Market review
The yield difference (spread) between the South African 10-year USD sovereign bonds and the US 10-year sovereign bond is at about 3% and is still 0.5% higher than where it traded on average in 2014 and 2015. This spread has recovered substantially from its high of 3.85% in the wake of the surprise dismissal of the Minister of Finance by the President in December 2015. The spread reflects the risk of default by the South African Government on its USD bonds and is referred to as the sovereign risk premium of South Africa. That some confidence has returned to the country is also evident from the strengthening of the rand, as well as the lowering in the inflation risk premium. Tenyear South African rand bonds strengthened, without any significant changes to the inflation outlook. The equity risk premium for companies that derive their income from the South African economy also improved, as is evident in the outperformance of the mid-cap and small-cap indices.

What we did during the quarter
We added to local equities over the quarter through the SIM General Equity Fund and the SIM Top Choice Funds. Both of these funds have delivered consistent, solid long-term returns in an increasingly competitive category and are well ranked relative to peers. We also added to the SIM Enhanced Yield Fund, the performance of which is driven by the diversified blend of attractively yielding, good quality credit assets. On the international front, the rand at heightened weak levels relative to the USD saw us bring back some local currency at fairly attractive levels. Even though the rand has recovered since then, it remains one of the weakest emerging market currencies relative to purchasing power parity. The rand remains more than two standard deviations cheap against the USD and one standard deviation cheap versus the GBP and EUR. We believe that purchasing power parity holds over the long run. This has been the case for the rand in 2001/2 and 2008 when it was cheap versus developed market currencies. In both cases the rand recovered to purchasing power parity. Our low exposure to offshore bonds was further reduced and we sold out of our remaining holding in the Sanlam Global Financial Fund with proceeds repatriated.

Local equities
We retained our underweight position in South African equities. Even though South African equities are fairly priced using a bottom-up valuation of the individual companies, we continue to prefer global developed market equities ahead of SA equities. South African equities continue to trade at a substantial premium to other emerging markets on both a price to earnings and a price to book basis.

Local bonds
We retained our overweight position in SA long bonds. In January, they traded at yields of 9.6%, thus offering a 3.6% real return assuming inflation is at the upper end of the inflation target band for the next 10 years. A holder of SA 10- year bonds since 1900 received a real return of 1.8% per annum. We believe that the policy of a 3% to 6% inflation target band will be maintained. The SA Reserve Bank’s recent rate hikes are to some extent a confirmation of this. The events in December surrounding the dismissal of the Minister of Finance and the reappointment appointment of Minister Pravin Gordhan do give confidence that the government heeds financial markets. In all likelihood National Treasury’s hand has been strengthened and it would find it easier to follow a prudent macro-economic policy that will be supportive of the inflation target. Over the next year or two, average inflation is likely to remain above the upper end of the target given the rand’s depreciation and increasing food prices. There is also the possibility of a downgrade of South Africa’s credit rating to sub-investment grade. Bond investors are well aware of these issues and their fears are more than likely reflected in the current bond prices. South African bonds are furthermore attractive relative to real returns available on bonds in other developing and developed markets.

Local listed property
We retained our neutral holding in listed property. We prefer international listed property companies, which we believe are cheaper.

Global equities
We retained an overweight position in global equities. We are of the opinion that on a relative basis, global equity remains an attractive asset class. The dividend yield of developed market equities is at 2.8%. This is higher than the average dividend yield of the past thirty years. Only in 2008 were dividend yields substantially higher than current levels.

Global bonds
The real yield on offer from developed market bonds remains unattractive relative to more risky assets. We retained our underweight position in favour of international listed property.

Global property
We retained our overweight position in international properties via the Sanlam Global Property Fund managed by AllianceBernstein in the UK. The average dividend yield of the portfolio compares very favourably relative to offshore cash and bonds.

