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 precious metal miners were the major contributors to performance, primarily as a result of higher precious metal prices which were underpinned by low valuations. Our positions in Impala Platinum, Sibanye Gold, AngloGold Ashanti and Northam Platinum all contributed meaningfully to performance.

Global defensives were also up strongly and our exposure to Anheuser-Busch, British American Tobacco and Reinet all provided strong outperformance. In addition to the weaker rand, Reinet’s discount to its underlying investments closed meaningfully, helped by share buy-backs. Anheuser- Busch’s corporate actions to reduce gearing were well received by the market.

Sasol detracted from performance as it delayed its annual financial results for a second time to allow for a more in-depth investigation into what went wrong during construction of its $13 billion Louisiana chemical project. Our holding in Anglo American detracted from performance as commodity prices came under pressure over the period.

We increased our position in banks post the sell off, and were well positioned into the rally in September. We increased our exposure to Anheuser-Busch, Reinet, and Quilter. We took profits in Impala Platinum and AngloGold Ashanti and switched into Sibanye Gold.

We reduced our weighting in Sasol due to higher risks associated with the counter. We reduced our exposure to the diversified miners, MTN and Woolworths all on valuation grounds.

Our holding in the New Gold Platinum ETF benefited from the higher platinum price and our holding in dollar denominated First Rand debt benefited from the weaker rand.

We purchased Phillip Morris as valuations were attractive post the collapse of the Altria deal. We increased our exposure to the MSCI Japan ETF and reduced exposure to the Euro Stoxx 50 ETF and Vanguard Value ETF. We took profits on the New Gold Platinum ETF.

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

We remain overweight in the resources sector, not as a function of any top-down view, but rather the result of our bottom-up assessment of value on a stock by stock basis. Our overweight in the gold sector is a function of our positive view on AngloGold which continues to trade at a large discount to its global peers. We also like the diversification it brings to the portfolio in a world of increasing geopolitical tensions. We remain overweight in the platinum sector as certain stocks are still trading at a significant discount to their intrinsic value, despite the recent exceptional performance. Our largest position in the diversified miners remains Anglo American where the valuation on its rump assets remains on an undemanding 3 times EV/EBITDA. We maintain our overweight position in British American Tobacco. Despite the significant derating seen in the stock, it continues to deliver earnings growth in-line with our expectations. Also, the stock trades on an attractive forward dividend yield of 7.5%.

On the 22nd of May 2019, Sasol issued an update on the progress of the construction of their Lake Charles Chemical Project (LCCP). The update was disappointing as they guided for an additional $1bn cost overrun on the project when it is almost 96% complete. This was particularly shocking given that Sasol management had issued an update on the LCCP project only 4 months earlier on the 8th of February 2019, where they assured the market the project would be completed within a range of $11.6bn - $11.8bn. Given the above disappointing update, we believe that management may not have had a sufficiently clear line of sight around what was happening on the ground at the project. As a result of the additional cost overruns, the expected project return has declined from 7.5% to 6 - 6.5%. As a shareholder, this is extremely disappointing but the cost of the LCCP project is largely sunk capital, which we still think should generate $1.0bn of EBITDA by 2022. At the current share price, the market is not putting any value on the capital spent on the LCCP. Once production at LCCP is ramped up over the next three years we expect the market to put a value on the cash flow produced by these assets. As a result, we maintain an overweight position.

South African focussed stocks continue to struggle in the current low growth environment. SA corporate margins are being squeezed by increasing costs which they are unable to pass through to consumers given the poor economic backdrop. If the broader SA economic backdrop does not improve, we expect that SA focused stocks will continue to struggle to deliver real returns, increasing the probability of a value trap. Our exposure to the local economy remains largely through the financial shares, being banks and insurers, which are reasonable value, and offer forward dividend yields of over 5% and mid-single digit earnings growth. These shares are liquid and more defensive than many of the direct consumer-facing shares, which have more exposure to the challenging economic environment. We remain underweight the retail and SA industrial shares as PE multiples are not cheap enough given the difficult economic backdrop. We remain underweight the property sector where fundamentals continue to look poor.

