Macro review

In the US, equities began 2018 strongly, buoyed by ongoing strength in economic data, robust earnings and the confirmation of a major tax reform package. US business confidence reached an unexpected, multi-decade high in March, while GDP for Q4 2017 was revised upwards to show growth of 2.9%. The latter part of the quarter, however, saw a marked increase in volatility as investors first digested the destabilising potential of an elevated US inflation reading and the possibility that the Fed may need to become more proactive in raising interest rates, as well as escalating US-China trade sanctions, which precipitated a renewed bout of turbulence in March.

In the Eurozone, the economic backdrop remained encouraging over the three months. GDP growth for Q4 2017 was confirmed at 0.6% quarter-on-quarter. Unemployment was stable at 8.6% in January 2018. However, forward-looking surveys painted a picture of slower future growth. The composite PMI hit a 14-month low in March, albeit the reading of 55.3 still implies solid growth. European Central Bank chairman Mario Draghi reiterated that interest rates would not rise until well past the end of the quantitative easing programme. On the political front, the key event of the quarter was Italy’s election, which yielded no overall winner. Germany formed a new government after its inconclusive elections in September 2017. Angela Merkel remains as chancellor after her centre-right CDU/CSU agreed another grand coalition with the centre-left SPD.

Emerging markets saw positive returns in the first quarter despite a rise in market volatility stemming from tensions over global trade. Brazil’s former president Luiz Inácio Lula da Silva saw his criminal conviction upheld, while in Russia the central bank cut interest rates and the country’s debt was upgraded to investment grade by ratings agency S&P. In China, macroeconomic data remained broadly stable, albeit there were ongoing signs of a gradual slowing in momentum, with official PMI easing to 50.3. By contrast, there was concern in India over reported fraud at a state -owned bank.

Global and local market review

Global equity markets declined in Q1 2018 with investors unnerved first by concerns about the path of US interest rate rises and then worries over trade. US equities began the year strongly, boosted by tax reforms, but ended the quarter lower amid concerns over inflation and the impact of US-China trade sanctions. Following a 10% correction from its January highs and rallying back 8% by early March, the S&P 500 Index suffered another 5% pullback in the last few weeks, ending the month of March down 2.5% and losing 0.8% over the last three months, which was the first negative quarter since the third quarter of 2015. Eurozone equities posted negative returns as worries over US rates and trade affected other markets. Italy’s election was inconclusive but had limited impact on the equity market.

Emerging market (EM) equities outperformed, delivering a positive return in US dollars. The MSCI EM Index was up +1.5% (total returns) in Q1 2018, ahead of the MSCI World (Developed Market) Index, which was down 1.2%, the first quarterly loss in two years. 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% Satrix Balanced Index Fund April 2018 (Fund Fact Sheet) years (Q2 2010: -8.2%). SA Industrials were the worst performer, returning -8.0% (Naspers and Tiger Brands were both down 12%). SA Resources lost 3.8% (rising global uncertainty) and SA Financials lost 3.6%.

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%).

US Treasury yields rose markedly across the curve over the quarter as expectations of growth, inflation and interest rates shifted higher. Volatility returned to markets, picking up sharply from low levels and impacting risk assets. In March, sentiment was negatively impacted by rising trade tensions between the US and China. Tenyear yields increased from 2.41% to 2.74%, reaching a high of 2.95% in February, five-year yields increased from 2.21% to 2.56% and two-year yields from 1.88% to 2.27%.

The Bloomberg Commodities Index posted a modest negative return in Q1 2018. This was attributable to weakness from industrial metals amid rising global trade tensions and concern that further escalation could impact demand. Copper was particularly weak, down 8.3%. Conversely, the energy and agricultural components recorded solid gains. In agriculture, corn (+10.6%) and soy bean (+9.8%) prices were notably strong. In the energy segment, Brent crude (+5.1%) rallied into quarter -end amid rising confidence that Opec would maintain its production cuts through the full year 2018. In precious metals, gold (+1%) posted a positive return but silver (-5.1%) lost value.

