Sanlam Select Defensive Bal comment - Sep 18
Market stress eased over the course of September as the Dollar retreated and risk aversion subsided. Yet this attempt for emerging market (EM) assets to stabilise belies persistent underlying risks relating largely to the impact on growth and inflation from the ongoing trade battles. While the latest round of tariffs (10% on US$200 billion) had little market impact, participants may be ignoring the mediumterm risks from shifting supply chains and higher US consumer prices on incomes.
The US Federal Reserve (Fed) remains steadfast in its gradual normalisation. Chairman Jerome Powell omitted the reference to ‘accommodative’ and the Fed still sees the peak at 3.5%. For the Fed to continue tightening growth will need to hold up. Tax cuts and fiscal stimulus limit the near-term risks to US growth. But the combination of weaker EM growth and a strong US Dollar will at some point hurt US corporates and so, too, the equity market. This will probably be the signal to the Fed to stall.
So far policy makers have not responded to slowing Chinese growth with significant easing, evident in the stabilisation in the Yuan and limited liquidity injections. Further weakness will very likely prompt more aggressive stimulus from China, which could perversely bail out other EMs.
Locally, policy uncertainty persists with the Constitutional Review Committee asking for yet another extension of its deadline, this time to November. The Zondo Commission on State Capture and the SARS enquiry continue to elucidate the extent of work needed to undo the systematic weakening of various SA institutions. Yet institutional strength remains a positive pillar for SA’s credit rating, with Moody’s commentary pointing to a stable rating for the next 12 months at least. Hence, the review on 12 October is set to be a non-event. The Medium Term Budget Policy Statement should be more exciting as it will show how government will incorporate President Ramaphosa’s stimulus packages in a deficit-neutral manner. We think the market is being too negative on the budget update, yet a credible story from Treasury will only buy time given the steady increase in debt to GDP and the risk of larger weekly bond auctions somewhere down the line. President Ramaphosa will host the long-awaited jobs and investment summits in October.
Inflation is back in focus given the downside surprise in the August release, which, coupled with the technical recession, tipped the odds in favour of a pause at the September Monetary Policy Committee (MPC) meeting. With Brian Kahn having retired, the composition of the MPC tilts towards the hawkish side. Hence, it is easy to see the 4:3 vote for no change in September ending up as a 3:3 vote in favour of a hike in November if the Rand is still perceived as a risk. On this score the domestic uncertainties will be compounded by global events, in particular the Brazilian election (7 and 28 October), the Iran sanctions (4 November) and the US mid-term elections (6 November).
Fixed income delivered positive total returns in September with fixed- and floatingrate credit each delivering 0.8%, while cash (0.5%), inflation-linked bonds (0.4%) and nominal bonds (0.2%) also posted modest returns. The laggards were listed property (-2.6%) and equities (-4.2%). For 3Q18, only fixed-rate credit (1.9%) managed to beat cash (1.7%), with floating-rate credit (1.4%), nominal bonds (0.8%) and inflation-linked bonds (0.5%) lagging the other fixed-income sectors. Listed property lost 1% during the quarter, while equities were 2.2% lower.
The recovery in EM assets and portfolio flows has been muted. The gyrations in the Dollar and the contagion from Argentina and Turkey left EM FX down 4% versus the Dollar for 3Q18. The Rand was hit by the market turmoil – while the unit gained 4% in September, it was still down 3% for the quarter. The Rand’s status as high vol/high beta was confirmed with the USD/ZAR trading below 13.50 in July and above 15.50 mid-August and early-September. The Rand has, for now, settled in line with our updated fair-value estimate around 14.00 -14.50.
After trading in a core 2.80% to 3% range, the US 10-year yield has again breached 3% amid a shift in the supply/demand balance. Issuance has been rising while the Fed has continued to shrink its balance sheet. Moreover, the increase in bund yields (from 30 bps to 55 bps) has at-the-margin reduced demand from offshore given higher hedging costs resulting from Fed hikes. The rise in US yields has so far not had an adverse impact on local currency bond yields, with most markets posting modest gains towards the end of September. Higher US yields will be a risk to EM rates only if they are followed by further Dollar strength. The SA 10-year yield traded between 8.75% and 9.50% during the quarter – at 9.20% the market is only moderately cheap compared to our fair-value range of 8.80% to 9%.
Global equities posted wide-ranging returns in September, with the Nikkei up by 5.5% and the Shanghai Composite up by 3.5%. The FTSE 100 rose by 1.1%, while the S&P 500 managed a 0.5% increase. The MSCI World Index rose by 0.4%, while the MSCI EM Index declined by 0.8%. The MSCI SA Index was a laggard, losing 6% during the month versus -5.3% for the FTSE/JSE All Share Index (ALSI) and -4.6% for the FTSE/JSE Shareholder Weighted Index (SWIX). Losses in pharmaceuticals (-40%), household goods (-18%), automobiles & parts (-15%), healthcare (-14%), beverages (-13%), and personal goods (-11%), were only partly offset by gains in industrial metals and mining (+20%). Despite the recovery in the exchange rate, resources (-0.3%) outperformed financials (-3.1%) and industrials (-7.0%). The latter was plagued by company-specific weakness, for example concerns about Aspen’s debt and asset sales, a weaker outlook from Netcare, and ongoing strain with Nigerian regulators.
Portfolio performance and positioning The fund’s performance (-0.6%) was driven largely by domestic equity (-0.7% contribution), offshore equity (-0.3%), and domestic property (-0.1%). There was a modest offset from the positive performance in domestic bonds (0.3%) and domestic cash (0.2%).
The fund is conservatively positioned for risk, as reflected by our domestic cash position (25%), overweight duration position in bonds (44%) via investments in high-yielding low-duration credit instruments and government bonds, and defensive local equity allocation (17%). During the month we moved to a moderate overweight duration position in bonds. We have a small holding in foreign equity (8%), with a higher weighting in Europe where we believe the earnings growth prospects are more favourable than the rest of the developed markets given the stronger GDP recovery. We have maintained a low US Dollar exposure of 3% and our local property exposure at around 4%. We remain defensively positioned with a focus on absolute returns and, as a result, prefer the real return available from government bonds, supplemented by highyielding low-duration credit instruments. Disappointing real activity data has supported our view that domestic retail and select industrial stocks ran too far in anticipation of a strong GDP rebound. We remain cautious on the extent of the growth recovery in the short term and we still prefer banks, resources, and global defensive stocks.