We think the risk of distribution resets remains high as rent negotiations still favour the tenants. While distribution yields in some cases remain optically attractive the quality of distributions is low. t Over the quarter the fund continued to reduce its exposure to the Ping An Insurance Group, which has rallied 35% since the fund built a position in the last quarter of 2018. We continued to reduce exposure to the US markets, which we think are expensive, by reducing our weighting in Vanguard Value ETF. The fund also reduced its positions in Naspers, Richemont, and Anheuser-Busch Inbev which have all done well over the last two quarters. Major purchases included iShares Euro Stoxx ETF, British American Tobacco, Sberbank of Russia, and BHP Billiton. As discussed in the previous quarter, our fixed income assets remain predominantly invested in the 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 oversubscription because of the lack of issuance driving the yields down to unattractive levels. While real yields on longer duration bonds look superficially attractive, the deteriorating fiscal position of the country means the probability of a ratings downgrade into 2020 remains high. As a result, we continue to prefer shorter duration assets.

The fund remains close to its maximum allowable offshore exposure.

Contributors and detractors

Top contributors for the quarter included BHP Billiton, Anglo American, AngloGold, and Impala Platinum, which all enjoyed the benefits of higher commodity prices and an improving earnings outlook. Other contributors included our underweight positions in Netcare, Life Healthcare and Glencore. Our overweight positions in FirstRand, Equites and the newly spun out Multichoice Group also made a meaningful contribution to performance. Detractors included Sasol as discussed above, as well as British American Tobacco plc which was a slight detractor on the back of continued negative market sentiment around the deteriorating US tobacco regulatory environment. Despite the poor performance from a share price perspective, the company guided for a better than expected second-quarter earnings performance, which should see full-year earnings grow at high single digits. The fund's underweight position in MTN detracted over the quarter as the market reacted favourably to MTN underpinning their dividend guidance by selling down non-core assets. KAP Industrial Holdings and Hulamin, two smaller industrial companies, also detracted from performance post disappointing earnings 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 funds underweight positions in many of the highly rated South African focused stocks paid off handsomely as the poor economic environment translated into difficult trading and ultimately resulted in very poor earnings updates from many of these companies. As we have been warning in previous commentaries for quite some time, the market was too optimistic in terms of the expected earnings growth from many of these companies given the above difficult economic environment. This combined with ratings that were still expensive resulted in significant share price underperformance as the companies released their earnings updates.

The fund's overweight positions in many of the cheap industrial and commodity-based Rand hedges generated significant outperformance as year on year Rand weakness and better global growth buoyed their earnings. In particular the funds overweight positions in platinum did particularly well after a significant improvement in the basket price of the Platinum Group Metals (PGM's) over the last year manifested in significant earnings beats as these companies released their results to the market. Our underlying investment thesis for the platinum sector has been that the lack of capital investment over the last decade as a result of poor economics would eventually manifest in a lack of supply. This would ultimately drive PGM basket prices higher to the point where producers were once again
incentivised to invest in new supply. South African platinum mines have grappled with a decade of declining profitability largely as a consequence of the excess supply resulting from SA mines historically chasing production at the expense of returns. This realization and the current reduction of unprofitable ounces comes at a time when underlying demand is accelerating and benefitting from tighter global emission standards in both developed market and emerging markets. This has resulted in a significant rise in the PGM basket price, specifically Palladium, which is in a significant deficit position and is expected to remain so for at least the next three years. Even at current PGM basket prices producers are reluctant to invest more capital to meet the current PGM shortages, as long-term concerns around electric vehicles taking more market share from internal combustion engines dominate discussions about the long-term demand outlook. This means we could well see the PGM basket prices move higher and stay elevated for quite some time.

We turned positive on Naspers in November last year. The share price had been weak as a result of a sell-off in Tencent due to concerns around a moratorium by the Chinese gaming regulators on new game approvals. We believed the moratorium would be temporary, and took the opportunity to increase our exposure to Naspers. As expected, the Chinese gaming regulators restarted approval in earnest this year, initially with domestic game approvals. The first batch of international games has just been announced. We think this should manifest in a better performance from the gaming business in 2019. Naspers also unbundled Multichoice this quarter, and announced the intended listing of most of its assets in Amsterdam. All of this bodes well for unlocking a portion of the significant discount on which the share trades.


Over the quarter the fund reduced exposure to Howden, Northam Platinum, Capitec, Vanguard Value ETF, Spar and Vodacom.

