Macro review
In the US, the fourth quarter saw two Republican defeats in Senate contests spur
House and Senate Republicans into action, resulting in the long-awaited tax reform
bill. Markets rallied on the news, with big permanent cuts for corporations as the
centrepiece of the package. US equities were largely also supported by generally
positive macroeconomic data, including better-than-expected third-quarter GDP
growth of 3.0% (annualised) and stronger-than-expected non-farm payrolls. As had
been widely anticipated, the US Federal Reserve (Fed) lifted interest rates by 25
basis points (bps) in December. The Fed also raised its growth forecasts for 2018 to
2.5% from 2.1%. The quarter also saw robust corporate earnings, particularly from
the technology sector.
In the Eurozone, data showed the region’s economic recovery continuing. GDP
grew by 0.6% in the third quarter, albeit a slight slowdown from 0.7% in the second
quarter. In October, the European Central Bank (ECB) announced that quantitative
easing would be extended to September 2018 but that the pace of purchases would
be reduced from €60 billion per month currently to €30 billion. In Germany, coalition
talks collapsed, while in Spain, Catalonia held a regional election which failed to
resolve the independence issue. In the UK, despite a sluggish economy, the Bank of
England (BoE)’s monetary policy committee raised interest rates for the first time in
10 years as annual CPI reached 3.1% in November, breaching the BoE’s upper
target. Furthermore, hopes rose around progress with Brexit negotiations, with an
agreement struck to allow talks to proceed to the future of trade arrangements.
Emerging markets experienced largely positive political developments. In South
Africa, pro-reform candidate, Cyril Ramaphosa, was elected as leader of the African
National Congress. This development increased the prospect for a return to more
orthodox policy after elections in 2019. In Greece, agreement was reached with
international creditors over reforms, paving the way for the dispersal of further
bailout funds, while India also announced plans for a major recapitalisation for statecontrolled
banks.
Global and local market review
For the first time on record, global equity markets rallied in all 12 months of a year,
advancing +5.8% in US dollars in the fourth quarter and 24.6% over 2017, one of
the strongest years since 2009. The S&P 500 Index ended a strong year with a
fourth-quarter gain of +6.6%, buoyed by hopes of tax reform, while Eurozone
equities declined amid some profit-taking and simmering political risk, although
economic data remained positive. The UK’s FTSE All Share Index also saw positive
returns, supported by gains for resource stocks and progress on Brexit negotiations.
Emerging market (EM) equities however outperformed their developed world
counterparts, returning +7.5% during the fourth quarter and 37.8% in 2017. Top EM
performers in the fourth quarter were South Africa (+21.5%), Greece (+13.6%) and
India (+11.8%). The MSCI South Africa Index rallied +36.8% in US dollar terms in
2017 broadly in line with EM, driven by Media (Naspers) and a metals rally, while a
Ramaphosa win buoyed SA domestic-demand sectors into year-end. However, the
MSCI SA ex Naspers was up only +16%.
The yields on the US 10-year Treasury note rose marginally from 2.33% to 2.40%
over the quarter, but for a brief period when they touched 2.5%. However, the curve
flattened aggressively as shorter maturities sold off in anticipation of the December
rate hike and continued tightening of monetary policy by the Fed in 2018. Yields on
German bonds rallied slightly from 0.46% to 0.42%.
The Bloomberg Commodities Index posted a robust return in the fourth quarter of
+4.7%, underpinned by a rally in industrial metals and energy. In industrial metals,
nickel (+22%), copper (+12%) and iron ore (+12%) posted the strongest gains as
Chinese demand remained firm. Together with measures aimed at lowering
environmental emissions, which have led to an increase in supply discipline, this put
upward pressure on prices. In the energy segment, Brent crude surged +18.2%,
primarily driven by an agreement among OPEC and a number of non-member
countries such as Russia to extend production cuts to the end of 2018. By contrast,
agricultural commodities lost value, notably wheat and palm oil. In precious metals,
gold gained +1.8% while silver was up +1.7%.
