Market review

Global financial markets took their lead from talk about the possible timing of US Fed tapering but were caught off guard when the central bank failed to move in September. Syria was also a focus for a while until US military intervention was taken off the table.

Against this backdrop markets were volatile but buoyant, with developed world stock markets breaking through five year highs and bond yields moving in lock step with any Fed-related news. By the end of the third quarter, the MSCI World Index had gained 8.2% on a total return basis in dollar terms, and the MSCI Emerging Markets Index 5.9%.

At home, the FTSE/JSE All Share (ALSI) gained an impressive 12.5%, propelled higher largely by a rebound in resource stocks, with the Resource Index delivering almost 20% during the quarter. The Financial Index added 6.9% during the period and the Industrial Index gained another impressive 11.3%.

The rand depreciated 1.6% against the dollar during the period, which meant the All Share offered foreigners a milder dollardenominated return of 11.0% The All Bond Index eked out a 1.9% gain for the quarter and the Inflation-Linked Bond Index 1.2%. Cash returned 1.3%.

SIM strategy

SA and global equity markets have more than doubled from their 2009 lows. Given current valuations, we believed it was appropriate to reduce the size of the overweight position in equities in our global portfolios by down weighting our SA exposure. Relative to international markets and other emerging markets, the SA equity market appears somewhat expensive and we therefore cut our domestic exposure but retained the overweight position in international equities.

Local Investments

Local equities | In our global multi-asset class portfolios, we are underweight local equities. The SA market currently trades at a 16 price-to-current earnings ratio (PE). We believe equities are fairly priced if they offer a prospective real return of 7% a year, which equates to a current PE ratio of about 12 to 13, assuming a long-run real dividend growth rate of 3%. The SA market is on an 18.5 Graham & Dodd PE ratio versus a long-run average of 13.5. (The Graham & Dodd PE ratio is calculated by dividing price by the average inflation-adjusted earnings over the past 10 years.)

Local bonds | With the SA 10-year conventional bond yield trading above 7.75% for most of the quarter, we retained our overweight position in local bonds. Using our long-run inflation target of 5.25%, this implies a real yield of 2.5%. SA cash currently offers a negative real return - three month cash rates are at 5.1% - and there is now almost a 2.6% spread between cash rates and long bond yields. We believe a 1% spread is sufficient compensation for the term and inflation risk associate with long bonds.

Inflation-linked bonds | During the first week of June, we implemented an overweight conventional bond and underweight inflation-linked bond (ILB) position. The difference in yield between the 10-year nominal bond and the 10-year ILB reached between the 10-year nominal bond and the 10-year ILB reached 6.6% at this stage compared with a 5.5% low a month earlier. This difference is a reflection of the market's inflation expectations over the next 10 years plus an inflation risk premium to compensate conventional bond holders for the risk of unexpected inflation. We disagreed with the market, seeing no reason for a significant rise in 10-year inflation expectations.

Towards the end of September, the yield difference between 10- year nominal and inflation-linked bonds fell back to 5.85%, at which point we successfully closed the position. Our long-run inflation assumption is 5.25% and, taking into account the inflation risk premium, we believe this difference is appropriate.

Local listed property | We retained our neutral holding in listed property.

Global Investments

Our portfolios currently have a benchmark weighting with respect to their total offshore exposure.

Global equities | We retained our overweight position in global equities, with a continued preference for Europe and the UK.

Global bonds | We retained the underweight position in global bonds, but reduced the size of our underweight position.US and UK 10-year treasury yields have risen by more than 1% since the middle of 2012, with US treasuries increasing to 2.7%. European government bonds have risen by about 0.5%. Inflation-linked bond yields weakened as well, so long run inflation-expectations, as implied by the markets, remain at about 2%, which is in line with our long-run inflation assumption for developed markets. The developed market government long bonds now offer a positive real return (excluding Japan), which compares favourably to the negative real rates available from cash.

Long bond yields can be viewed as a forecast of future cash rates. Given the pronouncements of the various central banks, it does not appear as if zero nominal cash rates are going to change soon. Future cash rates would therefore have to increase well above the current long bond yields for cash to be a better long-run investment than bonds. We prefer to take our overweight position in SA bonds.

Global property | We have a significant overweight position in international property via listed REITs. Currently our holdings have an average dividend yield of about 6.5%, which is in line with the 6.5% dividend yield offered by SA listed property.

Risks and opportunities ahead

We remain concerned that there is an outside chance inflation could increase in the indebted developed markets and spill over into the developing markets due to the very loose monetary policy followed by their central banks.

Market review

It was an eventful quarter that will best be remembered for the profound impact Federal Reserve chief Ben Bernanke had on the financial markets when he indicated the US central bank could well start withdrawing monetary life support as early as September this year.

Financial markets around the world went into a tail spin, unraveling the buoyant spirit that had predominated until then. By the end of the quarter, the MSCI World Index had just managed to stay in the black, up 0.8% in total dollar-based terms, notwithstanding June's 2.4% losses.