Major purchases included Anheuser-Busch, Reinet, Firstrand and Philip Morris. Although a significant portion of the fixed income assets remains invested in floating rate subordinated debt of SA top five banks, we have started to reduce these positions after making significant gains as a result of credit spreads narrowing over the last year. We are looking to increase the liquidity of fixed income holdings at this stage of the cycle as the spread compression seen over the last year is no longer sufficient to justify our current exposure

Contributors and detractors
There were some very large share price moves this quarter, but the stand-out performance was undoubtedly the platinum sector, up 49.7%! We have been steadily building a position in this sector since the middle of last year, and our positions in Implats and Northam contributed meaningfully to performance this quarter. We shared with you last quarter our investment thesis on British American Tobacco and why we thought the valuations were now pricing in a significant amount of risk. The share price increased 29.5% this quarter and our holdings in both British American Tobacco and Reinet were positive contributors. Ping An Insurance Group which we purchased last year also contributed to overall performance on the back of a 28% share price rise over the quarter. We sold out of all our Vodacom prior to their December quarterly update as we feared that the pressure on data pricing, combined with a weak macro, would produce weak numbers. Other contributors to performance were Quilter and the Vanguard Value ETF. Our positions in Pepkor, Sappi and Woolworths detracted from performance.

Market overview
Global economic growth is likely to slow into 2019
The global economy continued to experience non-synchronised growth across the three major economic zones. In the United States, growth remains strong as the Trump tax cuts fuelled strong internal demand. Although US interest rates are rising they are still low relative to history. The labour market in the US is very tight and we are seeing signs of building wage inflation. Output gaps conti nue to narrow and risk of further rate hikes seems high.

The European economies are enjoying steady growth however, growing trade disputes could dampen prospects for the export dependent economies. Chinese economic growth is expected to slow from a relatively high base largely driven by slowing infrastructure spending.

A further aggravating factor is the continued rise in the price of oil. If prices continue to rise from current levels it could trigger further pressure in emerging markets and weigh on global growth.

South Africa’s economic prospects remain weak
The South African economy remains weak, largely driven by poor demand and self-inflicted structural problems. Disappointingly, the formal employment sector continues to shed jobs adding further downward pressure on consumption spending. The unwelcome rising cost of fuel driven by both an increase in the dollar oil price and the weak currency will also impact negatively on consumption.

The stimulus package recently announced by President Ramaphosa, although well meaning, is unlikely to have much impact on overall growth as it will be funded from within the existing budget and is relatively small compared to the size of the economy. Having contracted in the first two quarters of the year, it is likely that even the subdued forecasts of growth for the full year will prove difficult to achieve.

Negative sentiment towards Emerging Markets has impacted on local equities
The disenchantment with emerging markets that became evident in the second quarter continued into the third quarter as the MSCI World Index outperformed the MSCI Emerging Market Index by about 6% over the quarter. Unfortunately, the South African equity market was one of the worst affected by the loss of confidence with only Greece and Turkey showing poorer year-to-date numbers in US $’s.

Local equities contracted in the 3... quarter with the most significant decline coming late in the quarter. The ALSI contracted by 2.2% over the quarter and by 4.2% in September alone. The resource sector continued to significantly outperform the financial and industrial sectors achieving a positive return for the quarter. However, this return was helped by a very strong recovery in the platinum sector off a low base with Impala and Amplats both enjoying a strong rebound. Year-to-date the 21% return from resources is well ahead of the financial and industrial sector largely driven by currency weakness.

Property continues to contract but bonds were steady
The property sector continued to contract, falling by 1% over the quarter. The falls were not limited to the Resilient group of companies as Growthpoint, the industry leader, also had a poor quarter contracting by about 9%.

Bonds had a flat quarter producing a 0.8% return as long dated yields rose by about ¼% over the quarter.

The Rand had a poor quarter
The rand had a poor quarter declining from 13.74 to 14.14 R/US$, a decline of roughly 3%, and faring similarly against the other currencies. At its worst the rand hit 15.4 R/$ but late in the quarter the currency did stage a welcome recovery. However, sentiment remains very fragile and further falls cannot be discounted. Fortunately, the rand did not suffer the losses experienced in the Turkish Lira or the Argentinian Peso.

