Market review

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 the second quarter, equity markets at historic highs, and the back-end of the treasury curve seemingly oblivious to any of the three hikes seen from the Federal Reserve (Fed) so far this year.

South Africa suffered no less from EM weakness than 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 secondquarter 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 the first quarter). Again, the largest contributor to the quarter’s disappointing growth outcome was the agricultural 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%+ GDP growth forecasts for 2018 that many economists still maintain. The country was at least spared the prospect of higher interest rates when the SA 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 (DM) stock markets, with the MSCI Emerging Markets Index down 1% in Dollar terms while the MSCI World Index surged 5%. Asset allocationLocal nominal bonds with prospective real yields of close to 4% are attractively priced. We continue to add bonds opportunistically to our funds. At current yields it makes valuation sense to do so. Local (enhanced) cash instruments, both in the credit space and negotiable certificates of deposit, are attractively valued and we have been continually enhancing our cash through the purchase of good quality instruments at decent yield pick-ups over money market rates. Currently, cash on a risk-reward measure stacks up well relative to some of the higher duration assets within the local bond universe. Local equities have been increased on an effective level. Using a bottom-up, fundamentallydriven valuation analysis of the equity market, we believe this asset class to be currently trading at attractive valuation levels and offering reasonably good value with a potential upside to intrinsic value in excess of 25%, excluding Naspers.

On the international side, we maintain our preference for equities and select property over fixed-income assets. This is based on relative valuation measures where fixed-income assets are still not offering as attractive prospective returns as we expect from the equity asset class. 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.

Investment strategy

The current environment is one that is fraught with concerns for any investor looking to manage volatility. Headlines from our major EM peers have not provided any amount of comfort to markets, which had already been questioning the resilience of EM economies in a world of rising DM rates. Add to that a feeble local economy and the result has been a volatile Rand and the troubling combination of higher bond yields and depressed equity market values. To his credit, President Ramaphosa has been talking a good game in encouraging international investment into the country at various international forums, but his efforts are being somewhat undermined by stubbornly weak economic growth, and concerns about how the country’s land restitution policy will play out (something that even made it onto President Trump’s Twitter commentary).

The sell-offs in both local bonds and equities in the third quarter mean that both asset classes can be considered cheap at current valuations, at least in comparison with historic levels. Our long-term fair value for the generic 10-year real nominal bond yield is 3%, which, given our long-term CPI expectation of 5.25%, comes to 8.25%. In comparison, the 10-year rate as at the end of September was 9.19%, suggesting an almost 1% additional yield sweetener at current levels. Equity valuations are also attractive, with our bottom-up analysis of the market showing it to be trading at well below its intrinsic or fair value.

Given the heightened levels of uncertainty surrounding current markets and the accompanying volatility experienced, we opportunistically embrace the valuations, albeit with a measure of caution. Under these circumstances, our approach has been to increase exposure to asset classes that we consider cheap in a cautious manner, and to use derivatives to protect against downside risk while giving us what we consider to be acceptable upside participation. We have also taken advantage of elevated money market rates to invest in term cash instruments that offer attractive premiums over inflation with little volatility. We remain unexcited by inflation-linked bonds that yield in the region of 3% when nominal bonds and term cash instruments yield above 4%.

As regards international markets, we are increasingly uncomfortable with valuations in US equities relative to their long-run history. US bonds remain unattractive in an environment of steady hiking of interest rates by the Fed. Although European valuations are relatively more reasonable, that region also has to contend with the impact of Brexit as well as an Italian economy that is still on wobbly legs. When combined with the fact that many major EMs also face all manner of challenges, we remain comfortable in our current, diversified allocation to foreign equities and may look for further opportunities to invest in domestic assets, which we consider more attractively valued.

Equities

The SWIX was down 3.3% this quarter, dragged lower by industrial stocks, which were down 7.8%. Resources once again had a strong quarter (up 5.2%), accumulating gains of 21% this year. Steel production has been very strong - a sign that the global economy is resilient ? but there are concerns about the Global Purchasing Managers’ Index (PMI) rolling over and that a trade war would impact commodity demand negatively.

In the resources space, Impala Platinum (overweight) led the pack this quarter (up 35.8%), disclosing plans to close unprofitable shafts in its lease area, reduce production by 230 000 ounces and curtail the cash burn. The company experienced large losses of over R10 billion at the end of June, mainly due to the impairment of its Rustenburg shafts. We also witnessed strong performance from Anglo American Platinum (up 29.7%) and African Rainbow Minerals (up 24.7%). Financials recovered modestly by 2.8% after a dismal second quarter. The industrial sector suffered the biggest sell-off as the market punished any earnings disappointment heavily. Even traditionally defensive businesses like Shoprite have found it tough going in the rest of Africa with sales in its rest-of-Africa business dropping 7%!

The SIM house view portfolio outperformed its benchmark by approximately 43 basis points (bps) this quarter. Our overweight position in Resources stocks drove our performance, especially our overweight position in Impala Platinum. Another overweight position, Exxaro, was up 19.9% as it delivered solid results and the market anticipates it to complete the disposal of its titanium business, Tronox. Sasol (overweight) also performed well, up 10.5%, with Brent oil up 7% this quarter in Rand terms. The oil price is at four-year highs with supply concerns augmented by the US threatening to boycott Iranian exports. On the financial side, the fund benefited from the overweight position in Old Mutual, which unbundled its stake in UK wealth manager Quilter and came back home for a primary listing on the JSE. Old Mutual was up 14.2% in the quarter, outperforming the SWIX. On the downside, the underweight position in Discovery detracted from performance after the insurer delivered results which beat expectations as its UK business appeared to turn the corner. The stock was up 15.3% in the quarter but trades at a hefty premium to embedded value.

