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November 2018 Update

Making the News

Trade tensions between China and the US seemed to thaw in November, as a 90-day freeze on any further tariffs was agreed. This development was not missed by the currency markets and offered some relief to Emerging Market investors.

The uncertainty surrounding Brexit ratcheted up as concerns over whether UK Prime Minister could get the deal negotiated with the EU through British parliament. It now appears, that all options are still on the table at this late stage in a country still completely divided on the topic.

Governor of the US Federal Reserve, Jerome Powell softened his stance with regards to the pace of future interest rate hikes in the US, indicating that the US could be closer to neutral (or more normalised) interest rates.

Locally, the South African Reserve Bank (SARB) Governor Lesetja Kganyago hiked interest rates by 0.25% in November despite a benign inflationary environment and a weak domestic economy (third quarter GDP figures released on the 4th of December showed that the local economy grew by 2.2% q/q (SAAR).

Digesting the News

Both developments at the US Fed and the SARB were positive for the Rand. In terms of the domestic interest rate hike, the stronger GDP figures released in early December proved that Governor Kganyago’s decision was a shrewd (forward looking) move. In our view, the governor stopped South Africa from falling further behind the US in terms of hiking interest rates in the short-term, thus providing much needed credibility and support for the currency going forward.

The easing of trade tensions was also positive for South African assets, particularly those that benefit from the stronger Rand such as SA Bonds.

The stronger Rand was less positive for many of the Rand hedge shares on the JSE, which continue to struggle. 2018 is shaping up to be the worst calendar year (in terms of performance) for not only South African equities but many other equity markets globally since the great financial crisis a decade ago.

Higher interest rates in the US, concerns around trade wars and a very volatile domestic political environment have made for a toxic mix of lower risk appetite from global investors and sustained lower confidence from local businesses, consumers and investors. When this is combined with an above average number of momentum eroding stock specific issues (i.e. Steinhoff, EOH, MTN, Resilient, BAT, Aspen), it is not surprising that almost half of the top 40 shares on the JSE have lost more than 20% of their value over the last twelve months.

Importantly, the loss in value on the JSE over the last twelve months have not been supported by underlying fundamentals. In fact, earnings on the JSE have grown 8% over the last year. For a long-term valuation driven investor, the combination of falling prices and growing earnings are more often than not, an excellent long-term opportunity, as assets of reasonable quality (growing earnings) are getting cheaper.

Quick Tangent – What is No Longer Making The News

Less of a surprise to us is that Bitcoin and other cryptocurrencies are no longer in the headlines every day, as they were at the end of 2017. Bitcoin peaked above $19 500 in December 2017 and traded at $3 971 at the end of November 2018, a loss of approx. 80% ($3 410 at the time of writing -82.5% down from its peak).

We have never argued that the potential for both cryptocurrencies as well as the blockchain technology is huge, only that it was impossibly difficult to value these assets accurately (given that they did not produce any cash flow to investors) and that the run up in prices looked and felt very similar to previous bubbles (think Tulip Mania of the 1630’s).

In 2018, we have seen that bubble burst as most crypto currencies are down more than 90% in value, with Bitcoin itself down more than 82% – as mentioned above. Given the aforementioned difficulty in valuing these coins, it is likely that some if not most will struggle to recover any material portion of the losses suffered over the last year, leaving those speculators that entered the market near the peak, unlikely to (ever) break-even.

Markets in the Month

The Rand strengthened significantly against the three major hard currencies in November (more than 6% stronger against the USD, GBP and EUR) as the easing of trade tensions and more dovish comments from Fed governor Jerome Powell saw a rebound in the Rand and other Emerging Market currencies. The Rand remains 11.6% weaker against the USD in 2018 as the impact of higher interest rates in the US have left liquidity available for EM markets limited as risk appetite has subsided.

The recent improved sentiment towards EM (including SA) saw inflows into the local bond market, which finished the month up 3.9% despite the 0.25% interest rate hike (that is often negative for bond prices). Bonds are now the best performing major local asset class in 2018 (7.0%), moving ahead of cash (+6.5%) that delivered 0.6% in November.

SA Growth assets (Equity and Listed Property) had a poor November, pushing the YTD returns deeper into the red.

The results from SA Listed Property shares remains soft, as the weak local economy continues to drag SA facing companies lower. This is of particular concern for those with retail exposure given the concerns regarding Edcon (Edgars, Boardmans, CNA and JET) and their ever shrinking presence in major shopping centres. In addition, the underlying exposure to the UK that some SA Listed Property companies (Intu, Hammerson, Capco, Rebosis) hold have come under increasing pressure due to the uncertainty regarding Brexit.

