in September. Also noteworthy was Angela Merkel winning a fourth term as the Chancellor of Germany in September. For the UK, the economy showed clear signs of slowing down, while inflation picked up, reaching 2.9% in August. During the quarter the Bank of England struck a more hawkish note with Governor Carney and a number of members of the Monetary Policy Committee openly discussing rate rises.

Emerging markets saw a positive economic backdrop of steady global growth, modest inflation, US dollar weakness and a continued momentum in the Chinese economy through a pickup in commodity prices. In China, Industrial profits rose 20% year-on-year in August vs. 16.5% year-on-year in July, driven by a rebound in industrial prices. In South Africa, the South African Reserve Bank (SARB) lowered the repo rate by 25 basis points in July, yet surprised markets by keeping the policy rate steady at 6.75% in September. GDP growth momentum recovered in the second quarter to lift by 2.5% %q/q saar after a brief technical recession in the first quarter.

Global and local market review

Global equity markets advanced in the third quarter with the MSCI World Index returning 5.0% in US dollars, and 16.5% year to date (YTD). This advance was largely driven by stable economic growth, benign inflation and positive earnings releases. Emerging market equities, however, outperformed their developed world counterparts, returning 8.0% during the third quarter and 28.1% YTD, in dollars. This streak of outperformance ended in September after eight months of positive relative performance. Top performers in emerging markets in the third quarter were Brazil(+23%), Russia (+18%) and Chile (+17%), while Pakistan (-16%), Greece (-12%) and Qatar (-7%) were the laggards. Brazil saw some reform progress and central bank easing, while Russian equities rallied as crude prices picked up and lower inflation opened the door for further interest rate cuts. In contrast, Pakistan’s market was weighed by their Supreme Court’s disqualification of the prime minister, while Greece declined amid a sell-off in banking stocks.

Bond yields oscillated over the quarter and, with the exception of the UK, which sold off sharply in September, were ultimately little changed against a largely unchanged global economic backdrop. While the late-June sell-off initially continued in July, it came to a halt as growing expectations of a hawkish shift among central banks were reined in. Yields moved lower in August, precipitated by safe-haven buying, before reversing course once more in September as risk appetite returned.

The Bloomberg Commodities Index rose in the third quarter. The energy component generated the strongest return, with Brent crude rallying 20.1% over the quarter. It was supported by a faster-than-expected fall in US crude inventories and increased expectation for an extension of production cuts amid rising global demand. Industrial metals also recorded a robust return as economic momentum in China remained firm. Iron ore was up 14.9% while zinc (+15.5%) and copper (+9.5%) both posted sizeable gains. In contrast, the agricultural component lost value. Wheat and corn prices fell sharply amid record global supplies. In precious metals, gold was up 3.2%, in part given an uptick in geopolitical concerns.

US 10-year yields began the period at 2.31% and finished at 2.33% with bund 10- year yields virtually unchanged from 0.47% to 0.46%. Ten-year UK gilt yields rose 10 basis points (bps) to 1.36%. The move reflected higher inflation and more hawkish central bank rhetoric. Corporate bonds made positive returns, outperforming government bonds. Global investment grade (IG) 2 credit rose 1.14% and high yield (HY) by 2.16%. The US led the way with IG gaining 1.37% and HY 2.04%.

Year to date, South African equities (Swix) delivered a healthy 10.6%, underperforming bonds (+4.0%) and cash (+3.7%) as commodity prices rallied and rate expectations buoyed equity markets during the third quarter. Over the quarter, the Swix returned 7.0%, driven by Materials (+17.8%), while Industrials (+7.4%) and Financials (+5.1%) also rallied. Within Industrials, Naspers (15.0%) continued to outperform on the back of a strong performance in Tencent. Interest rate-sensitive sectors such as Retail and Banks also bounced early in the third quarter, around the first rate-cut in July, although the SARB surprised markets in September by keeping the policy rate steady at 6.75%. MTN (+11.2%) also drove the equity market as MTN’s new management conveyed its aspirational growth potential, while Aspen (+5.7%) rallied after announcing the AstraZeneca (AZN) deal.

SA bonds (+3.7%) outperformed cash (+1.8%), yet underperformed SA equities (Capped Swix Index +5.9%) in the third quarter. The benchmark SA 10-year bond yield declined from 8.77% at the end of June 2017 to 8.55% at the end of September this year, supported by SA's high real yields, expectations of deceleration in inflation into year-end, and the global backdrop.

The FTSE/JSE SA Listed Property Index (SAPY) returned a total of 5.7% in the third quarter and 8.2% YTD. From January 2017 the SAPY has outperformed bonds and cash, but it has meaningfully underperformed the FTSE/JSE All Share Index (Alsi) (12.5%). The best performing shares in the SAPY for the quarter included shares with a high foreign exposure such as MAS Real Estate, NEPI Rockcastle as well as Greenbay Properties, which only recently entered the SAPY Index. This was driven by good fundamental earnings growth, which was partly driven by rand weakness. Conversely, shares with more pure-play SA exposure were some of the underperformers, such as Hyprop Investments, which derated substantially from well under a 6% dividend yield (DY) to over a 6.5% DY in the course of the quarter.

The year ahead
The main question facing investors, as in the third quarter of 2017, is whether valuations and positioning point to a tactical pullback from risk. We think the general market view currently is that it would probably not. This year’s equity rally has been driven by earnings growth, not multiple expansion; while the pace of this growth might slow, stocks should still out-earn bonds. It is difficult to see a plausible catalyst that could upset valuations in risky assets for the rest of 2017.