The Industrial sector suffered the sharpest downdraft with some heavyweights being subject to panic selling. MTN, a stock where we have a marginal overweight position, sold off 17.2% this quarter with yet another unexpected move by the Nigerian government. The Nigerian Central Bank demanded the return of US$8 billion of dividends which had been paid out over the past decade. The stock was sold off so sharply that the market implied a zero value for the Nigerian business ? MTN’s most profitable operation. While the government’s actions ahead of forthcoming elections remain unpredictable, our estimate is that the risk is now more than discounted in the share price and that a lengthy legal battle is likely to mean that some level of sanity will prevail. Aspen, where we have an underweight position, also sold off by 34.4% on the back of results which were marginally below expectations, and the sale of its Chinese infant milk formula business for R13 billion to French company Lactalis, which again fell short of the market’s expectations. The stock, which used to trade on high-teen multiples, has now derated to low-teen multiples as its operations were plagued by operational issues and some contract losses.

SIM equity strategy

As long-term value investors, our investment philosophy is based on taking long-term views and relying on fundamental analysis to make informed investment decisions. This means often avoiding glamour stocks which are the flavour of the day and also not panicking when the market irrationally sells off. It has been a difficult time for the JSE as emerging markets remain out of favour. The resources position we accumulated over the past few years when the sector was decimated is now bearing fruit. With the current sell-off in some blue-chip stocks, we are able to accumulate positions in stocks that are offering excellent upside to intrinsic value, which should yield outsized returns in the years to come.

Equity outlook

Post the Steinhoff debacle, market participants are increasingly jittery and the level of over-reaction to negative news has become extreme. Aspen used to be the darling of the exchange and evolved from being a local generics manufacturer to becoming a global pharmaceutical company with manufacturing capabilities in Europe, Australia and South Africa as well as distribution reach in Africa, Europe, Australasia and Latin America. Following an acquisition spree, the company is laden with debt and participants seem prepared to sell at any price to exit on the first sign of disappointing news.

Since the beginning of the year, we have seen the South African equity market decline along with other emerging markets. This fall can partly be attributed to the escalating global trade war started by the US. We are of the opinion that this fall is overdone in the local equity market. Given consensus earnings forecasts, our market now trades on a one-year forward price-earnings (P/E) ratio of 11, if we exclude Naspers. Including Naspers, the forward P/E is closer to 12.5.

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 local equities.

International

Headlines over the quarter continued to be overshadowed by tariff imposition rhetoric out of the US (in particular the Trump administration). Added to this, Fed Chair Jerome Powell hiked rates again on 26 September to 2.25%, citing that rates were still extremely accommodative and that the bank was still ‘a long way’ from neutral. At least one more rate hike is expected this year with three more in 2019. The US economy remains resilient with jobless claims now at half-century lows. US growth of 4.1% for the June quarter is at four-year highs, accelerating from the beginning of the year and boosted by strong final demand and exports ascounterparties tried to stockpile ahead of a tariff war. The Global PMI is rolling over from strong growth - except for the US. Globally, capex spending has also slowed from over 5% to 3%. The main risk to US economic growth remains high inflation ignited by a tight labour market and higher commodity prices, which will be exacerbated by US tariffs on steel and aluminium products. The implication of this is that the Fed may have to hike rates more rapidly. The first round of 5% tariff increases ($830 billion) is expected to impact GDP growth by 0.5% (and 0.2% on global growth) and drive inflation up by 0.5% on a one-off basis. On the European front, the main concern remains Italy, whose budget deficit is projected to spike from 0.8% to 2.4% as political parties try to make good on electoral promises. In the UK, demand remains upbeat, despite the uncertainty over Brexit terms that need to be finalised over the next month for the UK to officially exit the EU in March 2019. Japan’s GDP growth advanced sharply in the second quarter, driven by business spending. In China, the government is taking measures to boost infrastructure spend by increasing bank liquidity to maintain credit growth around 11% p.a. and facilitating local government bond financing. Chinese GDP growth is expected to weaken marginally from 6.8% to just below 6.5%, aided by robust consumer demand and stable total social financing, as long as the tariff war does not escalate further. However, there remains a concern about the high level of corporate debt in China. China is focusing on defensive easing by allowing local authorities to issue bonds.

For the quarter in Dollar terms, the MSCI World Index recorded a return of 5% while the MSCI EM Index declined 1%. Global bonds, as measured by the Bloomberg Barclays Capital Aggregate Bond Index, declined by 0.9% over the quarter. The local currency weakened by 3.3% versus the US Dollar.

Looking to our international asset positioning within the funds, we remain constructive on global equities over fixed-income from a relative valuation perspective. Although developed equity markets, specifically the US market, have rerated to expensive levels relative to their long-run history, we retain a preference for equities over bonds on the basis of pure relative valuation measures. Our global property assets have an average dividend yield of about 6.7%, which, too, compares favourably with the yields on global sovereign bonds.

Bonds

The backdrop for EMs deteriorated sharply during the past quarter as the global superpowers (China and the US) continue to wage ‘war’ on the trade front. The Turkish Lira and Argentine Peso were the worst performing currencies against the Dollar, declining by about 40% over the quarter. Turkey has been in a diplomatic standoff with the US over the incarceration of an American citizen. In Argentina, investors are worried that the country may soon default on its debt. The Rand traded to a low of R15.58/$ before recovering to R14.12/$ as South Africa is seen by some investors as having similar vulnerabilities as Turkey: current deficits and large external financing requirements.

US 10-year bond yields rose from 2.95% to 3.06%, leading to a sell-off in other DM bond yields. In Germany and Britain, 10-year bond yields rose 17 bps, while Japanese benchmark 10-year yields rose 9 bps. Bond yields in the US were pressured by increased supply and chances of more rate hikes. In South Africa, the sharp fall of the Rand and the rise in oil prices resulted in a deterioration of the inflation outlook. But the SARB decided not to increase the repo rate at the September meeting given the -0.7% GDP outcome for the second quarter and the lower than expected 4.9% CPI for August. The yield on the benchmark R186 bond rose 11 bps during the quarter from 8.88% to 8.99%. However, the FTSE/JSE All Bond Index managed to return a positive 0.78% for the quarter as shortdated bonds offset the capital losses on long-dated bonds. We think South African bonds offer value when the 10-year bond yield is between 8.25% and 8.50%.

