Market overview

World economic growth continues to be revised lower

The International Monetary Fund continues to revise projections for the world economic growth rate lower. The latest revision forecasts global growth in 2019 to slow to 3.2%, compared with the previous estimate of 3.3% made in April 2019. This compares with a global growth rate of 3.7% in 2018. In a synchronised slowdown, the IMF expects economic performance in 2019 from the United States, Europe and China to be below 2018 levels, with Europe expected to record the weakest growth. Chinese industrial production growth continues to fall and is currently at all-time lows in China’s modern era. Although the IMF expects a recovery in 2020, the news flow continues to be negative and it is likely that next year’s forecasts could, in the future, be revised still lower.

There is no sign that the trade relations between the US and China are warming. On the contrary the latest utterings suggest that the Trump administration is considering quantitative restrictions on US private sector investment in China. This would represent an escalation of the differences between the two countries that is likely to have a negative impact on investor sentiment. On both sides since late last year, as a result of the trade standoff, export tariffs have been steadily increasing and this has had a negative impact on global trade. As expected, the decline in US exports was the largest contributor to the deceleration of the economy in the 2nd quarter.

Brexit still dominates European politics. The UK government continues to adopt a very hard-line approach to any opposition to its objective of delivering a break from the European Union on October 31. Parliament and the Executive are currently firmly gridlocked, and it is apparent at this stage that all options from a hard no-deal Brexit to no Brexit and everything in-between are still possible with neither side in a consolatory mood.

Central Banks around the world have responded to the faltering economic prospects with a further round of monetary easing, but interest rates are currently so low that its effectiveness is questionable. Currently, according to the World Bank about a third of global debt is offering a negative yield.

Global currencies continued to reflect the mid-year realignment with the US $ strong relative to Sterling and the Euro, driven largely by the move to quality and higher interest rates. The Rand remains weak but has been supported by the high interest rates on offer.

The PGM basket continues to outperform most commodities

Both the Palladium and Rhodium prices increased over the month of September, largely driven by potential supply constraints. As expected, Middle East tension drove the oil price higher but fortunately the price closed below intra-month highs, but a more serious conflict could have a very negative impact on the future oil price. With the exception of nickel, base metal prices were generally weaker over the month.

South Africa’s growth prospects continue to disappoint

South Africa’s economic performance continues to disappoint amidst calls on the government to adopt a more growth focused economic policy increasing by the day. Confidence remains fragile as the very necessary restructuring of the parastatals and municipalities holds the prospect of job cuts and further tax increases, both impediments to a meaningful recovery in the short term. There is some evidence of an embryonic pick-up in the construction sector, coming after many years of steep declines. This was reflected in a good share price performance from the sector in the month.

Global equity markets in a trading range

Global equities have been trapped in a trading range for the last two years. Although the historic bull market is very mature, and valuations are modestly stretched, the current low interest rate environment is, in our opinion, not creating a sufficiently attractive alternative to encourage withdrawal of capital from equity markets. However, the risks are skewed to the downside given the limited scope for further monetary policy easing and the increased likelihood of negative earnings revisions. Global bond markets are not offering reasonable value either. Only in the US are 10 year yields roughly in line with the inflation rate but still not offering yields in-line with long term averages. Elsewhere developed market yields are either negative or only barely positive, as in the case of UK bonds

South African financial markets require an injection of confidence

South African equity markets eked out modest gains in September. Resources lost ground in the month but still remain the top performing economic group this year. Despite overall declines from mining shares, platinum shares were up in the month. Industrial shares also contracted in September but financials recovered strongly from the prior months’ losses.

Indices have been driven by the divergence of strong performances of global and export orientated companies and poor performances from companies reliant on SA Inc.

Given the likelihood of the SA economy remaining weak for a protracted period and consequently earnings growth remaining lacklustre, valuations for domestically focused counters are not compelling. Some of the large offshore exposed companies including British American Tobacco and Prosus appear to be offering reasonable value at these levels. SA bonds are offering very high real yields but are hostage to SA’s sovereign credit rating and economic woes. A downgrade by Moody’s, the only ratings agency to still maintain SA debt as investment grade, would be bad news, most likely preventing real yields from contracting much.

Portfolio Positioning

The portfolio remains predominantly invested in floating rate subordinated debt of SA’s top five banks, where we are earning better returns than on government bonds with no equivalent duration risk. Investment opportunities in the corporate debt market outside of the banks are few and far between with an over subscription because of the lack of issuance driving the credit spreads down to unattractive levels. While superficially real yields on longer duration bonds look attractive, the deteriorating fiscal position of the country means probability of a ratings downgrade into 2020 remains high, as a result we continue to prefer shorter duration assets.