Commodity prices remain largely flat to down except for oil
Precious metals had a largely flat quarter with only Rhodium having a strong advance of about 14% over the quarter. Since June 2016 Rhodium has risen from 650 $/oz to 2589 $/oz, an advance of 300%. For the local producers the Platinum Group Metals basket price has risen significantly as a result of the higher Rhodium price and currency weakness. The platinum sector should produce significantly better results in the second half of the year.
Base metals have on average declined over 2018 in US dollars and no major advance is expected until China resumes it historically high spending on infrastructure.

Against the trend of gold and base metals the oil price continues to strengthen helped by the recent re-introduction of sanctions against Iran. As the world supply/demand balance is currently tight further rises towards $100/bbl cannot be discounted.

The key risk to the SA economy is rising inflation
The key risk to the South African economy is a currency induced increase in the inflation rate requiring a tightening in monetary policy. The latest inflation numbers to August have yet to reflect the impact of the weaker currency and the rising fuel price, and at 4.9% remains well within the inflation targeting threshold of 6%. However, the trend is now up and higher numbers must be expected in the months ahead. If the inflation number settles above 6% the Reserve Bank may be forced to raise rates. Given the fragility of the economy this would be most unwelcome and it remains uncertain how the consumer would respond.

Portfolio Positioning
Equities
Domestically focussed equities continued to underperform in the 3rd of 2018 on the back of negative sentiment toward emerging markets, as well as a slew of disappointing earnings updates which fell well short of market expectations. The repositioning of the portfolio earlier in the year away from expensively priced domestically focussed companies into attractively priced rand hedge counters continued to benefit the fund.

Notably, two of the biggest companies listed on the JSE being MTN and Aspen, suffered significant share price declines over the quarter of 18.8% and 34.4% respectively. Truffle has not held positions in either of these stocks.

MTN came under fire from the Central Bank of Nigerian (CBN) after allegations of not following due process in their dividend repatriation. As a consequence, they are now required refund the CBN $8.1bn. To make matters worse they were also hit with a claim for outstanding taxes by the Auditor General of Nigeria for an amount of $2.1bn. MTN believe they have complied with the laws and are reserving their rights in respect of the allegations. This is the second time MTN has come to blows with the Nigerian authorities and demonstrates that investors should be demanding a much higher risk premium when investing in Nigerian assets. From a fundamental perspective, what is more concerning is that 50% of MTN’s free cash flow (FCF) is derived from Iran and Nigeria. Over the last few years, access to this cashflow has been difficult due to country specific issues. MTN’s net debt to EBITDA at the holding company level is currently 2.9 times. Optically this is not particularly high, but if due to sanctions in Iran or regulatory intervention in Nigeria, MTN can’t access 50% of its FCF, the leverage effectively doubles to 5.8 times. This significantly increases the risk of the dividend being cut.

Prior to the results update, Aspen has been under pressure to deliver a set of results with good organic revenue generation and improved returns. Unfortunately, the latest results showed no evidence of improvement on either point. Worryingly, the declining trend of the Return on Invested Capital (ROIC) has shown no signs of abating, with the latest ROIC now below their Weighted Cost of Capital (WACC) resulting in negative value creation for shareholders. We also questioned whether Aspen were forced sellers of their Infant milk business in an attempt to reduce debt levels which had increased to uncomfortable levels.

Sasol, one of the biggest positions in the fund, continued to performed well over the quarter, with the share price increasing 9%. Despite its re-rating, we still see significant upside in the stock, as very little value is being placed on their ethane cracker project. Commissioning of the project has already started and will reach beneficial operation by the second half of 2019.

Over the quarter the fund also increased exposure to Anglo American, Anheuser Busch, The Vanguard S&P Value ETF, Ping An Insurance and Standard Bank. These increases were funded by sales in Indiabulls Housing Finance, British American Tobacco, Growthpoint, iShares Core S&P 500 ETF, Firstrand and Naspers.

Fixed Income
The fund remains short duration and has no exposure to fixed rate long duration bonds. We remain focussed on the shorter end of the yield curve through floating rate notes where we continue to earn a significant premium to the longer end of the curve without the same duration risk. Inflation risks both domestically and globally are building with risks to the upside especially if the oil price remains at current levels. The strong US dollar and reduced global risk appetite and mounting local fiscal slippage concerns suggest risk to local yields are to the upside.

Contributors and detractors
Top contributors for the quarter included Old Mutual, Capitec, Ping An Insurance, Mitsubishi Corporation and CF Industries. Detractors included Spire Healthcare, Naspers, Growthpoint Properties, Anheuser Busch and Netease.