Credit market issuance improved in the third quarter after a disappointing first half of the year, headlined by a R3.3 billion issue of senior bonds from FirstRand Bank in July (with maturities of 3 to 7 years), R2.25 billion of 3-year floating rate notes issued by Mercedes-Benz in August, and R3.6 billion of senior bonds issued by ABSA Bank in August (also with maturities of 3 to 7 years). Other notable issues included R700 million of 8-year notes issued by Discovery Limited in August, R1.5 billion in 10 non -call 5-year subordinated notes issued by Nedbank Group, and R1 billion in 3- and 5-year notes issued by Woolworths Holdings. A number of new securitisation issues also took place, the largest of which was R1.2 billion of 3-year notes issued by Amber House in July. Little issuance was seen from SOEs, with the exception of Land Bank’s R1.5 billion issue of 3- and 5-year notes in September. Credit spreads have continued to tighten amid strong investor demand.

The outlook for DM bonds remains poor given a combination of lower liquidity as central banks buy less government bonds, increasing inflation and larger deficits in the US. We think yields in the US will end 2018 closer to 3%, perhaps even a little higher. However, guidance from the European Central Bank to keep rates on hold until the end of summer 2019 will have a dampening effect on yields in Europe. The trade war between China and the US is leading to risk aversion and capital flight towards DMs. Oil prices have risen further and pose a threat to our constructive view on bonds.

In October the Minister of Finance will deliver the Medium-Term Budget Policy Statement (MTBPS). The market will be looking for continued commitment to the expenditure ceiling and for bond issuance to remain unchanged. Government has already committed to a R50 billion stimulus package, to be announced at the MTBPS. Should this stimulus package not be financed within the expenditure framework previously announced, this would be negative for the bond market.

Market review

The beginning of the year saw global stock markets stumble 1.3% with US equities experiencing their first quarterly decline since almost two years, suffering from a volatility-induced whiplash. This reversed the unusual combination witnessed in 2017, where we experienced rising equity markets combined with low volatility. With President Trump on the rampage, volatility spiked after a benign 2017. In addition, the punch and counterpunch of a trade war left global markets dizzy and tethering to find their feet, while the US Federal Reserve (Fed) continued to hike rates.

Back home the first quarter of 2018 saw the nation let off a collective sigh of relief as a number of key political and macroeconomic events turned out more favourably than many had previously anticipated. After Cyril Ramaphosa’s close win in the ANC presidential elections in December, his first objective was to convince former president Jacob Zuma to relinquish the presidency of the country without antagonising him and the large faction in the party whose loyalties still lay with him. This Ramaphosa managed to achieve, while averting a feared political crisis. The State of the Nation Address delivered by the new president was largely well-received. The next important event was the Budget Speech, where significant fiscal measures were announced in order to address the country’s budget deficit and growing debt burden. These included the first increase in VAT in 25 years (from 14% to 15%), as well as strict expenditure ceilings. Then came the much-anticipated Cabinet reshuffle, where a number of compromised or unpopular ministers were duly removed and replaced with more technocratic individuals seen as more likely to appease the markets as well as ratings agencies.

These measures, and the prevailing mood of political certainty that accompanied them, saw Moody’s maintain the country’s long-term local debt rating at investment grade, while improving its rating outlook to ‘stable’. A long-feared exit of the country’s local currency bonds from the Citi World Government Bond Index and the accompanying likely sell-off in domestic bonds were thus averted.

The country’s morale received an unexpected boost when real GDP growth for the fourth quarter of 2017 printed at 3.1% (versus consensus estimates of 1.8%), with upward revisions to the figures of several previous quarters. This resulted in the final real GDP growth number for 2017 reaching 1.3%, higher than even the most optimistic forecasts, and well above the figure of 0.6% seen in 2016. The main contributors to this growth were agriculture (which increased by a massive 37.5% in the quarter), the trade sector (up 4.8%) and manufacturing (up 4.3%).

Further cheer was added to the markets by the decision of the South African Reserve Bank (SARB) to cut its repo rate by 25 basis points (bps) to 6.5% at its March meeting. However, with the increase in VAT being applied from 1 April, as well as higher petrol prices (from higher crude oil prices and fuel levies), the positive impact of the rate cut on consumers is somewhat muted.

While the above developments provided support to the rand and fixedincome assets in the quarter, the equity market failed to come to the party. For the quarter to March, the FTSE/JSE Shareholder Weighted Index (Swix) gave up 6.8% quarter-on-quarter with all major equity sectors off their December levels. Within equities, SA Financials declined 3.6%, SA Resources fell 3.8% and SA Industrials were 8.0% lower over the quarter. The local property sector especially saw a very severe selloff, with the SA Listed Property Index declining by 19.6%. The rand strengthened from R12.38/$ to R11.85/$. Nominal bonds returned 8.1%, Sanlam Namibia Inflation Linked Fund April 2018 strengthened from R12.38/$ to R11.85/$. Nominal bonds returned 8.1%, inflation-linked bonds were 4.0% higher and cash delivered 1.7%. On the international front, the MSCI Emerging Markets Index was 1.4% firmer in US dollar terms and the MSCI World Index declined 1.3%.

Asset allocation
On an effective level, additions were made to our position in conventional bonds as the asset class offers an approximate 3% real yield, which is attractive when compared to the domestic bonds of most other emerging markets. Since 1921 the mean rate of inflation in SA has been 5.25%, and since January 2009 it has been 5.5%. We consider a 3% real return to be fair for SA’s 10-year conventional bonds. Cash continued to be enhanced throughout the quarter with the additions of select credit assets offering attractive yield pick-ups over money market rates.