EM local currency bonds largely ignored the increase in developed market (DM) yields because the dollar was weakening and global growth projections were being revised higher. Stronger EM currencies also led to lower inflation in EM economies. South African bonds outperformed their EM counterparts as political risks waned and the rand strengthened more than other currencies. The FTSE/JSE All Bond Index (ALBI) returned 8.06% in Q1 2018 and the benchmark R186 yield fell to 7.99% from 8.64%.

The FTSE/JSE SA Listed Property Index (SAPY) delivered a total return of -19.6% during the three months to the end of March 2018, mainly due to company-specific concerns. Relative to other asset classes, the property index materially underperformed equities (ALSI: -6.0%; cash: 1.8%; bonds: 8.1%) over this period. On a rolling 12-month basis, the sector’s total return is -7.1% due to the negative first quarter of 2018.

Momentum: Globally, cyclical sectors performed more strongly in January and February, when the market was focused on faster rate hikes, while in March the broader decline in risk appetites saw more defensive areas outperform. From a style perspective, this was consistent with the global Momentum and Growth factors’ correction during March, as rotation and perhaps profit-taking have dragged on a generally positive Momentum factor during 2018, primarily driven by perceived increased risk to global growth.

In South Africa, there was large consistency with global outcomes, as back-endloaded cyclical pressure over the quarter dampened an otherwise strong Momentum signal. Earnings Revisions (a sub-component of Headline Momentum), on the other hand, once again has not performed in line with Price Momentum, generating negative returns as poor earnings sentiment failed to deliver in an environment with high levels of corporate uncertainty.

As an overall factor however, the Momentum strategy struggled during Q1 2018 relative to the FTSE/JSE Shareholder Weighted Index (Swix). The strategy’s performance was attributed on the positive side to exposure to its off-benchmark underweight positions in property stocks, including Resilient (RES), NEPI Rockcastle (NRP) and Fortress (FFB), while overweight positions in Standard Bank (SBK) and Barloworld (BAW) aided the strategy. On the negative side, cyclical exposure to Northam Platinum (NHM), African Rainbow Minerals (ARI), Kumba Iron Ore (KIO), Exxaro (EXX) and Assore (ASR) weighed on the strategy, while speculation around Capitec (CPI) fundamentals also contributed negatively.

At the last rebalance date (mid-March), we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Exxaro (EXX), Reinet (RNI) and Impala Platinum (IMP) were removed, and Harmony (HAR) and The Foschini Group (TFG) were added. Exposures in British American Tobacco (BTI) and African Rainbow Minerals (ARI) have also been reduced while exposures to Mr Price (MRP) and JSE (JSE) were added in line with the risk objective of the fund.

We remain convinced of the factor’s medium- to long-term significance and the premium it offers in the South African capital market and remain disciplined in our implementation and extraction of the factor.

Quality: After a stellar 2017, the S&P Quality South Africa Index experienced another strong quarter as investors continue to favour stocks with defensive characteristics. Despite largely pro-cyclical domestic sentiment (e.g. leadership optimism, declining risk of credit rating downgrade, improving inflation outlook), global macro concerns have instead dominated mindshare and subsequently weighed on the local share market.

This environment continued to suit companies with strong balance sheets, clean earnings and high return to equity, as represented in our Quality basket. Furthermore, based on our analysis, the valuation gap between Quality and the market is still not pricing in the substantial historic premiums of a Quality strategy, and thus still presents value to investors who seek the strategy’s diversification benefits within this factor portfolio construct.

In terms of stock selection, the largest relative outperformance over the quarter came from the overweight positions such as Mr Price (MRP), Truworths (TRU), Standard Bank (SBK) and Clicks (CLS), as well as underweight positions such as Naspers (NPN), Resilient (RES) and NEPI Rockcastle (NRP). By not holding these stocks, the fund accreted substantial value relative to the Swix. On the other hand, the largest two detractors in Value came from overweight positions in Capitec (CPI) and Tiger Brands (TBS), as a speculative report from Viceroy and an outbreak of listeriosis respectively weighed on these counters. Other overweight detractors included Exxaro (EXX) and Kumba Iron Ore (KIO). There were no constituent changes to the S&P Quality South Africa 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: After a fantastic performance during the 2016 calendar year, Value measures have experienced a disparate 2017 and start to 2018. The divergence between deep value measures (e.g. price-to-book) and yield measures (e.g. dividend yield) has been substantial, with the former struggling, and the latter continuing to perform well as investors seek defensive qualities during a period of high levels of uncertainty and flight to safety.