Domestically, SA equities (Capped SWIX) delivered a healthy 16.5% during 2017,
outperforming bonds (+10.2%) and cash (+7.5%). Over the quarter, the Capped
SWIX return was +8.4%, driven by Industrial Metals (+62.7%), Banks (+27.1%) and
General Retail (+22.3%). Underperforming sectors over the quarter were Household
Goods (-92.3%), Fixed Line Telecommunications (-18.8%) and Paper (-9.9%).
SA equities recorded outflows of US$2.5 billion during 2017, significantly lagging
inflows into EM equities of US$77.2 billion. However, dissecting the flows, it appears
that, excluding the outflows from dual-listed stocks, the Barclays and Vodacom selldown,
SA equities saw inflows of just more than R60 billion in 2017.
The benchmark SA 10-year bond yield declined from 8.9% at the beginning of the
year to 8.6% at the end of December, given expectations of a political and policy
shift in South Africa, post a Ramaphosa win at the ANC elective conference. For the
quarter, the FTSE/JSE All Bond Index (ALBI) returned 2.25%, outpacing cash
returns of 1.78% on the STeFI Composite. The 5.66% rally in December resulted in
bond returns of 10.22% for the year.
The FTSE/JSE SA Listed Property Index (SAPY) returned a total of 8.3% in the
fourth quarter of 2017 and 17.2% for the calendar year 2017. Over the 2017
calendar year, the SAPY outperformed bonds (10.2%) and cash (7.5%), but
underperformed the FTSE/JSE All Share Index (ALSI), which returned 21% over the
last 12 months. Interestingly, over a trailing five- and 15-year period, SA listed
property is still the best-performing major SA asset class, including equities. For the
calendar year, the best-performing shares in the SAPY were those with a 100%
foreign exposure, such as MAS Real Estate (35%), Sirius (41%) and Greenbay
Properties (60%). The best-performing local share was Equites Property Fund
(32%).
During the fourth quarter, and in particular December 2017, following the outcome of
the ANC conference where Cyril Ramaphosa was elected the new party leader, it
was actually the more pure SA stocks that delivered superior returns. The rand
hedge stocks, such as Growthpoint, Redefine and Hyprop, came off their intra-year
highs on the back of the stronger rand in December.
Momentum: Despite some rotation which started in November (which can largely
be explained by usual year-end profit-taking), globally, the Momentum factor
(particularly Price Momentum) has led factor performances for 2017. Factors such
as Growth and Quality/Profitability have also been solid strategies to be exposed to
last year, but Price Momentum has benefited most from US tax reform and global
synchronised growth.
In South Africa we’ve seen an alignment with global outcomes, as Price Momentum
has been the strongest signal domestically for 2017 and the prior quarter. Earnings
revisions (a sub-component of headline Momentum), on the other hand, has not
performed in line with Price Momentum, delivering only mildly positive alpha, while
defensive factors such as ROE and Dividend have been exceptionally strong during
2017, largely back-end loaded.
In our view, the earnings revisions factor was not well rewarded given high levels of
domestic economic and policy uncertainty flowing over to uncertain corporate
earnings estimates. However, with the domestic policy environment seemingly
improving at the margin, cyclical stocks with positive forward earnings momentum
should perform well.
As an overall factor however, the Momentum signal has translated into a topperforming
factor-based strategy relative to the SWIX in 2017, after a testing
environment in 2016. Over the prior quarter, the strategy’s outperformance was
attributed to exposure to a diverse range of sectors, with the largest contributors to
relative performance generated from overweight positions in Kumba Iron Ore (KIO),
Assore (ASS), Exxaro (EXX), Capitec (CPI) and Imperial (IPL). The underweight
position in Steinhoff (SNH) also significantly bolstered the strategy’s performance,
after the share fell 92.3% over the quarter due to accounting irregularities. On the
other hand, the largest detractors were overweight positions in Richemont (CFR),
Reinet (REI) and British America Tobacco (BTI), and underweight positions in
Barclays (BGA), Truworths (TRU) and Mr Price (MRP).
At the last rebalance date (mid-December), we transitioned the portfolio based on
the evaluation of new factor signals and the risk levels in the portfolio. Based on
these signals, Steinhoff (SNH), Blue Label Telecoms (BLU) and Supergroup (SPG)
were removed, and Discovery (DSY), Mr Price (MRP) and Northam (NHM) were
added. Exposures to Bidcorp (BID) and Glencore (GLN) have also been reduced
while exposures to Assore (ASR) and Richemont (CFR) were added in line with the
risk objective of the fund.
