Market review

The Fund delivered good returns over a relatively challenging investment period locally as well as globally with resulting spillover effects into our local market during the last 12 months, and again in the third quarter. Global investment returns did not bear much fruit during the first half of the year and came accompanied with a fair share of volatility. Global developed market equities ended the first half of the year relatively flat with emerging market equities down more sharply, while local South African equities finished the first half marginally negative, although all of these were bumpy rides along the way. International bond and credit markets remained under pressure amid rising global tensions and the US Federal Reserve (Fed) continuing on their path of monetary policy normalisation, with four hikes in the target range for the federal funds rate during the last 12 months. Investment-grade credit in the US has had a particularly bad start to the year and delivered negative returns for the first half, even underperforming US equities over this period, and the performance continued to face headwinds in the third quarter with spreads still facing a bit of upward pressure. Emerging market fixedincome markets have had a tough year so far with emerging market sovereign and credit indices finishing the first half in negative territory, both in local currency and hard currency terms, which was subsequently followed by another bout of volatility in the third quarter. Emerging market currencies were under pressure in the third quarter, with the Turkish Lira finishing the quarter down 24% and the Argentinian Peso down 30%. The South African Rand was not left unscathed and finished the quarter 12% weaker.

The upward pressure on local interest rates resulted in the South African All Bond Index underperforming cash in the third quarter and now also for the year to date, with the Namibian government bond performance tracking those of their South African counterparts. Looking more closely at the path of local interest rates and the bond market performance it was quite a bumpy course so far this year. The first quarter of the year delivered stellar returns from local fixed-interest assets on the back of ‘Ramaphoria’ and positive local sentiment, with the trend subsequently turning around sharply in the second quarter as international factors took centre stage and weighed on local bond market performance. Foreigners were significant sellers of South African bonds during the second and third quarter of the year and significant net foreign sales so far this year. The spread of Namibian government bonds compared to South African government bonds traded sideways at stable but elevated levels during the first half of the year, with the spread of Namibian government bond yields compared to South African government bond yields subsequently remaining under pressure in the third quarter.

The Namibian economy recorded the ninth consecutive quarter of decline and has now been contracting since the second quarter of 2016. Nominal GDP growth for the second quarter reported by the Namibia Statistics Agency (NSA) contracted 0.2% for the second quarter from a downwardly revised -0.2% in the first quarter. Although the growth numbers are still negative, the acceleration in decline seems to at least have halted, suggesting that the growth outlook is not deteriorating further. However, the meek growth environment stands in contrast with the Bank of Namibia’s more positive outlook for growth this year.

South African economic growth figures for the second quarter were reported and indicated that the local economy had slipped into a techreported and indicated that the local economy had slipped into a technical recession with two consecutive quarters of negative growth. This marks the first local recession since the global financial crisis a decade ago. South African GDP growth for the second quarter was shown to have contracted by 0.7% following a downward revised -2.6% in the first quarter. The market consensus expectations were for a positive number in the second quarter.

The asset allocation in the Sanlam Namibia Active Fund has worked well so far this year and we are relatively pleased with the overall outcomes and positioning of the Fund. The Fund managed to deliver performance during volatile market circumstances which were driven by swings on the local as well as the international front. The Fund has been able to participate in market strength but has also been more insulated from market volatility than could otherwise have been the case, especially considering the events and market movements during the year. The Fund’s investment objectives are always a key consideration when evaluating the overall positioning and underlying investments. This has continued to prove to work well for the Fund as the performance has managed to keep pace with the local market during periods of strength, while in addition we have had scope available to take advantage of investment opportunities during market weakness and when interest rates trade higher.

The mandate of the Sanlam Namibia Active Fund is orientated towards higher quality assets and it is also important to remember that the Sanlam Namibia Active Fund does not utilise offshore exposures. Offshore asset allocation brings the potential for associated currency diversification benefits and an expanded investable universe. This opportunity set could have added value, especially during the last 12 months as we witnessed big moves in the local currency, in particular reversals over shorter periods than is otherwise more generally the case. The Fund has performed well when considering the risk-adjusted real returns delivered as compared to both inflation and other assets classes. When looking at the return of the Sanlam Active Income Fund compared to inflation, the Fund has performed as good as it can be expected to. Going forward it should reasonably be expected that the performance will again normalise closer to historic norms.