The impact of the news in December regarding the accounting irregularity at Steinhoff still has investors on edge, with further speculation surrounding Capitec and technology shares continuing to weigh on market sentiment. Further to these stock-specific issues, global forward macro momentum has slowed, which has largely favoured defensive shares with high dividend yields, in particular domesticorientated shares, of which the Stable Dividend strategy has significant exposure to.

During Q1 2018, overweight exposure to Foschini (TFG), Mr Price (MRP), Truworths (TRU), AECI (AFE) and JSE played a strong positive role here, while an underweight position in Naspers (NPN) also added excess return. Holdings in Exxaro (EXX) and African Rainbow Minerals (ARI) detracted from the index’s relative performance.

There were many changes to the Satrix Stable Dividend strategy during the prior quarter, including 13 counters coming into the index, and 10 counters leaving the index.

In Closing

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.

Macro review

In the US, the fourth quarter saw two Republican defeats in Senate contests spur House and Senate Republicans into action, resulting in the long-awaited tax reform bill. Markets rallied on the news, with big permanent cuts for corporations as the centrepiece of the package. US equities were largely also supported by generally positive macroeconomic data, including better-than-expected third-quarter GDP growth of 3.0% (annualised) and stronger-than-expected non-farm payrolls. As had been widely anticipated, the US Federal Reserve (Fed) lifted interest rates by 25 basis points (bps) in December. The Fed also raised its growth forecasts for 2018 to 2.5% from 2.1%. The quarter also saw robust corporate earnings, particularly from the technology sector.

In the Eurozone, data showed the region’s economic recovery continuing. GDP grew by 0.6% in the third quarter, albeit a slight slowdown from 0.7% in the second quarter. In October, the European Central Bank (ECB) announced that quantitative easing would be extended to September 2018 but that the pace of purchases would be reduced from €60 billion per month currently to €30 billion. In Germany, coalition talks collapsed, while in Spain, Catalonia held a regional election which failed to resolve the independence issue. In the UK, despite a sluggish economy, the Bank of England (BoE)’s monetary policy committee raised interest rates for the first time in 10 years as annual CPI reached 3.1% in November, breaching the BoE’s upper target. Furthermore, hopes rose around progress with Brexit negotiations, with an agreement struck to allow talks to proceed to the future of trade arrangements.

Emerging markets experienced largely positive political developments. In South Africa, pro-reform candidate, Cyril Ramaphosa, was elected as leader of the African National Congress. This development increased the prospect for a return to more orthodox policy after elections in 2019. In Greece, agreement was reached with international creditors over reforms, paving the way for the dispersal of further bailout funds, while India also announced plans for a major recapitalisation for statecontrolled banks.

Global and local market review

For the first time on record, global equity markets rallied in all 12 months of a year, advancing +5.8% in US dollars in the fourth quarter and 24.6% over 2017, one of the strongest years since 2009. The S&P 500 Index ended a strong year with a fourth-quarter gain of +6.6%, buoyed by hopes of tax reform, while Eurozone equities declined amid some profit-taking and simmering political risk, although economic data remained positive. The UK’s FTSE All Share Index also saw positive returns, supported by gains for resource stocks and progress on Brexit negotiations.

Emerging market (EM) equities however outperformed their developed world counterparts, returning +7.5% during the fourth quarter and 37.8% in 2017. Top EM performers in the fourth quarter were South Africa (+21.5%), Greece (+13.6%) and India (+11.8%). The MSCI South Africa Index rallied +36.8% in US dollar terms in 2017 broadly in line with EM, driven by Media (Naspers) and a metals rally, while a Ramaphosa win buoyed SA domestic-demand sectors into year-end. However, the MSCI SA ex Naspers was up only +16%.

The yields on the US 10-year Treasury note rose marginally from 2.33% to 2.40% over the quarter, but for a brief period when they touched 2.5%. However, the curve flattened aggressively as shorter maturities sold off in anticipation of the December rate hike and continued tightening of monetary policy by the Fed in 2018. Yields on German bonds rallied slightly from 0.46% to 0.42%.