The fund’s gross and effective equity exposures were slightly lower, largely due to the equity down-move experienced over the first quarter of 2018. Given estimates of earnings growth, the local market is now fairly priced with the one-year forward price-to-earnings (P/E) ratio at 14.5x.

On the international front, our preference for equities and property over fixed-income assets remains. According to most valuation metrics the US equity market has rerated to expensive levels. This is despite the significant reduction in US corporate tax rates. Within global equities, we maintain our overweight position in European equities, which trade at a relatively low P/E ratio as well as price-to-book ratio. We believe global sovereign bonds are unattractive due to the low or negative prospective real yields on offer. As the US Fed hikes the federal funds rate, bonds become less attractive on a relative basis. We would require a premium above the long-run global inflation assumption of 2% before considering investing in developed market government bonds.

Investment strategy

Volatility has once again become the dominant factor in financial markets globally with South Africa unable to escape. Locally we have seen the sentiment pendulum swing 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. The trade war between the US and China is likely to stop short of reversing decades of global trade gains, while expectations that President Ramaphosa will, in one fell swoop, reverse years of maladministration and corruption are unrealistic.

Bonds have now rallied to a point where the 10-year conventional bond trades at a real yield of around 3%, assuming a long-run inflation target of 5.25%. (Since 1921 the mean inflation in SA has been 5.25%, and since January 2009 it has been 5.5%.) We consider a 3% real return to be fair for SA’s 10-year conventional bonds and prefer nominal bonds over inflation-linkers on relative valuation measures over the medium term.

We believe the SA equity market to be selectively attractive, offering fair upside from current levels. Our approach is to focus on company fundamentals and seize opportunities where quality companies are being sold off on pessimistic sentiment and to sell stocks which are attracting all -time high ratings in order that we stay the course of continuing to add value in the long term. In the shorter term, with the focus in our Absolute Return funds being deliberately skewed towards the capital protection bias of our offering, we believe that our consistent strategy of explicitly protecting a portion of our local equity exposure through derivative overlays, is well placed. This view is further entrenched given the sign overlays, is well placed. This view is further entrenched given the signs of increasing volatility observed in our markets of late. Internationally, we believe US markets to be erring on the expensive side. US companies on average have become riskier during the last few years as they issued debt to buy back stock. European equities in our opinion remain relatively cheap on several valuation metrics. We therefore continue to maintain a constructive view and fund position in Europe within our global equity and property allocation.

Equities

The Swix started the year off in reverse gear, with a decline of 6.8% for the three months ending March 2018. Within equities, SA Industrials fell 8.0%, SA Resources lost 3.8% and SA Financials declined 3.6% for the period under review.

The first quarter saw the equity market battling two opposing forces. On the one hand, the ‘Ramaphosa effect’ drove some SA Inc. stocks to new highs, while the ‘Viceroy effect’ led to a slew of rumours impacting a number of companies. The recall of President Zuma and ascension of Cyril Ramaphosa to the highest office in the land attracted elusive foreign flows to the JSE, which flowed mainly into local retailers and banks, a very narrow part of the market viewed as representative of the SA economy.

The JSE was also rocked by a human tragedy as a listeriosis crisis originating from a meat factory owned by Tiger Brands led to some 189 deaths. Tiger Brands (neutral) was down 17.6% in the past quarter. While there have been repeated calls for the quality of care in the public sector to be improved, there are now question marks about quality control in the private sector after the World Health Organisation labelled the outbreak the largest ever recorded globally. Such a tragedy caused by a disease which two years ago was not even considered to be notifiable by the Ministry of Health shows the potential reputational damage that can be inflicted on a business if world class standards are not upheld. We are therefore strengthening our research process to look beyond governance issues to also consider environmental and social impact of business strategies. Staying with industrial stocks, this past quarter saw heavyweight Naspers come under pressure with a decline of 16.2% after delivering solid returns in 2017. Naspers decided to reduce its holding in Chinese Internet giant Tencent by 2% for some US$10.6 billion. There have been various innuendoes in the market that the 34% holding in Tencent held via a variable interest entity did not entitle Naspers to dispose of its stake. To be able to do so, at a 10% discount and incurring a tax liability, shows that the 40% discount to the value of its Tencent investment at which Naspers trades is unwarranted. In addition, there were concerns that Naspers would over time have to issue more shares to settle liabilities linked to the exercise of share options; this liability can now be cash-settled. However, the market was disappointed that none of the cash raised would be returned to shareholders but would rather be reinvested in the business and that the rest of the Tencent stake is now subject to a three-year lock-up. In our view, the quickest way to close the discount would be to list the underlying assets that the market currently values at zero, such as the pay-TV and classified business offshore.

In the financial space, banking stocks performed well with Standard Bank doing particularly well this quarter (up 11.8%) on the back of strong fullyear numbers. Barclays Africa Group was up a more muted 4.2% in line with subdued year-end numbers. Within the insurers, Old Mutual plc delivered a respectable 6.4% total return and we anticipate that the managed separation of the UK and South African businesses will unlock value by eliminating hefty head office costs and allowing each asset to be more accurately priced. more accurately priced.

Resources stocks also weakened some 3.8% during the quarter as a result of rising global uncertainty. Commodity prices had a rip-roaring start to the year with oil prices at $70/barrel in January touching 2015 highs, zinc at ten-year highs and copper on a tear. Our position in Anglo American plc did us well with the share price up 10.6%, underpinned by strong cash flow generation and capital discipline. A less hostile approach by the new Minister of Minerals and Energy and agreement on the Mining Charter may well be the catalysts required for foreign investment in our local resources stocks, which have been trading at discounts to their international peers. Sasol was down a disappointing 4.7% on the back of weak interims but with its Lake Charles Project largely complete, the company’s $13 billion US project is coming close to completion this year. Platinum stocks disappointed, down 21.4% this quarter, as the strong rand continued to put pressure on the revenue line and the industry struggles to improve productivity at their deep-level mines.