The Fund has had low exposure to listed property assets over the last 12 months, but the limited exposure nevertheless detracted from performance. The positioning was based on valuations with the subsequent weakness in the listed property sector during the year, in particular during the second quarter, giving us the opportunity to take advantage with selective buying opportunities. However, the allocations remain selective and limited with consideration to the continued weakness in the sector. The listed property sector is quite attractively price even when taking into consideration that the fundamental outlook for the sector looks weak.

The investment case for the Fund remains a compelling one: the orientation of the Fund towards quality assets in an environment where local fixed-interest assets are offering attractive income-generating returns and good value at current levels. This rings even more true when remembering that we are still in a low return environment globally and yields on developed market bonds are still at ultra-low levels. The Fund is also a good alternative when considering that return expectations should likely be moderated for risky asset classes where valuations remain onthe higher end and the outlook has deteriorated. Economic growth expectations should be moderated and this would also weigh on risk assets as weaker earnings should be expected to follow suit. Lastly, the US Fed is still on a path of policy tightening, which makes US cash look more attractive but also brings with it the potential to impact valuations more generally. All of this suggest that the Sanlam Namibia Active Income Fund is an attractive income solution, especially in the current global environment.

Economic indicators continue to indicate synchronised global growth, with positive signals from a broad range of cyclical indicators such as purchasing managers’ indices, consumer sentiment, commodities and consensus GDP numbers. This is resulting in continued positive earnings revisions, which is further supported by actual GDP and earnings announcements. Given that this is happening while global policy rates are either kept stable, or raised very modestly, growth assets continue to see support and in the past quarter, growth assets again delivered strong returns, especially in emerging markets where there should be much benefit from synchronised growth.

It is difficult to find a high probability scenario under which developed market bonds will provide any form of real return in the foreseeable future. These bonds are offering low or negative prospective real yields and, in addition, their yields are more likely to rise than fall, due to the quantitative easing policies of central banks coming to an end. The low prospective returns from foreign fixed-interest assets continue to support valuations of foreign growth assets, despite them looking expensive by historical standards on most traditional measures. As long as global interest rates remain low or rise slowly and earnings don't contract, the current pricing levels for equities can be rationalised and hence could be maintained, with equities likely to continue delivering superior returns relative to fixed-interest assets. For this reason, we have retained a moderately high position in foreign equities and continue to avoid global bonds.

The US equity market is expensive in our opinion. US companies have, on average, also become riskier during the last few years as they issued debt to buy back stock. European equities remain cheaper on various valuation measures. We therefore continue to have a bias towards Europe within our global equity allocation. We have added a bit of exposure to emerging markets, which should continue to gain from the synchronised global growth. We also retained a small exposure to a select basket of developed market real estate investment trusts (Reits). This is due to a lack of attractively priced alternative investment opportunities. The properties we own typically have an average dividend yield of around 6%, which is fair if a real return of about 4% is required.

In the local markets we experienced much volatility due to a combination of a surprise, yet sobering medium-term budget speech, a further credit downgrade and the ANC elections. The equity market was also rocked by the Steinhoff saga and impacted by a significant see-saw move in Naspers. By mid-quarter the rand was significantly weaker and bond yields had spiked, but post the ANC elections these had turned around and bonds ended the quarter almost at the same yield to where they started, while the rand ended up much stronger.

Equities, on the other hand, had a strong start to the quarter, helped by a buoyant Naspers and the weaker currency. However, the asset class gave back some of those gains in the second half of the quarter, with Naspers pulling back by 15% from its peak and Steinhoff losing more than 90% of its value. Despite the latter-half weakness, both equities and property still strongly outperformed the local fixed-interest markets over the quarter, with gains of 9.6% and 6.3% respectively, against the 2.2% of bonds and 1.8% of cash. Due to the strength of the rand, local markets generally outperformed global markets, with even global equities - the best of the offshore assets with a 5.5% US dollar return from the MSCI World Index - being down 3.3% in rand terms.

We continue to see good returns on offer from just about all local fixedinterest assets, based on an increased risk premium applicable to South Sanlam Namibia Balanced Fund April 2018 interest assets, based on an increased risk premium applicable to South African investments. These prospective returns are higher than the longterm historical returns generated by local fixed-interest assets and we continue to hold a moderate position in local fixed-interest assets. Given that shorter-dated credit instruments offer returns that are similar to longer-dated government bonds, but with much lower volatility, we have deemed it prudent to divide exposure between these two investment options.

