Fund Manager Comment - Apr 18
Macro review In the US, equities began 2018 strongly, buoyed by ongoing strength in economic data, robust earnings and the confirmation of a major tax reform package. US business confidence reached an unexpected, multi-decade high in March, while GDP for Q4 2017 was revised upwards to show growth of 2.9%. The latter part of the quarter, however, saw a marked increase in volatility as investors first digested the destabilising potential of an elevated US inflation reading and the possibility that the Fed may need to become more proactive in raising interest rates, as well as escalating US-China trade sanctions, which precipitated a renewed bout of turbulence in March.
In the Eurozone, the economic backdrop remained encouraging over the three months. GDP growth for Q4 2017 was confirmed at 0.6% quarter-on-quarter. Unemployment was stable at 8.6% in January 2018. However, forward-looking surveys painted a picture of slower future growth. The composite PMI hit a 14-month low in March, albeit the reading of 55.3 still implies solid growth. European Central Bank chairman Mario Draghi reiterated that interest rates would not rise until well past the end of the quantitative easing programme. On the political front, the key event of the quarter was Italy’s election, which yielded no overall winner. Germany formed a new government after its inconclusive elections in September 2017. Angela Merkel remains as chancellor after her centre-right CDU/CSU agreed another grand coalition with the centre-left SPD.
Emerging markets saw positive returns in the first quarter despite a rise in market volatility stemming from tensions over global trade. Brazil’s former president Luiz Inácio Lula da Silva saw his criminal conviction upheld, while in Russia the central bank cut interest rates and the country’s debt was upgraded to investment grade by ratings agency S&P. In China, macroeconomic data remained broadly stable, albeit there were ongoing signs of a gradual slowing in momentum, with official PMI easing to 50.3. By contrast, there was concern in India over reported fraud at a state -owned bank.
Global and local market review
Global equity markets declined in Q1 2018 with investors unnerved first by concerns about the path of US interest rate rises and then worries over trade. US equities began the year strongly, boosted by tax reforms, but ended the quarter lower amid concerns over inflation and the impact of US-China trade sanctions. Following a 10% correction from its January highs and rallying back 8% by early March, the S&P 500 Index suffered another 5% pullback in the last few weeks, ending the month of March down 2.5% and losing 0.8% over the last three months, which was the first negative quarter since the third quarter of 2015. Eurozone equities posted negative returns as worries over US rates and trade affected other markets. Italy’s election was inconclusive but had limited impact on the equity market.
Emerging market (EM) equities outperformed, delivering a positive return in US dollars. The MSCI EM Index was up +1.5% (total returns) in Q1 2018, ahead of the MSCI World (Developed Market) Index, which was down 1.2%, the first quarterly loss in two years. Over the last three months the FTSE/JSE All Share Index (ALSI) posted a total return of -6.0%. This has been its worst quarterly performance in eight years (Q2 2010: -8.2%). SA Industrials were the worst performer, returning -8.0% years (Q2 2010: -8.2%). SA Industrials were the worst performer, returning -8.0% (Naspers and Tiger Brands were both down 12%). SA Resources lost 3.8% (rising global uncertainty) and SA Financials lost 3.6%.
Of the equity sectors, the top first-quarter performance came from Non-life Insurance (+24.4%), Fixed Line Telecoms (+10.0%) and General Retailers (+9.2%). The worst performance came from Real Estate Development and Services (-31.2%), Software (-30.5%) and Household Goods (-29.0%).
Portfolio performance, attribution and strategy
After a stellar 2017, the S&P Quality South Africa Index experienced another strong quarter as investors continue to favour stocks with defensive characteristics. Despite largely pro-cyclical domestic sentiment (e.g. leadership optimism, declining risk of a credit rating downgrade, improving inflation outlook), global macro concerns have instead dominated mindshare and subsequently weighed on the local share market.
This environment continued to suit companies with strong balance sheets, clean earnings and high return to equity, as represented in our Quality basket. Furthermore, based on our analysis, the valuation gap between Quality and the market is still not pricing in the substantial historic premiums of a Quality strategy, and thus 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 such as Mr Price (MRP), Truworths (TRU), Standard Bank (SBK) and Clicks (CLS), as well as underweight positions such as Naspers (NPN), Resilient (RES) and NEPI Rockcastle (NRP). By not holding these stocks, the fund accreted substantial value relative to the Swix. On the other hand, the largest two detractors in Value came from overweight positions in Capitec (CPI) and Tiger Brands (TBS), as a speculative report from Viceroy and an outbreak of listeriosis respectively weighed on these counters. Other overweight detractors included Exxaro (EXX) and Kumba Iron Ore (KIO). There were no constituent changes to the S&P Quality South Africa 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.
We believe that the benchmark choice and resulting returns form the most important elements of an equity strategy - by investing in a passive vehicle the returns to investment strategies are known. By applying a full replication strategy there is no risk of deviation from the chosen benchmark.