The SIM house view portfolio outperformed the Swix, which was down 6.8% in the first quarter. Hardest hit were industrial stocks, down 8.0% as the strong local currency and choppy global markets weighed on stocks with global footprints. British American Tobacco and Naspers were down by 15.1% and 16.2% respectively. The Ramaphosa effect was noticeable with banks (up 4.2%) and apparel retailers (up 9.2%). Resources were down 3.8% with Anglo American (overweight) up 10.6%, while Impala Platinum (overweight) fell out of the FTSE/JSE Top 40 Index after retreating 27.4% on the back of poor results.

SIM equity strategy

This past quarter is a reminder of Mr. Market’s mood swings. While SA Inc. has benefited from the Ramaphosa effect, many blue-chip global stocks have been heavily sold off and provided us with opportunities to add to some of our positions. The fund takes a number of moderate positions with our focus on stocks offering valuation upside. The local macro environment is poised to improve gradually as growth picks up and foreign investors are reassured by the fact that credit ratings agencies will give the new political administration the benefit of the doubt, but the obvious beneficiaries of a more buoyant local environment have already been bid up. On the other hand, the strong rand and global uncertainty have led to sharp sell-offs for a number of quality global stocks. As longterm value investors, our focus is to invest in companies with clear moats and diversified franchises trading at attractive valuations.

Equity outlook

The local market is fairly priced with the one-year forward P/E ratio at 14.5x. Aggregating the individual company valuations of SIM’s analysts, the market is attractively priced, but this is mainly due to Naspers, which we believe is circa 45% undervalued from current levels. We have seen companies in the financial and industrial sectors with a South African earnings base continue to rerate, given the political changes this quarter. Companies in the resources sector are still attractively priced, assuming that the recovery in commodity prices is sustained.

International

Most economic data confirmed that the global upswing remains intact. News out of the US was positive. Retail sales picked up pace in February, growing at a rate of 4.0% year-on-year and consumer confidence and job gains remained strong with a greater number of jobs having been created versus consensus expectations. The unemployment rate remained at a 17-year low of 4.1% while wages rose at close to 5.0% year-on-year. Most forward-looking manufacturing indices suggest that underlying trading conditions and business confidence strengthened even further in March. The Fed raised its target range for the benchmark interest rates by 0.25% to 1.5 - 1.75% in its first meeting under new Chair, Jerome Powell. This marks the sixth increase since the US began their policy of monetary tightening in December 2015. In the Euro area, the European Central Bank left interest rates unchanged and admitted that its bond buying programme will need to end soon. Growth remains upbeat and this has seen significant slack in the economy being taken up. China’s economy remained robust with both industrial production and retail sales growing at a faster pace in the first two months of 2018 than was the case towards the end of 2017.

Global markets were volatile in the first quarter of 2018, amid growing fears of a possible trade war between the US and the rest of the world, in particular China. These concerns were triggered by President Trump’s signing of a presidential memorandum outlining plans to impose a 25% import tariff on steel, 10% on aluminium and 25% on targeted Chinese technology and communications goods. China countered with plans to impose tariffs of up to 25% on US imports and threatened to lodge a complaint at the World Trade Organisation.

For the quarter in dollar terms, the MSCI Emerging Markets Index recorded a return of 1.4% while the MSCI World Index declined 1.3%, suffering its first quarterly loss in two years. Global bonds, as measured by the Bloomberg Barclays Capital Aggregate Bond Index, rose 1.4% over the quarter. The local currency gained over 4% for the year to date from R12.38/$ at the end of 2017 to R11.85/$ at the end of March 2018.

Looking to our portfolios, within global equities we retain our preference for European equities, which trade at a relatively low P/E ratio as well as price-to-book ratio over most other developed market peers. In our opinion, the US equity market remains on the expensive side, despite the significant reduction in corporate tax rates. Our select global property basket currently has an average dividend yield of just over 6.5%. This is attractive both in absolute terms, if a real return of about 4% is required, and relative to the sub-optimal real returns from global sovereign bonds.

Bonds

Bond yields in developed markets (DM) rose sharply in January and February before receding in March. The yield on the US 10-year bond rose 30 bps and 16 bps in January and February, respectively, and fell 12 bps in March to end the quarter at 2.74%. In January, the markets were concerned that inflation was accelerating after average hourly earnings rose by their fastest pace since 2009. The market also started to price in a higher probability of four rate hikes in 2018, one more than the Fed ‘dot plot’ had previously indicated. These inflation fears subsided somewhat in February with the release of a softer jobs report. In March, when equity markets sold off on increasing signs of trade protectionism as the US and China sparred on trade tariffs, investors sought the relative safety of bonds.

Emerging market (EM) local currency bonds largely ignored the increase in 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 EM currencies. The FTSE/JSE All Bond Index (ALBI) returned 8.0% in the first quarter and the benchmark R186 yield fell to 7.99% from 8.64%. The SARB cut the repo rate to 6.5% at its Monetary Policy Committee meeting on 28 March. The move was widely expected as the Committee meeting on 28 March. The move was widely expected as the stronger rand and Moody’s decision to keep the rating unchanged had reduced risks to the inflation outlook, despite the VAT increase.

