Sanlam Select Defensive Bal comment - Sep 19
Global policy discord was the main theme in 3Q19 as political decisions hurt growth, leading to demands from politicians for monetary policy to do more.
US President Donald Trump expanded tariffs on Chinese imports, although implementation will be staggered. The decline in the equity market stoked recession fears, with the US 2-10-year part of the yield curve inverting. The US Federal Reserve (Fed) cut rates twice since mid-2019, but the statements, minutes and dot plots have revealed a less dovish tone. Yet the Fed funds futures are pricing in one more cut for 2019 and two more for 2020.
It is a case of the Fed following the market, albeit reluctantly, given that falling rates, a 50-year low in unemployment, and trend GDP growth are offsetting fiscal tightening and trade wars. The slump in the ISM manufacturing index may be an overreaction to data and politics, but the fact that the oil price has not rallied despite attacks on Saudi Arabia production facilities suggests that global growth is faltering.
The European Central Bank has already embarked on the next round of quantitative easing with president Mario Draghi’s swansong delivering deeper negative rates and asset purchases of €20 billion per month. Negative yields across Europe and Japan are spilling over to the US and, from there, pushing investors further out the risk frontier. This search for yield has helped mask South Africa’s deteriorating fiscal position, as local bond yields have risen only modestly in the face of higher issuance.
The government announced a second large bailout for Eskom, which will have to be funded by higher taxes or expenditure reprioritisation. Both will be a net drain on the economy, as the cash injection will go towards debt redemptions rather than infrastructure.
While we all bemoan that the South African Reserve Bank (SARB) has not cut rates more aggressively, we must acknowledge that weak fiscal policy and lack of reform have hamstrung monetary policy. Cautious language accompanied the July Monetary Policy Committee repo rate cut, highlighting that the SARB is cognisant of the risks. Hence, the Medium-Term Budget Policy Statement will have to go beyond business-as-usual in laying out a clear and credible plan on how government will steer the fiscal ship on a more sustainable course.
During September, SA floating rate credit (1%) was the only asset class to beat cash (0.6%). Nominal bonds (0.5%) marginally beat inflation-linked bonds (0.4%), fixed-rate credit (0.3%) and property (0.3%), while equities (0.2%) lagged in a narrow return distribution month. Similarly, for 3Q19, floating rate credit (3.1%) beat cash (1.8%), while fixed-income asset classes – fixed-rate credit (1.5%), nominal bonds (0.8%) and inflation-linked bonds (0.3%) – trumped property (-4.4%) and equities (-4.6%).
Relatively resilient US growth and sporadic safe-haven demand related to trade tensions, geopolitical risks, and impeachment uncertainty added impetus to the greenback. The Rand lost 7.2% against the Dollar, with some of the weakness reflecting hedging activity. The Rand is marginally cheap versus our 14.50-15.00 fair value range for the Rand against the US Dollar, but weak productivity growth and a substantial fiscal funding requirement are headwinds to major gains in the local currency.
Local bond yields rose only 20 basis points (bps) during 3Q19, but this belies the sharp increase in SA’s risk premium versus emerging markets. SA’s five-year credit default swap spread over its peer group widened from 60 bps to 90 bps, while the SA/ JPMorgan Government Bond Index-Emerging Markets Index spread rose from 280 bps to 340 bps. SA-specific factors account for the underperformance, as high real yields are required to entice foreign funding. At 8.80%, the SA 10-year yield is trading 720 bps above the US equivalent, but within our 8.60-9.10% fair-value range.
Central bank easing did not counter trade wars and Trump tweets in 3Q19, with the MSCI World Index flat for the quarter, while the MSCI EM Index lost 5.1% in Dollar terms. The MSCI SA Index lost 13.2%, with the Rand accounting for just over half the decline. Despite the September rebound, the FTSE/JSE Shareholder Weighted Index (SWIX) lost 4.3% (total return) in 3Q19, with broad-based underlying weakness: telecommunications (-7.8%), financials (-6.8%), basic materials (-6.4%), consumer services (-6.2%), industrials (-3.9%), health care (-2.5%), technology (-1.1%), and consumer goods (-0.8%). Stock-specific issues and policy uncertainty constrained the local market, with gold (12.3%) and platinum (25.8%) the standout sectors thanks to the higher Rand commodity prices.
Portfolio performance and positioning
The fund’s performance (0.7%) during September was driven by domestic bonds (0.3% contribution), foreign equity (0.2%), domestic cash (0.2%) and domestic property (0.1%). Domestic equity and offshore cash were broadly neutral in the attribution. Given the attractive valuations in fixed income and curtailed return distribution, we increased our duration position from on-weight to overweight during the month.
Notwithstanding the 3.1% rebound in GDP in 2Q19, output in the first half of 2019 was still 0.5% below that of the second half of 2018. Moreover, the SARB’s leading indicator has trended downwards, third-quarter business confidence slumped to 21, and the manufacturing PMI has dropped to a post-crisis low of 41.6. While the market welcomed Treasury’s growth plan as being more private sector-friendly, policy uncertainty continues, particularly in the electricity sector. SOE bailouts have gathered pace, while revenues are running well short of budget estimates. SA credit and local currency risk premia are already reflecting the SA-specific weakness. The benign inflation outlook results in a real yield of over 4% in local fixed income. This is competitively priced versus local and peer group asset classes. Our equity positions still reflect a somewhat cautious view on global and local growth, being overweight resources and global diversified counters. With cheaper valuations in recent months, we have reduced our underweight allocations to various SA Inc sectors, including retailers.
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.