Quarterly Review Q1 2019 – with Portfolio Metrix

Looking at returns for the first quarter, one might be fooled into thinking that the general state of the economy and corporate South Africa is healthy and growing; however, this is not the case. Globally risk assets, including South African equities, have rebounded sharply this quarter but this is somewhat at odds with local sentiment. Corporate results have not been flattering, we have experienced rolling blackouts, a hamstrung government, a poor budget and a weak currency. As investors, we can take some heart that SA equities have taken cues more from a supportive global backdrop and buoyant late cycle commodity prices.

Figure 1: A disconnect between investment performance and state of the economy

Source : Bloomberg 

 

For the quarter the best performing asset class was global property, followed by global equity. Thanks in large part to the translation of the weaker rand over the quarter, all the global returns once again provided some great diversification benefits to the SA investor. However, certainly not disgraced, the JSE All Share Index almost recovered all of its -8.5% loss over 2018, gaining a substantial 8% in Q1.

Our local bond market was helped to an extent by easing global financial conditions taking the pressure off the South African Reserve Bank (SARB) to maintain a tightening bias. This, together with relatively contained inflation and subdued domestic demand translated into a slightly more dovish Monetary Policy Committee (MPC) meeting on 28 March. This provided further support to local bond prices. Right at quarter-end, the delay of the Moody’s credit review until after the elections on 8 May was also beneficial.

Figure 2: Asset class returns

Figure 3: Risk assets shoot back to the top

Source : Bloomberg

Q1 MARKET DRIVERS

Investment returns were largely shaped by the following drivers over this first quarter:

• US interest rate normalisation changes path as central bankers turn dovish
• US-China trade tariff negotiations near resolution
• Late cycle rally in commodity prices
• SA specific drivers at sector and stock level
  • Sector rotation largely driven by the Federal Reserve (Fed), SA macro and the rand
  • Stock specific issues plague Aspen, EOH and Tongaat-Hulett, amongst others
• SA macroeconomic and political landscape remains unhelpful

1.     Central bankers change tack

In many ways, the weakness in the last quarter of 2018 set the stage for the recovery in this first quarter. Two key drivers of the risk-off sentiment late 2018 related to: (1) A steadfast Fed in its path of normalising US interest rates that saw it raise rates on 19 December and (2) No clarity in the US-Chinese trade dispute and the extent to which these tariffs would damage global growth.

However, early in January 2019, we began to see the Fed chairman take a far softer tone; the message from the Federal Open Markets Committee (FOMC) minutes early that month was that the Fed could afford to be “patient”. At the next FOMC meeting at the end of January, the market was told that the Fed no longer plans to raise interest rates in 2019. Some analysts even took this to indicate that the next move may be down. Nonetheless, the path of normalising interest rates has clearly changed tack and this boosted investor sentiment. US stocks posted their best quarterly return in 20 years while China is the world’s best performing market for the year to date. A pause in the US hiking cycle is seen as very positive for emerging markets in general.

Although all eyes have been focused on Fed policy, it has certainly not been the only central bank to provide a softer tone on interest rates and accommodative policy. Weak economic data out of Europe has also kept the European Central Bank dovish. The Chinese have taken significant action via a series of pro-growth measures to bolster slowing economic growth and mitigate US trade war pressures. This included liquidity injections through bank reserve requirement cuts, fiscal stimulus through huge tax cuts for individuals and businesses, and more infrastructure spending.

2.     US-China trade tariff negotiations near resolution

Following on from the 90-day temporary trade truce declared in early December 2018, trade negotiations have progressed without much detail being provided. Encouragingly, the 1 March deadline was extended with no concrete date set for a new deadline and all recent commentary from both sides has suggested that a deal will be forthcoming. US Treasury Secretary Steven Mnuchin has said this past week that the biggest obstacle to a trade deal – how to enforce a pact – was nearing settlement and that this deal would be the biggest change in the economic relationship between the countries in 40 years.

The progress of talks has also been a strong sentiment indicator as the uncertainty and extent of the damage of the tariffs is forecast to have a meaningful impact on the global economy. As we get closer to an apparent deal, global markets, and in particular Chinese stocks, have been buoyed by this optimism of closure to this trade war.