The Bloomberg Commodities Index posted a robust return in the fourth quarter of +4.7%, underpinned by a rally in industrial metals and energy. In industrial metals, nickel (+22%), copper (+12%) and iron ore (+12%) posted the strongest gains as Chinese demand remained firm. Together with measures aimed at lowering environmental emissions, which have led to an increase in supply discipline, this put upward pressure on prices. In the energy segment, Brent crude surged +18.2%, primarily driven by an agreement among OPEC and a number of non-member countries such as Russia to extend production cuts to the end of 2018. By contrast, agricultural commodities lost value, notably wheat and palm oil. In precious metals, gold gained +1.8% while silver was up +1.7%.

Domestically, SA equities (Capped SWIX) delivered a healthy 16.5% during 2017, outperforming bonds (+10.2%) and cash (+7.5%). Over the quarter, the Capped SWIX return was +8.4%, driven by Industrial Metals (+62.7%), Banks (+27.1%) and General Retail (+22.3%). Underperforming sectors over the quarter were Household Goods (-92.3%), Fixed Line Telecommunications (-18.8%) and Paper (-9.9%).

SA equities recorded outflows of US$2.5 billion during 2017, significantly lagging inflows into EM equities of US$77.2 billion. However, dissecting the flows, it appears that, excluding the outflows from dual-listed stocks, the Barclays and Vodacom selldown, SA equities saw inflows of just more than R60 billion in 2017.

The benchmark SA 10-year bond yield declined from 8.9% at the beginning of the year to 8.6% at the end of December, given expectations of a political and policy shift in South Africa, post a Ramaphosa win at the ANC elective conference. For the quarter, the FTSE/JSE All Bond Index (ALBI) returned 2.25%, outpacing cash returns of 1.78% on the STeFI Composite. The 5.66% rally in December resulted in bond returns of 10.22% for the year.

The FTSE/JSE SA Listed Property Index (SAPY) returned a total of 8.3% in the fourth quarter of 2017 and 17.2% for the calendar year 2017. Over the 2017 calendar year, the SAPY outperformed bonds (10.2%) and cash (7.5%), but underperformed the FTSE/JSE All Share Index (ALSI), which returned 21% over the last 12 months. Interestingly, over a trailing five- and 15-year period, SA listed property is still the best-performing major SA asset class, including equities. For the calendar year, the best-performing shares in the SAPY were those with a 100% foreign exposure, such as MAS Real Estate (35%), Sirius (41%) and Greenbay Properties (60%). The best-performing local share was Equites Property Fund (32%).

During the fourth quarter, and in particular December 2017, following the outcome of the ANC conference where Cyril Ramaphosa was elected the new party leader, it was actually the more pure SA stocks that delivered superior returns. The rand hedge stocks, such as Growthpoint, Redefine and Hyprop, came off their intra-year highs on the back of the stronger rand in December.

Momentum: Despite some rotation which started in November (which can largely be explained by usual year-end profit-taking), globally, the Momentum factor (particularly Price Momentum) has led factor performances for 2017. Factors such as Growth and Quality/Profitability have also been solid strategies to be exposed to last year, but Price Momentum has benefited most from US tax reform and global synchronised growth.

In South Africa we’ve seen an alignment with global outcomes, as Price Momentum has been the strongest signal domestically for 2017 and the prior quarter. Earnings revisions (a sub-component of headline Momentum), on the other hand, has not performed in line with Price Momentum, delivering only mildly positive alpha, while defensive factors such as ROE and Dividend have been exceptionally strong during 2017, largely back-end loaded.

In our view, the earnings revisions factor was not well rewarded given high levels of domestic economic and policy uncertainty flowing over to uncertain corporate earnings estimates. However, with the domestic policy environment seemingly improving at the margin, cyclical stocks with positive forward earnings momentum should perform well.

As an overall factor however, the Momentum signal has translated into a topperforming factor-based strategy relative to the SWIX in 2017, after a testing environment in 2016. Over the prior quarter, the strategy’s outperformance was attributed to exposure to a diverse range of sectors, with the largest contributors to relative performance generated from overweight positions in Kumba Iron Ore (KIO), Assore (ASS), Exxaro (EXX), Capitec (CPI) and Imperial (IPL). The underweight position in Steinhoff (SNH) also significantly bolstered the strategy’s performance, after the share fell 92.3% over the quarter due to accounting irregularities. On the other hand, the largest detractors were overweight positions in Richemont (CFR), Reinet (REI) and British America Tobacco (BTI), and underweight positions in Barclays (BGA), Truworths (TRU) and Mr Price (MRP).