Financial markets bounced back from May's retreat Global markets bounced back strongly from May's contraction despite many of the market's pressing issues remaining unresolved. Firstly, while the trade negotiations between the US and China are back on track it will take compromise from both sides to reach an agreement. Brexit is firmly on hold as the UK Government's Tory party is still struggling to find a new leader to replace Theresa May even before a revised strategy can be contemplated. The global economy is currently going through a synchronised slowdown that has seen developed central banks pivot towards more accommodative monetary policy. This more dovish stance by developed central banks has opened up room for emerging markets to also cut rates. Given the limited room for the conventional monetary policy, we may yet see central banks turn more aggressively toward fiscal policy, in an attempt to avoid a recession in the years ahead. The S&P 500 Index advanced 6.9% in June, representing one of the strongest moves seen in recent times, driven, in the main, by the pivot on interest rate policy from the US Fed.

Much has been said about the demise of the current global equity bull market that, by many measures, is very mature. Having been in place for over a decade, it will rank as one of the longest in history. However, the excesses that normally signal the end of the cycle are not that apparent. But earnings have already enjoyed a very strong advance over the last half-decade and are looking like they are in top-of-cycle range. It is unlikely that earnings growth on its own can sustain further equity gains. The key risk to the current equity bull market would be earnings disappointments into 2020, or an unexpected rise in interest rates resulting in an upward spike in equity yields. As this does not appear to be on the very short-term horizon the global equity backdrop is likely to remain a benign influence with regard to domestic financial markets.

South African markets followed suit
In June the JSE All Share Index produced a total return of 4.8%, having fallen by 4.8% in May. This brings the year-to-date return of the ALSI to 12.2%. All sectors contributed to the performance in June, although the Financial sector and the Resource sector outperformed the Industrial sector by 3% and 2% respectively. The more broadly-based SWIX experienced a more modest advance but was still up 3.1% in the month and by 9.0% year-to- date. Bonds too enjoyed a good month with yields at the long end softening by about 20bp. Real yields remain high by historical standards. However, the Property index continues to lag, being barely in positive territory year-to-date. As the sector generally lags the economy, distribution growth is likely to disappoint for several years to come.

Precious metals also enjoyed a strong advance
Both gold and PGM's had a strong June and no doubt was a significant factor behind the good performance from the Resource sector. Equity returns could have been even better being it not for the currency strengthening by 3.5% against the US$. The gold price breached the 1400 $/oz mark for the first time in six years and the prices of the entire PGM basket rose, possibly indicating a change in sentiment with regard to precious metals that could signal a more sustained move.

SA's economic performance is cause for concern

The SA economy is currently trapped in a cycle of low economic growth and high unemployment that if not arrested soon, could result in a major crisis. The current trajectory is leading to greater levels of poverty and inequality that increase the probability of economic instability. Recent statistics on credit growth and retail sales suggest that the currently employed SA consumers are at their limits and are unable to meaningfully take on more debt. Spending on badly needed infrastructure is also declining as seen in the demise of the local construction industry. Barring an export-led windfall the only sustainable path to higher economic prosperity is to increase employment bringing in more people into the consumer economy. Despite President Ramaphosa's positive message at the State of the Nation Address, we have yet to see decisive action taken on critical structural reforms that are necessary to move us out of the low growth environment.

The currency has been surprisingly strong
Given the country's disappointing growth outlook it might have been expected that the Rand would remain weak; however, this has not been the case. A consequence of our low growth environment has seen imports decline and with rising commodity exports the country has experienced an improvement in the external trade balance over the recent months. Inflation has also been stable, surprising most economists on the downside. These metrics have underpinned the strong Rand and are likely to lend stability to the currency in the short term, in spite of the weak fundamentals.

Financial markets should produce modest positive returns
Low economic growth prospects for the year mean that SA focussed corporates will struggle to grow earnings and dividends in real terms over the next twelve months. Despite this, a large proportion of the SA market is dominated by resource and rand hedge stocks which are still enjoying the benefits of a growing global economy and should still produce modestly positive returns.

Over the shorter term, the outlook for fixed income assets is encouraging. The weak economy and the stable currency are taking the pressure off the inflation rate and are providing the SARB with the data to cut short term interest rates. Given that yields across the yield curve are positive, real returns can be expected from fixed-income investments over the next few months.




