Market review | Global and Local Capital Markets
Year to date Asia and Latin America have been the best-performing equity markets. Looking at the global leaderboard for Q1 2017, 33 out of 39 assets actually ended the quarter with a positive total return. Silver (+15%) led the way but the dominant theme was the strong performance from equities with the Spanish IBEX (+14%), Emerging Market (EM) equities (+12%), Brazil’s Bovespa (+12%) and Hong Kong’s Hang Seng (+10%) all performing well, but it’s also been a strong quarter for developed market (DM) equities with the Europe Stoxx 600 returning 8% and the S&P 500 6%.
After the first three months of the year, on a normalisation in investor sentiment (in Q1 2017 the VIX Index had its lowest average quarter since Q4 2006), the general call for the second quarter is to remain overweight equities and underweight bonds/cash. This reflects the view that real rates are in a bubble and there's risk of a significant re-pricing in the medium term as the rate hike cycle gathers steam. The Trump run may have a bit more to go. By avoiding a drawn-out battle over the Health Care Bill, investors' focus has shifted to tax reform and as this takes centre stage, stimulus-fuelled optimism could wane as friction around funding the Tax Bill rears its head. Stocks have been boosted by accelerating global growth and improving confidence. But the risk today is that, just as the Trump run may begin to fade, data could grow choppier. With positive
economic surprises at five-year highs, the math alone makes it difficult for data to accelerate from here. With the French elections, Turkish referendum, OPEC, and Brexit all on the calendar at a time when global central banks are transitioning to a tightening bias, we see a chance that the markets might take a breather at some time this year.
As anticipated, S&P eliminated South Africa's foreign currency sovereign investment-grade (IG) rating, downgrading to BB+ from BBB- with a negative outlook. The MSCI SA Index (-0.1%) underperformed the MSCI EM Index (+2.5%) in March in dollars, as the rand (+2.6%) was the worst-performing EM currency, on the back of a Cabinet reshuffle, with Finance Minister Gordhan removed.
The FTSE/JSE All Share Index (ALSI) managed to deliver a good return of 3.8% over the last three months, with the best-performing sectors being Consumer Discretionary, which was driven by the very good returns of Richemont, British American Tobacco and Naspers. In the Basic Materials sector Coal Mining and Forestry and Paper experienced a very good quarter. Laggards were Healthcare (-7%), heavily influenced by Netcare (-18%), and Banks (-6%), which were down on a weaker rand, weighing on the inflation outlook and consumer confidence. The worst-performing sector was Industrial Engineering, down a massive 15%.
The FTSE/JSE Shareholder Weighted All Share Index (SWIX) managed a total return of 3.3%, which was slightly worse than that of the ALSI, mainly driven by the higher weighting of resource companies in the latter.
The year ahead
For many of our clients, the question is why does a downgrade matter? There is an obvious risk that, in order to balance the books, taxes will rise, import tariffs will increase the cost of living and higher interest rates will discourage private sector investment and job creation. The key concern remains our local currency debt junk rating, which could make it more expensive to meet our fiscal commitments in the long term. The Cabinet changes have had a significant impact on financial markets to date. South Africa relies on foreign capital flows to fund its deficits, and with increasingly likely downgrades of its sovereign debt looming, further sharp declines in the rand is possible. The importance of the loss of independence of an institution like the Treasury is not something that should be underestimated.
While SA domestic equities might appear close to the bottom, failure to deliver on a turnaround in confidence in the political landscape could see the likelihood of a further near-term sell-off (with a vote of no confidence unlikely until early May), therefore we think that domestic equities such as Banks and Retail should offer better entry opportunities in the weeks to come. On the upside one could see some further outperformance of some industrial rand hedges, on the back of a further weakening in the currency.
We believe SA bonds are most threatened by unfolding political developments, as there is no place to hide, unlike SA equities where shelter can be taken in ‘safe-haven’ stocks. SA bonds could face headwinds from foreign unwinding of local currency bond positions (foreigners comprise more than a third of SA local currency bonds) on the threat of further credit rating downgrades and fiscal expedience creeping in under a mantra of the need for ‘radical economic transformation’ of the economy. On the back of all this negative news flow SA listed property stocks have had a very subdued reaction relative to the bond market. Historically the performance of listed property shares tracked that of the bond market, but that correlation has started to wane partly because of the local listed companies’ increased offshore exposures. Will they feel the brunt in the weeks to come?
