Macro review
In the US, consumer confidence remained strong and retail sales data suggested a rebound in consumption from a softer Q1. The unemployment rate also reached an 18-year low of 3.8%, accompanied by robust wage growth. As expected, the Federal Reserve (Fed) raised the target for the federal funds rate by 0.25% and marginally increased its 2018 forecasts for growth and inflation. The positive economic data were, however, balanced by moves from the Trump administration to impose tariffs on Chinese imports and withdraw from the Iran nuclear accord.
In the Eurozone, the quarter was marked by the return of political risk. There were concerns that Italy could need fresh elections following the inconclusive outcome of the March vote, while Spain also saw a change of government, although this was largely greeted with calm by markets. German Chancellor Angela Merkel clashed with sister party the CSU over immigration policy. Economic data pointed to steady growth but at a slower pace than last year, as GDP growth for Q1 was 0.4%, down from 0.7% in Q4 2017. The European Central Bank (ECB) announced that it expects to end its quantitative easing programme in December 2018.
Emerging markets (EM) saw an escalation in global trade tensions which also contributed to risk aversion as US-China trade talks failed to deliver a sustainable agreement. Brazil experienced a truck driver strike which paralysed the economy and amplified political uncertainty. Turkey saw currency weakness which forced the central bank to implement an emergency rate hike in May. China observed concerns over growth which contributed to Yuan weakness.
Global and local market review
Global developed market equities made gains in a volatile Q2, as resilient economic and earnings data vied with an unsettling geopolitical backdrop to establish the market’s direction. The MSCI World Index posted a positive Dollar total return of 1.9% (-1.2% for Q1), outperforming the MSCI EM Index (-7.9% in Q2 vs +1.5% in Q1). In the US, equities advanced in Q2 with the S&P 500 gaining 3.4% in Dollars, with positive earnings momentum and supportive economic data ultimately outshining escalating US-China trade posturing. Eurozone equities also posted positive returns in Q2. In EMs, equities recorded a sharp fall with US Dollar strength a significant headwind. Worst performing countries were Brazil (-26.4%), Turkey (- 25.7%) and Hungary (-14.4%), while the only countries to post positive returns were Colombia (+6.8%) and Qatar (+3.5%).
The SA equity market started June on a strong note, reaching a month-to-date total return of 4.2% by 14 June before reversing this to post a loss of 1.5% by 26 June. The FTSE/JSE All Share Index recovered on the last day of trade to record a June total return of 2.8%. Large caps returned 3.8%, while mid-caps and small caps lost 2.1% and 3.3% respectively. On a sector level, SA Resources was the best performer returning a solid 19.6% (Q1: -3.8%). SA Industrials returned 4% (Q1: -8%) while SA Financials lost 6% (Q1: -3.6%).
Global bond markets suffered from bouts of volatility in Q2 due to a confluence of factors. These included a greater dispersion between accelerating US growth and a softening of economic activity elsewhere, escalating trade tensions between the US and China and the formation of a populist coalition government in Italy. US 10-year Treasury yields rose from 2.74% to 2.86%. They rose significantly in April, touching a seven-year high in mid-May, as growth and inflation expectations continued to build, before risk aversion and ‘safe haven’ buying led to a significant retracement. Bund 10-year yields fell from 0.50% to 0.30% on safe haven demand and as European data saw further softening. The Bloomberg Commodities Index posted a slightly positive return in Q2. Crude oil prices continued to rally, with President Trump’s decision to withdraw the US from the Iran nuclear accord contributing to higher prices, despite OPEC announcing plans to boost supply. The industrial metals index registered a small gain.
Momentum: Global trade uncertainties and other geopolitical risks weighed heavily on investor minds over the prior quarter. This resulted in a clear risk-off performance of global styles. While Low Risk, and in particular Low Beta, were the best performing factors, the cyclical factors such as Momentum and Growth did not completely roll over and instead only suffered from some mild rotation and profittaking. In South Africa, there was large consistency with global outcomes, where we saw factor reversals as the cyclical Price Momentum factor underperformed. What was interesting, however, was how Earnings Momentum (a sub-component of headline Momentum) and Price Momentum exhibited divergent performances over the quarter. As opposed to Price Momentum, Earnings Revisions came alive in Q2 as investors gravitated towards companies with positive earnings sentiment. This could be seen as investors viewing Earnings Revisions as a more defensive component, which is aligned to how we utilise this factor in our overall Momentum strategy.
Quality: After a stellar 2017, underlying Quality factors, in particular Return on Equity (ROE), continue to experience strong signal strength during the first half of the year as investors favour stocks with defensive characteristics. Global macro concerns continue to weigh on risk appetites, which has compelled investors to seek companies that return high profits despite macro headwinds. This defensive posturing has been present notwithstanding the largely pro-cyclical domestic sentiment, e.g. leadership optimism, declining risk of credit rating downgrade, improving inflation outlook. The conundrum, however, has been that during Q2, this signal has been overwhelmed by stock-specific, sector and Rand risk in the portfolio. These impacts have significantly outweighed the Quality premium embedded in the portfolio, as well as the valuation gap the Quality basket offers relative to history.
Stable Dividend: After two consecutive very poor quarters, deep Value factors such as Price to Book rekindled its 2016 performance where cyclical value was favoured. To some extent the unwinding of Momentum has benefited these cyclical value measures in the short term, however, should macro uncertainty continue and deepen, we may see a shift towards more defensive Value or Quality strategies. Price to Book remains the worst performing strategy over 12 months. Dividend Yield, on the other hand, has experienced mixed fortunes, as the environment tussled between flight to safety and pro-risk. Over the previous year, however, investors continued to show a preference towards yield as opposed to more deep value. The conundrum, however, has been that during Q2, this Yield signal has been overwhelmed by sector and Rand risk in the portfolio. These impacts have significantly outweighed the Value and Yield premium embedded in the portfolio. There were no changes to the Satrix Stable Dividend Index over the prior quarter.
In Closing
There are growing concerns that global businesses may be subject to new regulation and be the target of tariffs if a US-China trade war escalates. Political risk is dominating fundamentals and we now have progressed into a new era where central banks are not the backstop supporting financial markets. In South Africa, the sentiment pendulum has swung 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. Also, the expectation that President Ramaphosa will, in one fell swoop, reverse years of maladministration and corruption is unrealistic.