Credit spreads continued to compress as demand outstripped supply. However, credit underperformed the ALBI owing to its lower duration. Issuance remained strong in the quarter, headlined by large issues by the banks (with Nedbank issuing senior paper, while Standard Bank and Nedbank issued subordinated bonds). Property borrowers were also prominent in the quarter, with issuances seen from Redefine, Growthpoint, Investec Property Fund and Hospitality. State-owned enterprises also made a tentative comeback into the market with the Land Bank issuing over R2 billion in a very well-received bond auction, and even Eskom borrowed as much as R11 billion in a series of private placements, despite being downgraded by all three major ratings agencies in the quarter. TCTA, however, cancelled a planned auction in February owing to insufficient market interest. Other notable issuers included Netcare and Mercedes-Benz. In February, Steinhoff redeemed all its JSE-listed bonds early after selling most of its equity stakes in PSG and KAP.

The outlook for (DM) bonds remains poor given a combination of lower liquidity (as central banks reduce their bond purchases), increasing inflation and larger deficits in the US. We think yields in the US will end 2018 closer to 3%, perhaps even a little higher. For EMs, firmer commodity prices are a positive and - coupled with stronger global growth - lead us to expect continued capital inflows and firmer currencies.

For our funds, cash continued to be enhanced throughout the quarter with the additions of select credit assets offering attractive yield enhancements over money market rates. On an effective level, our position in nominal bonds increased as the asset class offers an approximate 3% real yield, which remains attractive when compared to the domestic bonds of most other emerging markets. Since 1921 the mean inflation rate in SA has been 5.25%, and since January 2009 it has been 5.5%. We consider a 3% real return to be fair for SA’s 10-year conventional bonds.

The risks to our view are that an increase in protectionism by the US could result in a global trade war, which could have a profound impact on global GDP growth, inflation and, ultimately, the capital markets.

Market review

The end of the quarter brought a number of unknowns to the fore, leading to some sharp share price dislocations. We knew about the precarious financial position of state-owned enterprises (SOEs), but did not know that it would be Steinhoff International that would make the ignominious headline as possibly one of the largest collapses in the history of corporate South Africa. We also knew that South Africa’s credit rating was on a knife-edge, but did not know that Moody’s would decide on a stay of execution. And finally, we have become accustomed to expect the unexpected when it comes to global political events. And yet, it still came as a surprise that one of the longest-serving African presidents, Robert Mugabe, was deposed in a bloodless coup and Cyril Ramaphosa was chosen to lead the ANC, 27 years after standing next to Nelson Mandela on the balcony of the Cape Town City Hall.

The FTSE/JSE Shareholder Weighted Index (SWIX) had a strong close to the year, up by some 9.6% in the final quarter to end the year up 21.2%. This is also a reflection of very positive risk-on sentiment towards emerging markets globally with the latter also up a whopping 37.4% in dollars in 2017, which led global equities up by over 20%, the best returns we have experienced since 2009. Globally, politics played a key role to drive markets higher with US President Trump’s tax reform plan driving the S&P up 21.8% for the year, while Emmanuel Macron’s unexpected victory at the French presidential elections helped inspire European equities (up 22%) and Japanese Prime Minister Shinzo Abe’s landslide victory fuelled the Japanese market (up 22%) to anticipate more reflationary policies.

Bond market developments in the final quarter were dominated by the Medium-Term Budget Policy Statement (MTBPS) delivered by the minister of finance on 25 October 2017. The MTBPS disappointed deeply as it projected deficits of more than 4% for the current fiscal year due to a revenue shortfall of around R50 billion and increased spending in support of South African Airways, the South African Post Office and other SOEs. The minister also projected spending of R3 billion in excess of the expenditure ceiling, thus going against an earlier undertaking to keep support for SOEs ‘budget neutral’. The MTBPS alerted on much wider deficits over the forecast horizon and a deterioration in the net debt-to- GDP ratio to 60.8% in 2022 from current levels of about 52.3%. Failure to stick to the previously outlined fiscal consolidation path was the main reason why S&P downgraded South Africa further into junk status on 24 November. On the same day Moody’s placed South Africa on review for a downgrade, which must be resolved within 90 days. In Moody’s judgment the election outcome of the ANC president could have a material effect on the policy direction of the ruling party and thus the country and as a result they decided to delay the rating action. For now, our sovereign debt remains part of the Citi World Government Bond Index, which has an estimated US$6 - 10 billion in mandates tracking our bonds via that index. Since our sovereign bonds had sold off ahead of the downgrade and were already anticipating a double downgrade, this was a positive surprise. Initially our currency weakened slightly from below R14 to the US dollar by some 30 cents, but subsequently staged a rally, which was also fuelled by the outcome at the ANC elective conference.

As soon as the credit downgrade event was out of the way, markets started focusing on the ANC elective conference. Given the spectacular failure of polls to predict political outcomes globally over the past few years, the leadership race threatened to be another embarrassment for the pundits. Early on, it appeared that market participants favoured the more market-friendly Cyril Ramaphosa and the rand and domestic stocks strengthened slightly ahead of the conference. That trend accelerated when indication of a Ramaphosa win emerged with domestic financials experiencing an 8.4% rally in December with the rand being one of the strongest currencies in December, gaining 9.6% against the greenback. Bonds followed the currency stronger, with the yield on the R186 benchmark bond rallying from 9.20% to 8.60%, surpassing pre-MTBPS levels.

As market participants, we were more interested in the policy pronouncements at the conference. The announcement of free tertiary education for the poor will have long-term benefits, but details of the funding model for the R12 billion per annum needed and conditions attached to such a project to ensure deserving students gain access to further education while maintaining the quality of outcomes, remain key. Last year there were some 150 000 applicants for 100 000 tertiary places, showing the chronic undersupply of available capacity. In addition, it is key that scarce skills needed to boost economic growth get prioritised. There was also a declaration on redistribution of land without compensation. Again, a dovish view is that our constitution already makes provision for such a pronouncement.

