Market overview

The third quarter of 2018 was characterised by a growing dislocation in the economic performance of the US in contrast to the rest of the world. Even more stark has been the difference in the prospects of the US and several of the major emerging markets (EMs), which have been plagued by concerns around trade tensions, the impact of higher US policy rates, and various idiosyncratic issues. The latter include the continued trade spat between the US and China, the likelihood of a messy election in Brazil, the threat of further sanctions on Russia, and (most prominently) Turkey seeing a massive sell-off in its currency and bonds when a war of words between Presidents Erdogan and Trump added to the already fragile situation that country’s economy has been in. Turkey eventually settled the market to some extent by hiking rates by a substantial 6.25%, joining a group of several EMs that have hiked rates in recent months. By contrast, it’s been plain sailing over in the US, with growth reaching 4.2% in Q2, equity markets at historic highs, and the backend of the Treasury curve seemingly oblivious to any of the three hikes seen from the Federal Reserve so far this year.

South Africa suffered no less from EM weakness as most of its peers, with a strong July for the Rand and bonds being undone by the significant turbulence seen in the latter two months of the quarter. Perhaps the most unsettling news for the nation over the period was the release of Q2 GDP, which confirmed that SA’s economy had suffered a second consecutive quarter of negative growth (-0.7% quarter-on-quarter, following on from -2.6% in Q1). Again, the largest contributor to the quarter’s disappointing growth outcome was the agriculture sector, which saw a particularly severe decline of -29%. Under these circumstances, it remains to be seen how the economy can reach anything like the 1%+ forecasts for 2018 GDP growth that many economists still maintain. The country was at least spared the prospect of higher interest rates when the South African Reserve Bank (SARB) narrowly avoided hiking the repo rate at its September meeting (owing mainly to CPI continuing to surprise on the downside, as well as the general weakness of the economy).

In his bid to challenge the stagnation seen in the local economy, President Ramaphosa continued on his crusade to kickstart a wave of foreign direct investment into South Africa, managing to get Saudi Arabia and the United Arab Emirates to each pledge US$10 billion in investment, with China pledging a further US$15 billion (including a large loan to Eskom that has raised some questions).

In keeping with the challenging macroeconomic environment, all domestic asset classes had an unimpressive quarter. The FTSE/JSE Shareholder Weighted Index (SWIX) returned -3.3%, with only the Resources and Financial indices bucking the trend. Nominal bonds returned a mere 0.8%, while inflation-linked bonds returned 0.4%. Cash was the top performer, yielding 1.8%. The Rand was 33% weaker over the quarter, sliding from R13.71/$ to R14.15/$.

Global equity market returns in the quarter demonstrated the divergence between EM and developed market stock markets, with the MSCI Emerging Markets Index down -1% in Dollar terms while the MSCI World Index surged 5%.

What we did during the quarter
We have during the course of the quarter added to our enhanced cash position via purchases of the SIM Enhanced Yield Fund. Overall, the investment proposition for the SIM Enhanced Yield Fund remains a good one. The Fund is supported by well-established fixed-interest processes as well as an extensive credit process. In addition, the valuations of assets which form part of the investable universe of the Fund are more than fair. Most of the purchases were funded from reductions to the local bond fund.

On the international front, we lightened our exposure to global properties and global bonds over the quarter. Global bonds, outside of the US, are unattractive with negative real yields on offer.

Local equities | We retained a neutral position in SA equities. Since the beginning of the year, the South African equity market has dropped along with other EMs. This fall can partly be attributed to the escalating global trade war started by the US. Higher trade barriers would increase global inflation and are likely to harm global growth. This affects EMs more as they are expected to grow faster than developed economies. A lower expected growth in the earnings of EM companies, as well as an increase in perceived risk, expressed through a higher required equity risk premium, could explain the recent re-pricing of emerging equity markets. We are of the opinion that this fall is overdone in the South African equity market. Given consensus earnings forecasts, our equity benchmark now trades at a one-year forward price-earnings (P/E) ratio of 11, if we exclude Naspers. In addition, the SIM equity analyst estimates that Naspers trades at a substantial discount to its fair value.

We believe a P/E ratio of about 13 to 14 is more appropriate for the SA equity market given our required real return of 6% for the South African equity market.

Local bonds | We have an overweight position in bonds. The current yield of about 9% on the 10-year bonds still offers an attractive prospective real return. CPI is expected to remain within the 3-6% target band for the foreseeable future, despite a weaker Rand and higher oil prices.

Local listed property | We have a slight underweight holding in listed property. The dividend yield of SA listed property shares has weakened to about 8.4%, partly in response to a decline in the growth of their earnings.

Global equities | The earnings of US companies have benefited from a corporate tax cut in the US this year. However, they remain highly geared and are expensive relative to their historical levels. Since 1970, global equity markets have given a 4% real return, with most of the real return explained by the markets’ dividend yields. Over the past five years, global equity markets (MSCI World) gave an annualised real return of more than 10%. Almost half of this return is due to a revaluation of equities, with the rest due to dividend yield and dividend growth.

From a relative valuation perspective, we remain well weighted in foreign equities, on the back of the view that they should continue to deliver returns that are better than expected from bonds.

Global bonds | We retained our underweight position in global sovereign bonds. Even though 10-year US Treasuries have now weakened to above 3%, sovereign bonds in the other major developed countries are trading at yields well below our 2% long-run inflation assumption. Given our 1% real required return from developed market bonds, global sovereign bonds remain unattractive.

Global property | We retained an overweight position in our global property basket via an investment in the Sanlam Global Property Fund managed by AllianceBernstein in the UK. Currently the properties we own have an average dividend yield of about 6.7%. This compares favourably relative to offshore bonds and cash.