The poor performance on the JSE in 2018 is so widespread it is impossible to single out any one driver for the weak returns. The major drivers of the weak returns in 2018 are:

  • Higher interest rates in the US coupled with trade war concerns (resulting in lower liquidity and therefore less demand for risky assets such as EM Equities) have hurt large EM stocks (Chinese in particular) such as Tencent and therefore Naspers.
  • Brexit uncertainty (Intu, Capco, etc.)
  • Stock Specific issues that could not have been predicted (i.e. Tiger Brands – Listeriosis, Resilient – Governance, Steinhoff – Governance, MTN – Nigerian Fines, BAT – US Menthol Ban etc.), as well as
  • A Weak local economy, tight local government finances, the drought in the Western Cape in early 2018, and poor performing foreign acquisitions that continue to be drag on locally listed companies.

These headwinds have left local investors with nowhere to hide in 2018. If one compares the performance across market caps (Top 40, Mid Cap and Small Cap), performance has been very similar with returns down between 12.5% to 13.9% in 2018. Comparing the JSE/FTSE Value and Growth indices shows that value has outperformed growth by 3.9% (-9.8% versus -13.7%) in 2018, which is to be expected in a market that saw P/E levels fall.

Impact on Our Portfolios

The weak returns from SA Equity and Listed Property coupled with the stronger Rand resulted in the CWM Income portfolio that invests mainly in SA Cash and short-dated bonds being the only positive performance in November (+0.5%).

The returns from the longer-term (more aggressive relative to CWM Income) local strategies were all weak (down between 1.9% and 4.0%) for the month. These portfolios were unable to shake off the impact of the negative performance from SA Equity and Listed Property, as well as the stronger Rand.

The Foreign Balanced and Equity Houseviews lost 6.2% and 5.7% (in Rands) respectively as the Rand strengthened by more than 6% against the three major hard currencies during the month, acting as a drag on performance when converted into Rands.

3 Year Returns (p.a.) CWM Local Model Portfolios / Foreign Strategies

Over the last three years SA Equity has delivered 2.9% p.a. (before any costs), while SA Listed Property has lost 2.9% p.a. (also pre-costs). This has significantly lowered the potential returns available to long-term investors (especially retirement investors given the limitations in place regarding foreign exposure within retirement products) over this period, and it shows in the absolute returns delivered by the more aggressive strategies we manage on behalf of clients.

While exposure to Global Equity would have helped improve the likelihood of receiving an above inflation return due to the 7.2% p.a. achieved by this asset class, investors who simply parked their funds in hard currencies like the US Dollar or Pound Sterling would have lost value as the Rand strengthened against both over the period (by 1.6% and 6.7% p.a. respectively).

As a consequence of the weak local growth asset markets over the last three years, returns from the local model portfolios have been modest in absolute terms. However, performance relative to the average fund in their respective peer groups has been strong, with all local model portfolios outperforming their respective peer group averages since their respective inceptions in 2012/13 (average outperformance of 1.2% p.a.). The relative performance is consistent over the last three years, with the average annual outperformance of 0.9% p.a. versus their respective peer groups (including CWM Defensive which was the only local strategy to lag [by 1.0% p.a.] its peer group over the period).

The chart below shows the performance of the local models versus their respective peer groups over the last three years and since their respective inceptions in 2012/13. The chart highlights that the low return environment over the last three years has reduced the performance from the model portfolios on average by 3.5% p.a., and the peer group averages by 3.2% p.a. The more aggressive strategies and peer groups have seen the biggest drop-off in returns over the last three years (versus returns since inception) driven by the very weak returns from SA Equity and Listed Property.

Looking Forward

After periods of sharp market movements up or down, it is easy to become overly focused on the past. However, managing client portfolios must be done looking forward. While a thorough understanding of history is critical in implementing a successful investment strategy, too much emphasis on what has happened (particularly in the recent past) may cloud one’s view of the future.

For us, looking forward is not about trying to predict what is going to happen, that is impossible and a futile way to spend one’s day. Rather we prefer to focus our energy on understanding the underlying fundamentals of an investment opportunity and then positioning a portfolio in a diversified manner, where the valuations suggest the best risk-adjusted returns could come from going forward.

As is the case with many valuation driven investment managers, this often results in some of the less loved investment ideas making their way into our portfolios. Managing our clients’ assets in this manner is not the best way to achieve success in the short-term, but rather ensures that the odds of success over the long-term are stacked in their favour.

The recent volatility in both local and foreign markets have resulted in some short-term losses, but in our view, have also unearthed some attractive long-term opportunities for those investors with the ability to withstand the short-term pain, and the patience to wait for the long-term benefits.

To all our clients across South Africa and farther afield, we hope you have a wonderful festive season and a prosperous new year. If you are travelling during the holidays please do so safely, and we look forward to seeing you in 2019.

October 2018 Update
December 2018 Update