For the quarter to December, the rand strengthened from R13.50 against the US dollar to R12.38. Nominal bonds returned 2.2%, cash returned 1.8% and inflation-linked bonds 1.5%. On the international front, the MSCI Emerging Markets Index was 7.3% firmer in US dollar terms and the MSCI World Index returned 5.5%. Locally, the SWIX rose 9.6% quarter-on-quarter with all major equity sectors delivering positive returns. Within equities, SA Financials rose 16.0%, SA Resources increased 4.9% and SA Industrials were 4.7% higher over the quarter.

Asset allocation
We slightly increased our position in conventional bonds as the asset class offers an approximate 3% real yield, which is attractive when compared to domestic bonds of similarly rated countries. Inflation remains under control and well within the target inflation band. Cash continued to be enhanced over the quarter via the addition of select credit assets at attractive yield pick-ups over money market rates.

The fund’s gross and effective equity exposures were higher, largely due to the strong equity move over the three-month period to end December. Given estimates of earnings growth, the local market is now fairly priced with the one-year forward price-earnings (P/E) at 13.5 if we exclude Naspers, which now makes up 25% of the SWIX. If we include Naspers, the one-year forward P/E is at 16.

On the international front, we retain our preference for equities and property over fixed-income assets, with a favourable bias to European assets from a relative valuation perspective. The backdrop for developed market bonds remains poor as central banks remain on course to withdraw liquidity.

Investment strategy
While markets have discounted a view that economic policy will become more market-friendly, corruption will be halted and credit downgrades postponed, there is still a lot of water to flow under the proverbial bridge. There is no doubt that the business experience of the new ANC president will bring in more rationality to some of the policy debate, but we believe that the minister of finance will find it tough to meet expectations of ‘radical social economic transformation’ while striking a conservative tone and finding R40 billion in expenditure cuts/tax hikes to satisfy the rating agencies come March.

Over the very long run, conventional SA government bonds gave a 2% real return. In the third quarter of 2017 we increased our long-run real required return for SA long bonds from 2% to 3% due to the deteriorating position in state finances. Bonds currently trade marginally above this 3% real return assuming inflation remains well behaved within the target range. We see nominal bonds as fairly valued and prefer nominals over inflation-linked bonds on relative valuation measures over the medium term.

We believe the SA equity market to be selectively attractive, offering reasonable upside from current levels. Given the current market valuation together with capital protection over a 12-month rolling basis being one of the key fundamental goals of our Absolute Return offering, we believe it prudent and necessary to continue our strategy of explicitly protecting a portion of our local equity exposure through derivative overlays. Internationally, we believe US markets to be overpriced on most valuation metrics while European equities remain relatively cheaper on several key valuation metrics. We therefore maintain a positive outlook and fund position with respect to Europe through our global equity and property allocation.

Equities
The SWIX had a strong close to the year, up by 9.6% in the final quarter to end the year up 21.2%, delivering exceptionally strong returns against a politically and economically challenging backdrop. Within equities, SA Financials rose 16.0%, SA Resources increased 4.9% and SA Industrials were 4.7% higher over the quarter.

Financial stocks experienced a Santa Claus rally driven by a strengthening of the rand and net inflows into domestic stocks of approximately R63 billion for the year (while the overall market recorded net outflows of some R35 billion). Industrials had a challenging final quarter as the Steinhoff International debacle weighed on sentiment but nonetheless was up by 22.5% for the year. On a relative basis for the year, Resources stocks lagged after a bumper 2016, up 17.9% over the 12-month period.

The SIM house view portfolio was up 19% this year with our position in Steinhoff International, down 92%, hurting performance in the final quarter of the year. This was an extremely disappointing outcome with value as a philosophy underperforming this year and our position in Steinhoff being the main detractor from performance, costing over 1% of outperformance in the past year. The largest position in the portfolio remains Naspers, which was up over 71.8% this year. Within the resources space, we were pleased that our overweight position in Anglo American delivered a 34.2% return for the past year. However, despite being relatively overvalued and delivering lacklustre results, Discovery led the way in the financial space, up by 64.1% in the year. We remain concerned that at 100% premium to embedded value, the downside risk to owning the stock is even larger. Capitec, another underweight in the portfolio, was up 59.9% and remains very expensive at a price to book of 6x!

SIM equity strategy
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 sidelines, which teed up the strong relief rally we witnessed at the end of the year with the SWIX up 21.2% in 2017. This witnessed at the end of the year with the SWIX up 21.2% in 2017. This is also a reflection of very positive risk-on sentiment towards emerging markets globally. As contrarian investors, we are the most cautious when market participants become overly bullish and discount potential risks. 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.

December saw the Steinhoff International share price collapse as auditors held back on signing off its financial statements and its CEO abruptly departed. This could well be one of the worst cases of value destruction that corporate South Africa has witnessed as the market value of Steinhoff International, a global company ranking second in Europe in the household goods sector to IKEA, with over 130 000 employees, dwindled from R242 billion to R20 billion in a matter of days. We don’t know yet what will emerge from the Steinhoff debacle but remain cautious of its potential ripple effects. The value destruction inflicted is nonetheless disturbing and we will pursue all possible avenues to rescue some value for our investors.

The fund remains focused on investing in companies with clear moats and diversified franchises with the muscle to stay the course in the long term.

Equity outlook
The local market is now fairly priced with the one-year forward priceearnings (P/E) at 13.5 if we exclude Naspers, which now makes up 25% of the SWIX. If we include Naspers, the one-year forward P/E is at 16.

In this past year the risk of a China hard landing appears to have abated but there are continued concerns about the path of the US economy and future Fed actions. Emerging markets, SA included, benefited from a buoyant global growth environment but valuations have now normalised.

That being said, as fundamental value investors, although the market (at an aggregate level) appears to be trading at fair value, we still see selective value in local equities.