At the last rebalance date (mid-December), we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio. Based on these signals, Steinhoff (SNH), Blue Label Telecoms (BLU) and Supergroup (SPG) were removed, and Discovery (DSY), Mr Price (MRP) and Northam (NHM) were added. Exposures to Bidcorp (BID) and Glencore (GLN) have also been reduced while exposures to Assore (ASR) and Richemont (CFR) were added in line with the risk objective of the fund.

Quality: The S&P Quality Index experienced a challenging first three quarters of the year, as the market grappled with interchanging 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 fourth quarter however, the strategy hit a definitive turning point in performance, provided by a few notable catalysts.

Firstly, the emergence of news in December that an accounting irregularity had occurred at Steinhoff had investors scrambling. Not often has one stock moved the entire benchmark that much, as companies with strong balance sheets, cash/quality earnings and high returns benefited from the flight to quality. Notwithstanding this seismic shift, any portfolios (such as our strategy which follows the S&P Quality Index) that managed to have less exposure than benchmarks - or even better, zero exposure - were treated to substantial relative performance outcomes after the Steinhoff share price plummeted.

Secondly, leading up and subsequent to Cyril Ramaphosa’s election as the new ANC president, the rand rallied strongly relative to the dollar (appreciating 10.9% over 2017), with investors beginning to price in a positive macroeconomic impact supporting a cyclical recovery. To this end, shares with domestic cyclical exposure rallied hard during the fourth quarter, including General Retail (+15.9%), Banks (+15.2%) and Industrial Transportation (+8.9%). The Quality strategy had substantial exposure to all these sectors through its strong rand exposure.

Thirdly, the valuation gap between Quality and the market has been closing since its peak in 2015, and now the premium is closer to normalised levels. While the valuation spread has increased given Quality’s recent run, our view is that the Quality basket still presents value to investors who seek the strategy’s diversification benefits within this factor portfolio construct.

In terms of stock selection, the largest relative outperformance over the quarter came from the overweight positions in a broad range of sectors such as Mr Price (MRP), Kumba Iron Ore (KIO), Capitec (CPI), Bidvest (BVT), Sanlam (SLM) and Tiger Brands, as well as underweight positions such as Steinhoff (SNH), British American Tobacco (BTI) and Richemont (CFR). By not holding Naspers (NPN), FirstRand (FSR) and Barclays (BGA), the fund detracted value relative to the SWIX, while holdings in Adcock Ingram (AIP) and South32 (S32) also diminished the strategy’s value-add. There were many constituent changes (eight deletions and 10 additions) 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: After a fantastic performance during the 2016 calendar year, Value measures have experienced a disparate 2017. The divergence between deep value measures (e.g. price to book) and yield measures (e.g. dividend yield) has been substantial, with the former struggling, and the latter continuing to perform well as investors seek defensive qualities during a period of high levels of uncertainty and flight to safety, particularly during the fourth quarter. As mentioned above, the Steinhoff debacle caused investors to seek out companies with defensive characteristics and high dividend yields. Also, this strategy had some meaningful exposure to the rand rally through constituents in domestic sectors such as Banks and General Retail.

During the fourth quarter, exposure to Kumba Iron Ore (KIO), Foschini (TFG), Barclays (BGA) and Exxaro (EXX) played a strong positive role here, while an underweight position in British American Tobacco (BTI) also added excess return. 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 Steinhoff (SNH), Telkom (TKG) and AECI (AFE) detracted from the index’s relative performance. There were no changes to the Satrix Stable Dividend strategy during the prior quarter. 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. A year ago, there was general apathy towards SA equities and the focus on political and economic downside risks in South Africa meant that many investors sat on the sidelines, which teed up the strong relief rally we witnessed at the end of the year. In South Africa, the danger is that too much, too soon may be expected from the new ANC leadership and, also, global risks from Fed tapering may now be underestimated.