If we contrast the fortunes of overseas markets to our local one, it is clear that investor confidence is an important behavioural factor driving investment markets. Companies which have delivered results below expectation are being marked down heavily and a number of former darling stocks have suddenly been found wanting.

Momentum: Globally, the Momentum factor (particularly Price Momentum) continues to lead the race among factor performances YTD, followed closely byQuality/Profitability and Growth. In South Africa, we are starting to see an alignment with global outcomes, as Price Momentum’s strong recovery in the third quarter of 2017 has seen this factor among the leading factors in the domestic market YTD. This, after a particularly poor 2016 calendar year, has seen the Momentum factor redeem itself somewhat and recoup much of the losses it experienced last year. Earnings revisions, however, has not seen the same recovery, and continues to be tepid during 2017, given still high levels of domestic economic and policy uncertainty flowing over to uncertain corporate earnings estimates.

Notwithstanding the testing environment, our Momentum offering (which combines Price Momentum and Earnings revisions) has steadily improved its year-to-date performance relative to the Swix. Given that most of the stocks enjoying the highest earnings revision characters are hard commodities, the higher beta nature of these counters will likely influence the portfolio’s factors over the coming months.

Stock selection within the resource sector was the primary driver of positive relative performance over this quarter, where names such as Kumba Iron Ore (KIO), Exxaro (EXX), Assore (ASR), and Glencore (GLN) were the largest contributors from overweight positions. Industrial counters such as Barloworld (BAW), Naspers (NPN), both overweights, and Remgro (REM), an underweight, also lent support to outperformance. On the other hand, the largest detractors were underweights in Anglo American (AGL) and BHP Billiton (BIL), and overweights in British American Tobacco (BTI) and Sappi (SAP). At last rebalance date, we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Sappi (SAP), Old Mutual (OML) and Curro (COH) were removed, and African Rainbow Minerals (ARI) and Reinet (REI) were added. Exposures in RMI (RMI) and Kumba Iron Ore (KIO) have also been reduced while exposures to Assore (ASR) and Richemont (CFR) were increased in line with the risk objective of the fund. The biggest fundamental change in the portfolio’s positioning over the course of 2016 has been the rotation into the hard commodity stocks whose price and earnings revision signals remain strongest in our domestic universe.

Quality: The S&P Quality Index experienced a challenging first half of the year, as the market grappled with inter-changing risk-on and risk-off environments. Predictably, during the months of February and June where the South African equity market (Swix) experienced deep negative returns, the S&P Quality Index provided meaningful protection. Over the third quarter, however, the strategy started to gain substantial traction relative to the Swix, as investors preferred counters with high profitability and strong balance sheets to weather the market volatility. Noteworthy was the portfolio’s strong relative performance during positive equity markets such as July and August, illustrating the strategy’s ability to keep pace through cyclical upswings. The strategy’s diversification benefits have also been of significant value within this factor portfolio construct.

The largest relative outperformance over the quarter came from the overweight positions such as Kumba Iron Ore (KIO), Exxaro (EXX), Mr Price (MRP) and Assore (ASR), as well as underweight positions such as Steinhoff (SNH) and British American Tobacco (BTI). By not holding Naspers (NPN), the fund substantially detracted value relative to the Swix, while holdings in Anglo American (AGL), MMI Holdings (MMI) and Tiger Brands (TBS) also diminished the strategy’s value-add. There were no constituent changes to the S&P Quality Index over the prior quarter, as this index rebalances in June and December each year.

The index and portfolio remain focused in its extraction of Quality and should markets give way to further risk aversion, the defensive character of the basket should prove rewarding while not meaningfully compromising returns during up markets.

Stable Dividend: Value measures have experienced a poor 2017 thus far, after a fantastic performance during the 2016 calendar year, both domestically and globally. The yield factor specifically has struggled to get out of the blocks despite the continuing high levels of economic and policy uncertainty typically being a fertile environment for this factor. To this end, it appears that the Value style turnaround has somewhat stalled in line with protracted domestic economic recovery.

During the third quarter, overweight exposure to Exxaro (EXX), Richemont (CFR), Mr Price (MRP) and Truworths (TRU) played a strong positive role here, while underweights in British American Tobacco (BTI) and Remgro (REM) added. The concentrated nature of our market index proxies and its Naspers exposure also largely contributed to the relative underperformance; this index holds no Naspers exposure. Holdings in Tsogo Sun (TSH), Telkom (TKG) and Steinhoff (SNH), as well as an underweight position in Anglo American (AGL) detracted from the index’s relative performance.

Additions to the Stable Dividend Index during the prior quarter included African Rainbow Minerals (ARI), AVI (AVI) and Foschini Group (TFG), while deletions included Bidvest (BVT), Richemont (CFR), Datatec (DTC) and Mondi (MND and MNP).

This portfolio strategy maintains a sector-neutral position, and thus any relative sector performances would not adversely impact the portfolio’s performance. In addition, the portfolio construction approach is designed to optimise the reliability of high dividend yields, which the portfolio successfully has managed to achieve.

In Closing
We remain convinced of all equity factors’ medium- to long-term significance and the premium they offer in the South African capital market and remain disciplined in our implementation and extraction of all factors.

The outlook for markets is again uncertain. The global backdrop is one of improvement on the margin, which all else being equal should benefit SA assets and the currency. Relative to this support, the risk of additional downgrades to SA’s credit ratings will now cast a new shadow over SA assets.