During the first half of the quarter, bond yields rose strongly and bonds became more attractive, but still faced the risk that political developments could push yields even higher (and prices even lower). Over the period of the ANC elections we implemented a derivative structure to provide additional exposure, but with reduced downside to bonds, in case of a bond rally. When a strong rally did occur in the week after the ANC conference, we closed out the structure and locked in the gains, capturing the bulk of the positive move in the bond market.

A derating of local property over the last three years took place despite property's resilient growth in dividends, which has kept pace with inflation and was much stronger than dividend growth from equities. Furthermore, approximately 35% of JSE-listed property companies’ earnings are now from outside South Africa, with a skew towards euro exposure, a currency that still seems cheap against the rand on a purchasing power parity basis. Given the increased political uncertainty in SA during the previous quarter, listed property companies with a South African rental income stream became cheaply priced. The three largest and most liquid SA Reits (Growthpoint, Redefine and Hyprop), which derive 80% of their earnings from SA, offered an average dividend yield of about 8%. Even with very modest distribution growth - well below our assumption for longterm inflation - these counters were priced to deliver real returns in excess of what we require from SA listed property companies. We therefore built on our position in SA listed property by buying a blend of these three stocks.

We have added to our exposure to South African equities. Companies with a South African earnings base (i.e. financials and retailers), have rerated given the outcome of the ANC elective conference in midDecember. Naspers now makes up about 25% of the Swix Index. According to our analysis, Naspers was trading at 34% below its fair value at quarter end. If we exclude Naspers, then the forward P/E of the market is about 13.5 times. Based on this, the SA equity market is fairly priced in the context of globally repriced equity markets. This is supported by a bottom-up valuation of the Swix, where we aggregate the fair values of its constituents as calculated by the SIM analysts.

No discussion of equities for the past quarter would be complete without reference to the terrible loss experienced in Steinhoff. Although we had exposure to the share and hence suffered a loss of almost one percent of fund value as a consequence, this illustrated again the benefit of having a diversified portfolio to reduce the impact of such a negative event.
Risks
Global real yields have dropped substantially after the 2008 financial crisis. We remain unsure whether this is a temporary phenomenon, due to central bank policies of quantitative easing, or whether this is more permanent due to globalisation and demographic changes. Even if temporary, we can't predict the rate of normalisation.

Assets are currently priced as if real yields are going to remain low for a prolonged period and we can express a rationale for such based on global debt levels. On a relative basis, growth assets are priced to continue giving the type of outperformance (over fixed-interest assets) that they have historically given. The risk does lie in a more rapid normalisation of pricing levels (to historical average values) that would detract from growth assets' relative returns.

South African assets have rerated given the outcome of the ANC elective conference. To what extent the management of the country will improve given the change in leadership remains to be seen. A lot of good news has been priced in, even though the government’s financial position remains precarious.

The fourth quarter of 2017 had more than its fair share of events to keep market participants on their toes, but the positive momentum in performance across most global and local asset classes continued. Global financial markets continued to deliver strong performance with both international stock markets as well as our local equity market reaching all-time highs during the last quarter of the year. Looking at the full calendar year returns, global asset classes delivered either good or at least positive returns to investors almost across the board. Global bond markets also showed resilience and traded with a stronger bias even though factors such as the growth outlook and the suggested monetary policy paths are against the already stretched valuations. German bunds were a notable outlier as they were an underperformer compared to most global asset classes for the year. In the US, the Fed continued on their path of monetary policy normalisation with another hike in the federal funds rate target range during December to 1.25 - 1.50%, while the European Central Bank (ECB) and the Bank of Japan (BoJ) kept their rates at 0.0% and -0.1% respectively. Global markets seem to be somewhat complacent - looking at the VIX it is still around its lowest level ever and was hovering below or around a level of 10 for most of the quarter.

The performance of South African fixed interest assets stood out as outliers for most of the year, with South African government bond yields showing higher volatility and trading with a weaker bias during the year - in particular during the final quarter of 2017. South African bonds recovered in the nick of time, rallying strongly during the last few weeks of December. In fact, December was one of the best months on record for our All Bond Index (Albi) in US dollar terms. After initially showing quite a bit of weakness during October and November, South African interest rates subsequently turned around and recovered the previous months’ losses during December.

