Sanlam Select Defensive Bal comment - Jun 19
It has been an erratic three months for equity markets. The S&P 500 Index was Goldilocks in April (+3.9%), but lost it all and then some in May (-6.8%) due to Trump's tariff tweets, only to rebound strongly in June (+7.2%) on the expectation of US Federal Reserve (Fed) easing, and to make a record high in the first week of July on a renewed trade truce. Notwithstanding the ongoing damage to the global economy from existing trade tariffs and persistent uncertainty, the equity market is signalling strong growth ahead. Admittedly, the sharp fall in bond yields has assisted valuations.
The slump in developed market bond yields is telling a different story - it signals concern about growth, evident in lower real yields, as well as deflation fears. The first half of 2019 repricing in monetary policy expectations has seen a scramble by some analysts to revise forecasts to Fed cuts. While few are projecting a US recession, some expect insurance cuts to offset the impact from trade wars and the waning impact of prior fiscal stimulus.
It is not obvious that the Fed should be cutting rates based on the performance in equities and US GDP. Yet the expectation of Fed stimulus has contributed to the easing in financial conditions, with the market pricing in at least 25 basis points for the July meeting. Hence, the Fed would have to explain a pause carefully to prevent a sharp sell-off in rates and risk assets.
The Fed's dovish pivot has given emerging market central banks room to manoeuvre. The SA market reflects this, with the forward rate agreement curve fully priced for a 25-basis point rate cut in July. SA is a more obvious candidate for substantial central bank easing, but fiscal risks and capital flow volatility have so far prevented an easing cycle. With only five Monetary Policy Committee members contributing to the July meeting, the divisions within the committee make the repo rate outcome a much closer call than what the market is reflecting.
A more dovish Fed and hopes of a trade truce left local equities (4.8%) in the lead for June. Bonds (2.2%), listed property (2.2%) and fixed-rate credit (2%) beat cash (0.6%), while floating-rate credit (0.5%) and inflation-linked bonds (0.3%) underperformed. For 2Q19 all the asset categories beat cash (1.8%), with listed property taking a surprising lead (4.5%), followed by fixed-rate credit (4.2%), equities (3.9%), bonds (3.7%), inflation-linked bonds (2.8%) and floating-rate credit (2.6%).
The lower Fed dot plot and US yields left the Dollar 1.6% weaker in June and emerging market FX 2.5% stronger. The Rand rallied 3.5%, taking the USD/ZAR to the low 14.00s. At 14.10, the Rand is neutral on our short-term 14.00-14.50 fairvalue range, but potentially expensive on a medium-term view given the weak growth trajectory and potential for credit rating downgrades.
Developed market bond yields plummeted in June with the German 10-year Bund falling deeper into negative territory (-0.4%) and the US 10-year bond moving sub-2% for the first time since the 2016 US elections. Expectations of Fed rate cuts and European Central Bank President Draghi's 'whatever it takes 2.0' boosted global bond markets. SA lagged the global rally due to the negative impact of the first-quarter GDP data, political news flow, and fiscal fears. Even so, the 10-year yield fell by 30 basis points in June, to 8.70%, which is at the lower end of our 8.60- 9.10% fair-value range.
Falling yields contributed to the surge in equities in June, with the S&P 500 Index rebounding by 6.9%. The MSCI World Index gained 6.5%, marginally beating the MSCI Emerging Markets Index's 5.7% gain. SA was a relative outperformer, in part due to FX appreciation, with the MSCI SA Index up by 6.2%. The FTSE/JSE All Share Index gained 4.8% and the FTSE/JSE Shareholder Weighted All Share Index 3.1%. The underlying performances were wide-ranging: resources outperformed (8.9%), in particular gold mining (+24.5%) stood out, followed closely by consumer goods (8.4%), while industrials (-4.1%) and health care (-0.5%) declined outright. Financials (1.3%) and consumer services (0.6%) underperformed, while technology (4.4%) and telecommunications (4.1%) outperformed modestly. The rally brought valuations closer to fair value with the market now trading on a forward price-toearnings ratio of 13.5.
Portfolio performance and positioning The fund's performance (1.6%) was driven largely by domestic equity (0.9% contribution), followed by domestic bonds (0.6%), domestic cash (0.3%) and foreign equity (0.2%). These were partly countered by the negative performance from foreign cash (-0.3%), which was due to the appreciation in the Rand. Domestic property was neutral for the portfolio's performance. The rebound in developed market equity assets amid a more dovish Fed and the expectation of a trade truce at the G20 spilled over to emerging market assets. Our allocation to domestic cash declined in June in favour of offshore cash, which partly reflects the expiry of an FX derivatives position. We maintained a moderate underweight-duration position in domestic bonds. Domestic activity, confidence, and consumer metrics remain disappointing. Escalating trade tensions in May have given way to a renewed truce in June, with US-Sino trade talks set to resume. However, a deal is unlikely to transpire, leaving uncertainty elevated. South African asset valuations are no longer attractive, justifying a cautious stance as weak growth will lead to slowing earnings momentum, while also weighing on the fiscal position. President Ramaphosa's State of the Nation Address was promising, but the pace of political and economic reform remains pedestrian and, therefore, underwhelming. As such, we remain cautious and still prefer global defensive stocks and resources, and a moderate underweight allocation to duration.
The fund invests in a combination of equities, money market instruments; nominal and inflation linked bonds and listed property as well as international equities and fixed interest investments. The fund manager employs an active asset allocation and securities selection strategy with a focus on achieving stable returns. The fund holds a maximum of 40% in equities (including offshore equities) and is Regulation 28 compliant. The investment manager will also be allowed to invest in financial instruments (derivatives) as allowed by the Act from time to time in order to achieve its investment objective.