Macro review
In the US, economic growth remained robust and this ultimately overshadowed simmering concerns around the escalating US.China trade war. Stability in growth and employment figures allowed the Federal Reserve (Fed) to enact its widely anticipated increase in the federal funds rate by 25 basis points. The committee dropped its long-standing description of monetary policy as eaccommodativef and reaffirmed its outlook for further gradual hikes into 2019. Data released in September showed wages to be growing at the fastest rate since 2009, while additions to non-farm payrolls remain above 185 000 on a three-month average. As yet, industrial activity indicators show little impact from the trade wars.

In Europe, worries over trade wars and potential US tariffs on cars were a feature of the period. On the economic front, Q2 2018 growth was revised up to 0.4% quarteron- quarter, compared to the initial estimate of 0.3%. Forward-looking activity indicators continued to point towards expansion, albeit at a more subdued pace than at the start of 2018. The Flash Eurozone PMI Composite Output Index (1) for September fell to a four-month low of 54.2. Eurozone inflation was estimated at 2.1% for September, up from 2% in August. There was no change in policy from the European Central Bank who reiterated that interest rates would remain on hold eat least through the summer of 2019.

In emerging markets, there was little progress in bilateral trade negotiations and China responded with tariffs on $110 billion of US goods. Meanwhile, Chinese macroeconomic data disappointed. Turkey experience a sharp sell-off in the Lira, as geopolitical tensions with the US exacerbated ongoing concerns over its wide current account deficit, above-target inflation and central bank independence. South Africafs macro backdrop deteriorated as global liquidity tightened given the economyfs twin deficits, and Q2 2018 GDP growth disappointed, slowing to 0.4% year-on-year. Mexico saw positive general elections and an agreement with the US on NAFTA renegotiation. Despite ongoing risk of new US sanctions, Russia benefited from crude oil price strength.

Global and local market review

The MSCI World Index posted a Dollar total return of 5.1% (+1.9% for Q2 2018), once again outperforming the MSCI Emerging Markets Index (-0.9% in Q3 2018 vs - 7.9% in Q2 2018). In the US, despite political uncertainty and trade concerns, the US equity bull market became the longest in history on 22 August, and advanced in Q3 2018 to significantly outperform other major regions. Over the quarter, the information technology and healthcare sectors were boosted by a slew of robust earnings. Eurozone equities posted a modest gain in Q3 2018 with the the MSCI EMU (European Economic and Monetary Union) Index returning 0.4%. Energy and industrial stocks were among the leading gainers. The FTSE/JSE All Share Index fell 0.8% amid Brexit uncertainty and a tempering of the global growth outlook, as a result of the escalating trade war between the US and China. Although trade tensions continued to escalate during the quarter, the Japanese stock market ended September above its recent range to show a total return of 5.9% for the quarter.

Emerging market equities lost value in what was a volatile Q3 2018, with US Dollar strength and the US.China trade dispute weighing on risk appetite. China underperformed as the US implemented tariffs on a total of $250 billion of Chinese goods, some of which are set to increase in January, and threatened tariffs on a further $267 billion of goods. There was little progress in bilateral trade negotiations further $267 billion of goods. There was little progress in bilateral trade negotiations and China responded with tariffs on $110 billion of US goods. Turkey was the weakest index market amid a sharp sell-off in the Lira. South Africa also underperformed. The market is vulnerable to global liquidity tightening given the economy’s twin deficits, and Q2 2018 GDP growth disappointed, slowing to 0.4% year-on-year. SA Resources and SA Financials outperformed in Q3 2018 with total returns of 5.2% and 2.8% respectively, while the SA Industrial sector was the drag on the index, shedding 7.8% over the same period.

The FTSE/JSE Capped Shareholder Weighted All Share Index (Capped SWIX) delivered a return of -1.65%, which was better than that of the FTSE/JSE Shareholder Weighted Index (SWIX), which realised -3.34%. The return difference could mainly be attributed to the weight difference in Naspers and to a lesser extent to Aspen and MTN.

Core government bond yields rose over the quarter due to positive economic data, particularly from the US. This outweighed a bout of safe-haven demand in August caused by concerns related to emerging market instability, trade tensions and political issues in Europe. The Fed implemented its third rate hike this year, removing references to ‘accommodative’ policy and striking an optimistic tone. In commodities, the S&P GSCI Spot Index posted a marginally negative return in Q3 2018 with US Dollar strength weighing on prices. Industrial metals were weaker on global trade uncertainty. Copper was down 5.5%, while nickel (-15.6%) and lead (- 15.9%) registered steeper declines. Precious metals were also weaker, with silver and gold down 8.9% and 4.8% respectively. By contrast, the energy segment posted a positive return as spot prices for Brent crude gained 5.5% and natural gas was up 2.9%.

In Closing

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.
Although local factors have weighed on the Rand, i.e. Ramaphoria sentiment souring, risks of a Moody’s downgrade, uncertainty surrounding the Mining Charter and land expropriation without compensation, much of the weakness in the Rand has been driven by external developments - a stronger US Dollar, weaker commodity prices, tighter monetary policy from the Fed, contracting global Dollar liquidity and lately, emerging market contagion risks from Turkey and Argentina.

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% (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.

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 (Q4) 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, even though there was a slight slowdown from 0.7% in Q2. In October, the European Central Bank 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’s (BoE) 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 Q4 and 24.6% over 2017, one of the strongest years since 2009. The S&P 500 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 equities (EM), however, outperformed their developed world counterparts, returning 7.5% during Q4 and 37.8% in 2017. Top performers in EM in Q4 2017 were South Africa (+21.5%), Greece (+13.6%) and India (+11.8%). MSCI South Africa rallied +36.8% in US dollar terms in 2017, broadly in line with EM, driven by Media (Naspers), a metals rally, while a Ramaphosa win buoyed SA domestic-demand sectors into year-end. However, MSCI SA ex Naspers was up only 16%.

The yields on the US 10yr rose marginally from 2.33% to 2.40% over the quarter, but for a brief period when they touched 2.5%. However, the curve flattenedaggressively 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 Q4 of 4.7%, underpinned by a rally in industrial metals and energy. In industrial metals, nickel (+22%) and 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. In contrast, agricultural commodities lost value, notably wheat and palm oil. In precious metals, gold gained 1.8% while silver was up 1.7%.

Domestically, South African 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 Telcos (-18.8%) and Paper (-9.9%).

SA equities recorded outflows of $2.5bn during 2017, significantly lagging inflows into EM of $77.2bn. However, dissecting the flows, it appears that, excluding the outflows from dual-listed stocks and the Barclays and Vodacom sell-down, SA equities saw inflows of just more than R60bn in 2017.

The benchmark SA 10-yr 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 All Bond Index 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 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 PLC (35%), Sirius (41%) and Greenbay Properties (60%). The best performing local share was Equities 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 GRT, RDF and HYP, came off their intra-year highs on the back of the stronger rand in December.
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 side lines, 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.