South African inflation (CPI) slowed to 4.6% year-on-year (y/y) in November from 4.8% in October with core CPI slowing to 4.4% y/y from 4.5% in October. We are still importing deflation but disinflation stemming from the exchange rate is fading out. The inflation print continues to reinforce that CPI is to bottom out during the first quarter of 2018 before starting to pick up again. We expect CPI to remain relatively contained within the South African Reserve Bank (SARB) inflation target band of 3 - 6% and our forecast is for an annual average of 5.1% in 2018. The risk to the inflation number stems from the potential for exchange rate volatility as well as the impact of commodity prices.

Namibia’s CPI for November printed at 5.2% y/y. The inflationnumber is being kept relatively low due to food inflation, which narrowed to 3.0% in November from 11.6% in November of 2016 - on the back of white maize prices, which are trending lower as well as overall food prices, which have been in decline during the year. Upward pressure on inflation stems from transport inflation as well as housing, water and electricity inflation. Transport inflation is currently 6.1% as the higher pump prices have their effect on the economy. The Ministry of Mines and Energy increased pump prices in November, which will add further upward pressure to transport inflation. Housing, water and electricity inflation remains high at 8.6%, supported by the growth in rental prices, which are 9.6% higher compared to a year ago.
South African Finance Minister Malusi Gigaba delivered his maiden Medium-Term Budget Policy Statement (MTBPS) during October. The minister noted that the economic growth outlook for South Africa has been downwardly revised and the primary deficit was no longer forecast to narrow, resulting in an escalating debt ratio. It was indicated that National Treasury will increase its borrowings in the international market and also increase issuance locally to fund the higher borrowing requirements. The MTBPS stated that a team of cabinet ministers will develop proposals to ‘stabilise the national debt over the medium term’, including proposals to narrow the deficit and try to ensure the expenditure ceiling is adhered to. It was also noted that asset sales are being considered over and above additional fiscal consolidation measures, including expenditure cuts and revenue-raising measures which are to be presented in the 2018 Budget. South African bonds were punished in response to the MTBPS with local bond yields trading higher. Offshore investors started offloading South African bonds and the rand also weakened substantially. The Albi lost 2.3% during October as the South African 10-year government bond yield ended the month 54 basis points higher. In contrast, the JSE hit a record high on the back of the weaker rand. The spread of Namibian government bonds compared to South African government bonds continued to stabilise during the course of the quarter, but finished 2017 at a higher spread compared to the end of 2016.

South African GDP growth for the third quarter was an annualised 2.0% y/y following an upward revised 2.8% in the second quarter. If one excludes agriculture, the economy grew at a much slower rate of 1.1%. The momentum in the primary sector has been relatively more robust, averaging 15% for the first three quarters of the year, while the secondary sector grew at 0.2% and the tertiary sector contracted -0.2%. Only two sectors of the economy were positive for the first three successive quarters of 2017, which was agriculture on the one hand, with mining and quarrying being the other. The numbers show that household consumption expenditure has been holding up relatively well, while also encouraging is that there was a rebound in gross domestic fixed investment - driven by both the public and private sectors. The economic growth trends remain concerning and growth momentum has relied on the volatile primary sector while the more stable tertiary sector has been weakening.

According to the Namibian Statistics Agency (NSA), the Namibian economy remains at a recession through to the third quarter of 2017. Their figures show that real GDP growth contracted by - 1.9% y/y in the third quarter, following contractions in the first and second quarters of -2.1% and -0.7% respectively. They noted that the negative growth rate during the third quarter was mainly on the back of contractions in construction (-36.9%), water and electricity (-5.5%), wholesale and retail sales (-4.4%), public administration (-4.0%), education (-0.4%) and fishing (-1.3%).

The last quarter of the year also had its fair share of local political events. During October, South African President Jacob Zuma implemented his second cabinet reshuffle for the calendar year. Some of the ANC’s top officials said they were not consulted in the decisions. The changes included Higher Education Minister Blade Nzimande being fired and a further six changes to the cabinet. The ANC’s elective conference was held during December with most of the country keeping a keen eye on the race for who would be the next party president, with the frontrunners being Nkosazana Dlamini-Zuma and Cyril Ramaphosa. In the end, Cyril Ramaphosa was elected as the ANC’s next president with the top six positions in the ANC’s National Executive Committee (NEC) being an even split between those aligned to Ramaphosa versus those who are more loyal to President Zuma, while the composition of the entire NEC suggests that there might be a bit more broader support for Mr Ramaphosa.