Momentum
Price momentum and earnings revision factors have been sternly tested in 2016. This last calendar year has brought with it extraordinarily high levels of economic and policy uncertainty on both the domestic and international stages, keeping us pensive. The first quarter of 2017 has not failed to disappoint in contributing to the uncertain outlook. On the international stage the price and earnings revision factors have also been among the poorer performers. There has, though, been a continuing recovery in the factor during this first quarter of 2017, mainly driven by the earnings revision factor while price momentum was more muted. Given that most of the stocks enjoying the highest earnings revision characters are hard commodities, the higher beta nature of these counters will likely influence the portfolio’s factors over the coming months. In spite of this
the portfolio weathered the uncertainty of the first quarter rather well, posting a positive relative performance above the market benchmark (SWIX).
Once again stock selection within the resource sector was the primary driver of positive relative performance over this quarter. Industrials were benign in effect while Financials were slightly negative. Stocks that detracted most were Bidvest (BVT), FirstRand (FSR) and Spar (SPP). In the Resources sector the overweight position in Kumba Iron Ore (KIO) added most. British American Tobacco (BTI) and Exxaro (EXX) also lent steady support contributing to the positive result. As we closed the quarter, we transitioned the portfolio based on the evaluation of new factor signals and the risk levels in the portfolio with two shares (Blue Label Telecom: BLU and JSE Ltd: JSE) being removed. Glencore (GLN) and Barloworld (BAW) have been additions over the quarter while exposures in Mediclinic (MEI), Steinhoff (SNH) and Anglo American (AGL) have been reduced. Underweights in MTN Group Ltd (MTN) and Sasol (SOL) were narrowed to keep tracking error limits within bounds. The biggest fundamental change in the portfolio’s positioning over the course of 2016 has been the rotation into the hard commodity stocks whose price and earnings revision signals remain strongest in our domestic universe. Stable Dividend: Dividend yield and other cash flow related measures of value had a strong 2016 along with deeper extractions of value like price to book. The yield factor struggled to get out of the blocks in 2017 but still kept tread with the market. On an absolute basis the value family of factors provided a solid start taking inflation into account. Exposure to Truworths (TRU) and Richemont (CFR) played a strong role here. The concentrated nature of our market index proxies and its Naspers exposure were pretty much behind the relative under performance; this index holds no Naspers exposure. Our Satrix Stable Dividend Index had its review in March. A summary of the major additions and deletions are below:
Additions: Exxaro (EXX), Steinhoff (SNH), Spar (SPP), Tsogo Sun (TSH)
Deletions: AVI (AVI), MTN (MTN), Foschini (TFG)
As long as the extraordinarily uncertain market environment persists this factor is likely to provide investors with the necessary defensive character inside their portfolios. Quality: The S&P Quality Index had a topsy-turvy start to the year as risk-on and risk-off environments changed hands quite regularly with the last week of the quarter proving decisive. Having run ahead of the market leading into the last week of the quarter the final week’s underperformance resulted in a negative quarter relative to the market (SWIX). In spite of this, its diversification benefits have been of significant value within this factor portfolio. As with our
Dividend Yield (Value) factor, the largest relative underperformance came from the underweight position in Naspers (NPN) while overweight positions in Kumba Iron Ore (KIO), Capitec (CPI) and Sanlam (SLM) helped offset the performance relative to the market (SWIX). The low beta character of this index was challenged given that high beta resource (earnings revision) ideas rerated and featured strongly this quarter. There were no changes to the S&P Index over the past quarter.
The index and portfolio remain focussed in its extraction of Quality and should markets give way to further risk aversion, the defensive character of the basket should prove rewarding.
In Closing
We remain convinced of all equity factors’ medium- to long-term significance and the premium they offer in the South African capital market and remain disciplined in our implementation and extraction of all factors.
The outlook for markets is again uncertain. The global backdrop is one of improvement on the margin, which all else being equal should benefit SA assets and the currency. Relative to this support, the risk of additional downgrades to SA’s credit ratings will now cast a new shadow over SA assets.
Should a ‘sanity prevails’ event occur in the near future, the impact of that on SA bonds and the currency could be material. But in the absence thereof, investors will be faced with the impossible question of whether local assets are priced cheaply enough to reward investments in them despite the additional downgrade risk that President Zuma’s actions have brought. While the capital markets provided a less than pleasant experience in the riskier asset classes in the recent short term (year), we remain convinced of the medium- to long-term investment strategy of having measured strategic exposure to all the necessary asset classes for the purpose of
diversification.