Emerging markets were much harder hit as investor sentiment turned for the worse on indications economic prospects may not be as positive as they expected. As a result the MSCI Emerging Markets Index slumped 8% (6.3% in June alone). SA was not as hard hit as the index, shedding 7.3% during the quarter, even though the rand depreciated further during the period.

In local currency terms, the JSE All Share Index ended the quarter just in the red (-0.2%) but again with highly divergent performance between the different sectors. Resources were again knocked by the commodity price meltdown and lost 11.8% during the quarter. The Financial Index also ended in negative territory, off 1.6% for the period. In contrast, the Industrial Index continued its winning streak, gaining another 6.9% during the quarter.

Of the fixed interest assets, the All Bond Index declining 2.3% and inflation-linked bonds slumping 4.9%. The only asset class to gain ground during the second quarter was cash, which delivered positive returns of 1.3%.

SIM strategy

Local Investments

Local equities | We currently have a benchmark holding in SA equities as we believe SA equities are fairly valued. The market trades on a forward price-to-earnings ratio of about 13 times. Also, in summing up the individual company valuations, as calculated by our equity analysts, the market appears to be fairly priced.

Local bonds | During the quarter, the SA 10-year conventional bond yield rose by almost 200 basis points from a low of 6.1% to a high of 8%. Using our long-run inflation target of 5.25%, this implies that a real yield of 2.75% was on offer. The Reserve Bank targets an inflation range of 3% to 6%. Even if we are, on average, at the upper end of this target, the SA 10-year bond still offers a 2% real yield, which equates to the real return SA nominal bonds have offered since 1900.

Rapid price movements in assets often provide fertile ground for valuation driven asset managers but we need to ascertain whether the news and events have warranted this price change. If we frame this in terms of the 10-year bond, it implies there has been a significant change in the outlook for 10-year inflation, 10- year real yields and/or the required 10-year inflation-risk premium in SA. Given the weakening in the rand, shorter-term inflation expectations have risen as domestic currency weakness would cause a once off re-pricing in imported goods. However, it would only have a significant impact on 10-year inflation expectations if there is a belief that the rand will weaken more than the prevailing there is a belief that the rand will weaken more than the prevailing inflation differential - from already cheap levels (see comments below) - over the next 10 years.

Inflation-linked bonds | Inflation-linked bonds did not weaken to the same extent as nominal bonds during the quarter. The difference in yield between a nominal bond and inflation-linked bond of the same maturity should be marginally higher than the market's inflation expectation for the next 10 years (it should be higher because of the additional compensation conventional bond holders require for the risk of unexpected inflation). This differential widened from 5.5% at its low point in May to 6.6% on June 7, implying a significant increase in 10-year inflation expectations and/or the inflation risk premium. We took the market on with regards to this by selling inflation-linked bonds and adding to conventional bonds.

Local listed property | We retained our neutral holding in listed property.

Global investments

The rand has weakened to more than one standard deviation below the fair exchange rate, as measured by purchasing power parity. Valuing currencies is notoriously difficult. Purchasing power parity is theoretically a sound way to make an attempt at this and it does seem to hold over the very long term. It is based on the assumption that goods and services should cost the same across currencies. This assumption has some flaws as not all goods, and especially services, are tradable. Moreover, the developed market economies have become more serviceorientated lately.

We introduced a 2% overweight position in offshore assets in May 2011 when the rand was expensive relative to purchasing power parity. In December 2011, the rand was trading at purchasing power parity, at which stage we reduced our overweight position in offshore assets to 1%. In theory, we should then have reduced our overweight offshore position to neutral. However, we retained our offshore bias for two reasons. Firstly, according to our analysis, offshore risky assets (equities and property) were cheaper than SA risky assets. Secondly, SA's terms of trade position had started to deteriorate after the financial crisis of 2008. Until then, thanks to globalisation, imported manufactured goods were dropping in price, while the commodities exported by SA increased in price. The globalisation drive has stalled and, commodity prices have not reached the same heights again. Theoretically, all else constant, this should result in a weaker rand.

Even so, the rand has weakened to such an extent that we now believe it is appropriate to neutralise the overweight offshore position.

Global equities | We retained our overweight position in global equities, with a preference for Europe and the UK.

Global bonds | We retained our underweight position in global bonds. Benchmark 10-year sovereign bonds in the developed world have weakened considerably during the quarter but still offer too low a prospective real yield relative to the alternative asset classes in our opinion. We prefer to take our overweight position in SA bonds.

Global property | We have a significant overweight position in international property via listed REITs. Currently our holdings have an average dividend yield of about 6%, which is attractive compared to the 6% dividend yield offered by SA listed property.

Risks and opportunities ahead

Due to the very loose monetary policy followed by developed market central banks and the incentive this gives developed market governments to reduce their debt burden in real terms, there are concerns that inflation could increase in these economies and spill over into the emerging markets. Even though we have an overweight position in SA conventional bonds, this should, however, be seen in conjunction with the 3% underweight position in global bonds. This provides some protection in an environment of unexpected inflation.