3.     Late cycle rally in commodities benefits emerging markets

Commodities enjoyed a second wind with the Fed’s dovish outlook for 2019 and its interest rate normalisation; history shows a strong negative correlation between interest rates and prices for commodities. Note in the table below the 2018 price weakness in key commodities when US rates were rising. Also review the strong surge seen in Q1 in these same commodity prices, particularly oil and iron ore – two commodities closely tied to the global economic cycle and global growth. History has also shown that commodities generally rally sharply late in the business cycle leading up to a recession. This is because key interest rates are usually lowered to stimulate economic activity.

Commodity prices are also largely dependent on global growth, particularly Chinese growth. With Chinese authorities providing a shot in the arm in terms of fiscal and other stimulatory measures, indications are that Chinese growth may not falter in the short term. This has a positive knock-on effect on those emerging markets rich in commodities like South Africa, Brazil and Russia.

Figure 4: Commodity prices and emerging market performance during different rate environments

Source : Bloomberg 

SA specific drivers at sector and stock level

Sector rotation largely driven by the Fed, SA macro and the rand

Figure 5: Super Sector’s performance and currency moves over the quarter

Source : Bloomberg 

Investors switch into resources

The strong performance of commodity prices in the quarter resulted in significant upside in our resource stocks, most of which topped both the sector and stock performance tables over the period. Furthermore, the weaker rand fuelled the export appeal of these companies (their rand-based costs and dollar-based sales translates into healthy profits). Given how leveraged these cyclical companies generally are, changes in commodity prices can very quickly lead to volatile share price moves and significant swings in the bottom line (multiplier effect). The large caps such as BHP Billiton and Anglo American both rose 22% in these three months while highly geared companies such as Lonmin, Implats and Kumba Iron Ore showed returns well in excess of 50%.

Large cap rand hedge industrials also favoured

Top JSE stock Naspers, now 20% of the JSE All Share Index and 25% of SWIX, surged a further 19% in the year to date. Other rand hedge industrial exporters were supported too; British American Tobacco staged a very impressive comeback from its lows in 2018, rallying 30%. AB Inbev ended the quarter +27%, Richemont +12%, Bid Corp +14% and Barloworld +13%.

Investors switch out of domestic names

March was a particularly bad month for financials, which includes the listed property stocks, as investors pulled money from the domestic names to buy resources and rand hedge industrials. In March alone, Absa lost 15.8%, Nedbank fell 11.7%, Discovery -10.6% and Sanlam -6.3%. Property stocks also felt the pinch with Delta down 30% while Fortress lost 16.9%.

For the quarter the domestic names that led the declines were mostly the retail stocks given their reliance on the ailing SA consumer and poor macroeconomic growth. This included Mr Price -23%, Massmart -22%, Nampak -19%, Truworths -18%, Dischem -16% and Shoprite -16%.

Figure 6: Q1 Best and worst sector performances

Source : Bloomberg 

Figure 7: Q1 total returns

Source : Bloomberg 

Stock specific issues plague Aspen, EOH and Tongaat-Hulett, amongst others

Aspen suffers

After Aspen’s December trading update and profit warning, investors continued to punish the once much-loved stock as it struggled to reduce its debt levels and reposition itself as an emerging market pharmaceutical company. The delays in the sale of its global infant milk business due to regulatory issues resulted in the stock losing 30% of its value in the quarter. The $830 million transaction is central to helping Aspen slash its worrying debt pile that includes a €1 billion loan that matures in May 2020 and a further €500 million facility that is due in May 2022. Aspen has said that it will look to exit some of its non-core European businesses to focus on selling hormones, anaesthetics and anti-retrovirals in emerging economies.

EOH is heavily punished -66%

IT service management company EOH’s shares continued to plummet this quarter after Microsoft terminated several contracts due to irregularities in tenders and corruption charges. This follows from last year’s disclosure that the company’s management had been implicated in several other irregularities, the suspension of all dividends and then further concern about the delay in the release of its financial statements that were due to be published at the end of March. The stock slumped 66% in the year to date.