As regards our holding in Steinhoff International, the company is presently caught in an information vacuum. There have been no pronouncements as to what was inflated or omitted from the past financial statements and we will have to await the release of new information to know the full extent of over- or under-statements of the accounts. In addition, the company is now caught up in a liquidity squeeze with the risk that funders are unlikely to roll further funding and credit agencies having downgraded the company’s rating to sub-investment grade. Finally, various directors such as billionaire Christo Wiese and former CEO Markus Jooste had borrowed against the security of Steinhoff International shares and the collapse of the share price has led to margin calls, which have triggered further selling as covenants were breached and lenders took hold of the collateral, exacerbating the share price decline.

Our view is that the group will have to be restructured, broken up and its structure simplified. New management will have to be brought on board to regain investor confidence and those guilty of wrongdoing will have to be held responsible legally with the commensurate punishment. Until then, the stock is likely to remain highly speculative and a value trap. We have therefore curtailed our position to neutral in the portfolios notwithstanding the potential upside that we see in a breakup scenario

International
Most economic indicators suggest that the global upswing has remained in place in the fourth quarter. The US economy remained strong and consumers remained upbeat. There were signs of faster wage growth in some industries and house prices continued on their uptrend. In December, both business and investor confidence received a boost when President Trump signed into law the Comprehensive Tax Reform Bill. As part of this tax bill, the corporate tax rate will be cut from 35% to 21%. On the interest rate side, as was expected, the Fed hiked the target range for the federal funds rate by 0.25% to 1.25 - 1.5%. In Europe, the European Central Bank kept policy rates intact at its December meeting. The opening policy statement suggests that quantitative easing (QE) is still scheduled to run until next September, or longer if required, and rates are expected to be on hold until the end of the QE purchases. Underlying economic conditions remained strong with manufacturing conditions pointing to the fastest expansion since 2011 and services growth remaining steady. In China, the People’s Bank of China raised the reverse repo rate by 0.05% during December, their third rate hike in 2017. Industrial production, exports, imports and retail sales rose in November. China’s top policymakers met in December to set out economic policies with the aim of pursuing high-quality growth and further promoting supplyside structural reforms. For the quarter in dollar terms, the MSCI Emerging Markets Index (MSCI EM) recorded a return of 7.3% while the MSCI World Index returned 5.5%.

For the calendar year 2017, the MSCI EM outperformed world markets with a return of 37.4% versus 22.4%. EM performance in 2017 was largely boosted by the strong Asian region with heavyweights China and Korea each delivering close to a 50% return. Global bonds, as measured by the Bloomberg Barclays Capital Aggregate Bond Index, rose 1.1% over the quarter. The local currency appreciated by a whopping 9.1% over the quarter to a level of R12.38 to the US dollar from R13.50 at the end of September, proving to be the strongest global currency performance against the dollar for the three-month period to end December 2017.

Looking to our portfolios, within global equities we maintain a preference for European equities over other developed markets from a relative valuation perspective. The US market looks highly valued on most valuation measures such as Tobin's Q ratio (EV/replacement value), stock market capitalisation to GDP ratio and the Shiller P/E ratio. Europe is still a fair degree cheaper. We therefore retain our overweight Europe position in our global equity portfolio. Our select global property exposure currently has an average dividend yield of close to 6%, which remains attractive if a real return of about 4% is required.

Bonds
The rand strengthened over the quarter from R13.50 against the US dollar to R12.38 at the end of December. The local bond market endured a tumultuous ride and yields sold off more than a 100 basis points as the market anticipated a negative mini-budget and Finance Minister Malusi Gigaba revealed the extent of the fiscal deterioration in the MTBPS. 2017 foreign inflows into the bond market reversed sharply from a high of R73 billion in October to around R45 billion just before the ANC conference, before recovering to R53 billion on confirmation of a Ramaphosa win. The FTSE/JSE All Bond Index returned 2.2% for the quarter, outpacing cash returns of 1.8% on the STeFI Composite. The 5.7% rally in December resulted in bond returns of 10.2% for the year. The benchmark SA 10- year bond yield rallied from 9.2% to 8.6% over the quarter.

The local corporate bond markets saw very robust issuance in 2017, with final gross issuance for the year achieving an all-time record of R142 billion, driven by record bank and corporate issuance, despite muted SOE issuance. The event that rocked the market, however, was the announcement by Steinhoff International of possible ‘accounting irregularities’ with respect to the annual financial results released by the group since at least 2015. The announcement kicked off a 92% decline in the share price and a downgrade by Moody’s from BBB- to CCC+. Our portfolios had about 80 basis points exposure to Steinhoff bonds and spreads on Steinhoff bonds issued in the local market widened, resulting in bond prices of 10% to 15% below par. Despite this, we have decided to maintain our holdings of these bonds in the absence of any definitive news from the company, and with no reasonable bids in the market for the bonds.

November saw S&P downgrade the sovereign’s foreign currency rating to BB and its local currency rating to BB+, i.e. sub-investment grade. The knock-on effect of this was that several local borrowers with international scale ratings (mainly banks and SOEs) also faced rating downgrades or reviews for downgrades, at least in line with that of the sovereign. The possibility exists that these downgrades, as well as the adverse news from Steinhoff International (previously a significant borrower in local markets) will result in softer corporate bond market conditions at the start of 2018.

For our funds, cash continued to be enhanced through investments in select corporate debt as specific opportunities presented themselves at decent yield pick-ups over money market rates. Nominal bonds were marginally increased earlier in the quarter on valuation grounds. We believe that local fixed-income assets remain an attractive investment to consider if compared to the domestic bonds of similarly rated countries. Locally, we see real yields of some 3% on offer against a contained inflation target range background. That being said, we err on the side of caution. We agree that political risk is now lower and, in fact, should President Jacob Zuma be recalled by the ANC, local assets could rally further given positive sentiment. But the medium- and longer-term outlook are more challenging owing to the deteriorated fiscal situation and the political stalemate in the ANC that could potentially hinder much-needed fundamental reforms. Nominal bonds are preferred to inflation-linked bonds on a relative value basis.