Quality: The S&P Quality Index experienced a challenging first three quarters of the
year, as the market grappled with interchanging risk-on and risk-off environments.
Predictably, during the months of February and June where the South African equity
market (SWIX) experienced deep negative returns, the S&P Quality Index provided
meaningful protection. Over the fourth quarter however, the strategy hit a definitive
turning point in performance, provided by a few notable catalysts.
Firstly, the emergence of news in December that an accounting irregularity had
occurred at Steinhoff had investors scrambling. Not often has one stock moved the
entire benchmark that much, as companies with strong balance sheets, cash/quality
earnings and high returns benefited from the flight to quality. Notwithstanding this
seismic shift, any portfolios (such as our strategy which follows the S&P Quality
Index) that managed to have less exposure than benchmarks - or even better, zero
exposure - were treated to substantial relative performance outcomes after the
Steinhoff share price plummeted.
Secondly, leading up and subsequent to Cyril Ramaphosa’s election as the new
ANC president, the rand rallied strongly relative to the dollar (appreciating 10.9%
over 2017), with investors beginning to price in a positive macroeconomic impact
supporting a cyclical recovery. To this end, shares with domestic cyclical exposure
rallied hard during the fourth quarter, including General Retail (+15.9%), Banks
(+15.2%) and Industrial Transportation (+8.9%). The Quality strategy had substantial
exposure to all these sectors through its strong rand exposure.
Thirdly, the valuation gap between Quality and the market has been closing since its
peak in 2015, and now the premium is closer to normalised levels. While the
valuation spread has increased given Quality’s recent run, our view is that the
Quality basket still presents value to investors who seek the strategy’s diversification
benefits within this factor portfolio construct.
In terms of stock selection, the largest relative outperformance over the quarter
came from the overweight positions in a broad range of sectors such as Mr Price
(MRP), Kumba Iron Ore (KIO), Capitec (CPI), Bidvest (BVT), Sanlam (SLM) and
Tiger Brands, as well as underweight positions such as Steinhoff (SNH), British
American Tobacco (BTI) and Richemont (CFR). By not holding Naspers (NPN),
FirstRand (FSR) and Barclays (BGA), the fund detracted value relative to the SWIX,
while holdings in Adcock Ingram (AIP) and South32 (S32) also diminished the
strategy’s value-add. There were many constituent changes (eight deletions and 10
additions) to the S&P Quality Index over the prior quarter, as this index rebalances
in June and December each year.
The index and portfolio remain focused in its extraction of Quality and should
markets give way to further risk aversion, the defensive character of the basket
should prove rewarding while not meaningfully compromising returns during up
markets.
Stable Dividend: After a fantastic performance during the 2016 calendar year,
Value measures have experienced a disparate 2017. The divergence between deep
value measures (e.g. price to book) and yield measures (e.g. dividend yield) has
been substantial, with the former struggling, and the latter continuing to perform well
as investors seek defensive qualities during a period of high levels of uncertainty
and flight to safety, particularly during the fourth quarter. As mentioned above, the
Steinhoff debacle caused investors to seek out companies with defensive
characteristics and high dividend yields. Also, this strategy had some meaningful
exposure to the rand rally through constituents in domestic sectors such as Banks
and General Retail.
During the fourth quarter, exposure to Kumba Iron Ore (KIO), Foschini (TFG),
Barclays (BGA) and Exxaro (EXX) played a strong positive role here, while an
underweight position in British American Tobacco (BTI) also added excess return.
The concentrated nature of our market index proxies and its Naspers exposure also
largely contributed to the relative underperformance; this index holds no Naspers
exposure. Holdings in Steinhoff (SNH), Telkom (TKG) and AECI (AFE) detracted from the index’s relative performance.
There were no changes to the Satrix Stable Dividend strategy during the prior
quarter.
This portfolio strategy maintains a sector-neutral position, and thus any relative
sector performances would not adversely impact the portfolio’s performance. In
addition, the portfolio construction approach is designed to optimise the reliability of
high dividend yields, which the portfolio successfully has managed to achieve.
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. 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. 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.