Tongaat Hulett down 61%

Tongaat Hulett, the agriculture and agro-processing stock, also suffered heavy declines after announcing that it may need to restate previous financial results as “certain practices have come to light that may require remedial action”. Furthermore, as with Aspen, Tongaat allowed its debt burden to balloon at the same time as the country experienced a severe drought and government neglected to impose tariffs on certain imports.

Figure 8: Q1 best and worst stock performances

Source : Bloomberg 

SA macroeconomic and political landscape remains unhelpful

GDP shows a heart beat

The SA economy advanced 1.4% in Q4 2018 after emerging from the technical recession it faced earlier in the year. On the production side, growth was driven by the finance and transport sectors as well as government services. The construction, mining and agricultural sectors detracted from GDP growth last year. For the year, economic activity grew by 0.8%, which is certainly not supportive for corporate South Africa and growing earnings.

Figure 9: SA GDP growth and inflation

Inflation trending higher in 2019 but contained

Headline inflation remained tame largely due to the petrol price declines late December, although the benefit is likely to be short-lived given March’s increase in fuel prices. The February 2019 reading was 4.1%, slightly higher than the 4% recorded in January but down from the 5% levels in Q4. 

Current account deficit surprisingly narrows

The current account deficit narrowed to 2.2% of GDP in Q4 from a downwardly revised 3.7% deficit in Q3. The narrowing in the external balance was driven by the trade balance, which recorded a surplus of 1.4% of GDP, largely due to a 12.4% surge in exports and a 4.1% contraction in imports.

Figure 10: SA current account trade balance

Fiscal Policy fraught with risk

Fiscal policy is currently a hot topic as ratings agencies deciding on SA’s credit ratings take a very long hard look at the fiscal gap. The South African Revenue Service (SARS) recently announced a R15 billion shortfall for the 2018/2019 tax year as levels of compliance continue to decline and VAT refunds bite.

In the February budget speech, Finance Minister Tito Mboweni avoided raising income taxes after the Treasury hiked VAT in 2018 for the first time in 25 years, choosing instead to push up fuel levies and taxes on alcohol and tobacco products. The 2019 budget proposes large-scale expenditure reprioritisation and tax measures in an effort to reduce the budget deficit from 4.5% to 4% by 2022. However to accomplish many of these objectives, South Africa requires an uplift to GDP growth and employment. It is hard to see the upside just yet.

SARB leaves repo rate unchanged in Q1

At both meetings held over the quarter, the SARB left the repo rate unchanged in January and late March at 6.75% as expected. The MPC members were unanimous in their decision. Although the backdrop and underlying data could have afforded the committee the opportunity to start signalling the possibility of rate cuts, instead the governor reiterated that monetary policy will continue to focus on anchoring inflation expectations closer to the midpoint of the inflation target.

Headline inflation forecasts for 2019 and 2020 were unchanged, at 4.8% and 5.3%, while the 2021 forecast was revised lower to 4.7% from 4.8%. Forecasts for GDP growth were revised to 1.3%, 1.8% and 2.0% in 2019, 2020 and 2021, from 1.7%, 2.0% and 2.2% previously.

Following the March MPC announcement, the FRA curve (forward rate market) shifted lower and implies a 12% chance of a cut in the next nine months, despite the relative hawkish tone from the governor.

Headwinds aplenty

SA experienced its worst power blackouts in years this February and March as state utility Eskom struggled with repeated faults at its coal-fired power stations, along with low water levels at hydroelectric plants and diesel shortages. The cost of these blackouts is forecast in the billions of rand according to energy experts (approximately R14 billion in February and a further R16 billion+ in March). However a general erosion of confidence doesn’t help matters either and in March we witnessed business confidence fall to its lowest level since Ramaphosa’s appointment last year.

Figure 11: SA interest rates and inflation expectations

Figure 12: Rebounding global markets provide support in risk-on quarter

Source : Bloomberg

HEADLINES THAT SHAPED THE QUARTER:

  

SOUTH AFRICAN HEADLINES