Market review
In December the risk premia attached to South African assets increased significantly after the surprise dismissal of the Minister of Finance by the President. The yield of South African USD 10-year sovereign bonds weakened by approximately 0.6% after the announcement, which is a reflection of the increase in the sovereign risk of the country. Local 10-year bonds weakened by approximately 2% to 10.4%, offering a real return of 4.5% above the upper end of the inflation target. This reflected an increase in the inflation risk premium of South Africa. The equity risk premium for companies who derive their income from the South African economy did also increase substantially.

We are in agreement with the market that the sovereign risk premium of South Africa, the inflation risk premium and the equity risk premium required for investing in the South African markets did increase substantially given this event as it has affected investors’ confidence in the country’s leadership. The subsequent appointment of Minister Pravin Gordhan as the new Finance Minister should give some confidence that the government does heed the financial markets. In all likelihood these events have strengthened the hand of National Treasury to continue with its fiscally prudent policy.

Even so, the sovereign risk premium has not recovered, as the SA 10-year USD bonds still trade about 0.5% weaker than before the surprise dismissal. The yield on rand-denominated long bonds has recovered somewhat but at 9.5% it still trades about 1% weaker than before the dismissal.

What we did during the quarter
The final quarter of 2015 saw the rand sell off massively to unprecedented lows against the US dollar, trading closer to three and two standard deviations cheap against the USD and GBP respectively from a purchasing power parity perspective and one standard deviation cheap versus the EUR. We believe that purchasing power parity holds over the long run as we have seen in 2001/2 and in 2008 when the rand was cheap versus developed market currencies. In both cases the rand recovered to purchasing power parity. We used the weaker rand levels over the quarter as an opportunity to rebalance (reduce) our offshore exposure while at the same time locking in some profits. Offshore equity too was rebalanced mainly through sales out of the funds that have greater US equity exposure, namely the Sanlam World Equity Tracker and the more actively managed Sanlam World Equity Funds. We lowered our holdings in the Sanlam Global Financial Fund and repatriated the cash.
Locally, we added to the SIM Enhanced Yield Fund, the performance of which is driven by the diversified blend of attractively yielding good quality credit assets. We used the sell-off in equities and bonds over the quarter to add to the SIM Top Choice Fund and the SIM Bond Plus Fund. The SIM Top Choice Fund continues to deliver consistent competitive returns in the equity space and holds positions in companies that trade at a lower forward PE than the market, lower price-to-book ratios and higher dividend yields. Nominal bonds at current levels represent a good, long-term buying opportunity.

Local equities | We retained our underweight position in South African equities. Emerging markets derated in 2015. South African equities continue to trade at a substantial premium to other emerging markets on both a price to earnings and a price to book basis. Even though South African equities are about 10% cheap using a bottom-up valuation of the individual companies we do prefer global developed market equities.

Local bonds | We retained our overweight position in SA long bonds. Ten-year bonds weakened from 8.5% to 9.5% during the quarter. We are of the opinion that inflation remains contained within the inflation target. A real return of approximately 4.0% is on offer, which is attractive relative to other asset classes. The rand weakened further during the quarter and trades at very weak levels on a purchasing power parity basis. An appreciation of the rand should be positive for SA bonds as it would result in lower short-term inflation.

Local listed property | We retained our neutral holding in listed property, even though dividend yields have weakened about 0.7% from their best levels. We prefer international listed property companies, which we believe are cheaper.

Global equities | We reduced the magnitude of our overweight exposure to global equities. Developed market risky assets and particularly equity markets are expensive relative to their own long-run history. The US market is trading at 26 times its inflation-adjusted average 10-year earnings (the Graham and Dodd PE) relative to its long-run average of 16.5. We believe the overvaluation is, to some extent, justified due to the fact that global risk-free assets, US government debt, are trading at extremely low real yields. These low real yields are partly due to central bank and government policies that are being followed in the wake of the 2007 financial crisis.

Global bonds | The real yield on offer from developed market bonds remains unattractive relative to more risky assets. We retained our underweight position in favour of international listed property.

Global property | We retained our overweight position in international properties via the Sanlam Global Property Fund managed by AllianceBernstein in the UK. The average dividend yield of the portfolio compares very favourably relative to offshore cash and bonds.