Portfolio Positioning

Unchanged from the previous quarter our fixed income assets remain predominantly invested in floating rate subordinated debt of SA's top five banks, where we are earning approximately 120bps above government bonds with no equivalent duration risk. Investment opportunities in the corporate debt market outside of the banks are few and far between with huge over subscription because of the lack of issuance driving the yields down to unattractive levels. While superficially real yields on longer duration bonds look attractive, the deteriorating fiscal position of the country means probability of a ratings downgrade into 2020 remains high, as a result we continue to prefer shorter duration assets.ings updates.

Global markets enjoyed a strong 1Q 2019

Global financial markets bounced strongly this quarter, recovering from the weak close to 2018. Global equities made impressive gains, with the MSCI World Equity Index delivering a 12.6% USD return, compared with a decline of 8.2% in the previous quarter.

Emerging market equities were not far behind, producing a 10% USD return for the quarter, having fallen by 14.2% in the previous quarter. Global government bonds returned a positive 1.9% for the quarter in USD’s.

South African equity returns for the quarter were strong, but lagged other emerging markets, producing an 8% return for the quarter in Rands, and a 7.7% return in USD. South African Bonds were up 3.8% in the quarter.

The global economy is giving mixed signals

Since late 2018 global developed market bond yields have fallen significantly, signalling the market’s expectation of the first synchronised slowdown since the 2008 economic crisis. Already weak numbers have emerged from Germany with the rest of the Euro area likely to follow. More and more company profit updates are warning of slowing sales across many industries. Brexit is also not helping and remains a source of major uncertainty even though it may be delayed.

In the United States, economic growth still remains strong with consumer confidence at high levels and unemployment at record lows. However, business confidence is deteriorating and earnings downgrades have not yet troughed. However, a more dovish FED will help maintain expansionary financial conditions which will aid in extending one of the longest US economic cycles in history.

China’s slowdown, which started in the last quarter of 2018, might be nearing its end as fiscal stimulus and a positive credit impulse bring its economy back to the boil. A turn around in Chinese growth would help lift other Asian economies, as well as Europe, which benefits via its export industries.

Despite the possibility of a global turnaround, we remain concerned by the record low unemployment rate and elevated profit margins in the US. Furthermore, the exceptionally low real yields in developed bond markets do not bode well for future financial market returns.

Monetary policy will likely remain accommodative

With the South African repo rate set at over 2.5% above the inflation rate, South African real yields screen as globally attractive. While there is some scope for the SARB to cut interest rates in the quarters ahead, the need to protect the currency, and prevent the knock-on inflation effect, remains.

The South African economy is facing major challenges

South African economic growth has been anaemic for some time now. This has been driven by numerous structural issues. Whilst government spending has remained strong, our lack of employment growth, very high and increasing levels of indebtedness and a tax burden that is already high, are now putting a huge strain on the consumer. Official growth forecasts are all pointing to a very lacklustre economic performance in 2019 that will make the worryingly high inequality gap difficult to address. In addition, the parlous state of many of the country’s parastatals, notably Eskom, is making efforts to stimulate growth more challenging.

On the positive side, if President Ramaphosa is returned to power with a strong mandate after the May elections, the country could see a major initiative to tackle corruption and service delivery, issues that have been plaguing the country for some time. If combined with increased policy certainty and fiscal discipline, South Africa could start to meaningfully address the structural issues which have been holding us back. This would no doubt be good for overall business and consumer confidence and could attract higher levels of investment that would raise growth rates and living standards over the medium term.

Domestic equity values continue to improve

In previous commentaries we have observed that domestic equities are not cheap, although value has steadily been improving. Given that the global monetary environment is likely to remain benign and that domestic inflation is under control, domestic interest rates are currently poised for either a cut or at worst, remaining steady. Equity returns, in our view, will be determined less from rating changes than by earnings growth. The poor economic outlook points to earnings growth remaining weak, suggesting that equity returns will, at least in the quarters ahead, continue along the path of subdued returns similar to the last few years. Earnings growth needs to accelerate if equities are to enter a new bull market.

Property returns are expected to be subdued

In line with equities, property returns are also expected to be subdued as the growth in distributions is likely to remain weak for the foreseeable future. Although the running yield appears attractive, this needs to be balanced against the poorer quality earnings we are seeing from the property counters.

Portfolio Positioning

The fund has continued to benefit from the healthy credit spreads over the JIBAR floating rate by investing in predominantly floating rate bank subordinate debt without the risk associated with fixed rate bonds. During the period there was also limit narrowing of credit spreads that benefited the fund.