30 Mar CHANGES IN THE FINANCE MINISTRY
Events of the past week will probably go down in the South African financial market history as our own internally induced financial crisis – on Wednesday President Jacob Zuma announced that he is replacing the Minister of Finance Nhlanhla Nene with the relatively unknown David van Rooyen, who was also subsequently replaced on Sunday by the ex-Minister of Finance Pravin Gordhan. These events sent our markets into a tailspin, with the currency depreciating to its worst evels falling 9% versus the U.S. Dollar, nominal bond yields rose around 1.5% and inflation-linked yields were higher by approximately 0.5%. Equity market’s reaction was somewhat mixed with all the rand hedge counters benefiting as a esult of the currency depreciation. The financial sector, in particular banks, was hammered by the change in sentiment in the stability of our financial markets. The latter (Minister Gordhan) announcement did settle the markets somewhat but they are still not back at the same levels pre redeployment of Minister Nene.
Impact on our Portfolios
Fixed Income Portfolios
The events at the Finance Ministry directly hit at what is important to debt investors – policy certainty on fiscal sustainability and accountability. These are normally priced into the level of yields so as to compensate investors for the perceived risk. Traditionally, this component of our local yields has been stable and consistent, i.e., our policy making institutions are lauded for the “developed world” like way in which they have long conducted monetary and fiscal policy. It is true that of late we have been slowly sliding towards the ill-named “junk” credit rating status, but this has principally been due to an incredibly poor hand that the current state of global affairs has dealt. The events of the last week have left fixed income investors floundering in a cocktail of disbelief, anger and defiance. They have had the very fixed income investment philosophy that has been applied consistently for so long shaken to the core. The risk premium referred to above has exploded, and indiscriminate “voting with their feet” has plunged the rand and bond yields into lows not modeled by even the most contrarian fixed income investor. These moves wiped billions of Rands off the local market cap of fixed income assets and were only moderated by the retracement seen once the decision had been reversed. Even with the reprieve, total returns across the fixed income board remain sharply negative for the month-to- date. We are facing a watershed moment as local fixed income investors – we are on the precipice of a fiscal cliff. It is during these uncertain times that our well established investment philosophy and portfolio construction process comes into its own. The focus on fundamental valuation, while taking into account risk and volatility allows for a diversified portfolio that is constructed to withstand dramatic episodes such as the one we have just been through. Our investment process generates alpha from various diverse sources which allows for a well-diversified portfolio that can withstand the impact of such volatility.
An objective assessment of the current state of affairs leads us to believe that credibility has been severely damaged, notwithstanding the reversal of the President’s decision. There are just too many unknowns for us to believe otherwise. We believe the risk premium in fixed income yields is set permanently higher, for now, and will only be reduced gradually as policy certainty is demonstrated. This likely means that fixed income markets will remain volatile, with yields at higher levels than previously expected. This impacts our appetite to run material risk positions in the portfolio and by choice we head into year-end marginally overweight in nominal bond funds and underweight in inflation-linked funds. This reflects our relative return expectation between the two asset classes.
The overall impact on the domestic equity market ranged from negative 7% for the All Share Index to almost 10% for the SWIX and SWIX 40 indices. Within those indices, Financials (Banks/Insurance and Property) stocks bore the brunt of the selloff, dropping as much as 25% before some recovery on Monday 14 th December. The index was pulled up by stocks that benefit from a weaker currency and by some of the big industrial stocks. Our equity portfolio positioning has a bias towards rand hedge stocks which served as an advantage during the Rand sell off, but the overweight in FirstRand and Standard Bank did hurt the portfolio. The sell-off was not all bad as we took
advantage of the lower prices in rate sensitive domestic retail stocks. We are still positive on both our banks position from a valuation perspective. From a portfolio performance point of view, the behavior of our domestic equity funds did not surprise us, registering alpha in the range of – 1% to + 1%. The portfolio is sufficiently diversified with independent alpha drivers to withstand such market turmoil. We remain comfortably ahead of benchmarks on a medium to long term basis, with an average alpha of 5% on a 1 year view. This is in line with our investment philosophy, which focuses on generating consistent risk adjusted performance over a full market cycle. We continue to place emphasis on active investing based on equity selection and a portfolio construction process that places emphasis on risk budgeting.
Multi-Asset Class Portfolios
We have been underweight domestic equities and property, with no holding in the inflation linked bonds (after being underweight for most of the year). We used the opportunity presented by higher bond yields to close our underweight in domestic bonds to a neutral position post the ratings downgrade but before the massive sell off of last week. We remain fully invested offshore to the maximum allowable limit, and are comfortable in our macro views and valuations.
Africa ex-SA Portfolios
African markets and our portfolios (both fixed income and equity) were largely sheltered by the events that unfolded, as they benefited from the effects of a weaker rand and alpha within the local markets. While 2015 has proven to be a challenging year for Africa ex-SA asset classes, our underlying investment case of diversification and favourable valuations (in the case of equity) and yields (in the case of fixed income) remain intact. We remain of the opinion that an investment into African markets offers South African investors a compelling diversification opportunity. This view was strongly supported by the events of the last week, with SA bonds, equity and property asset classes reacting in unison to the developments in the Finance Ministry. The MSCI Africa ex-SA equity index was up 9.4% in ZAR month to date while the Standard Bank Africa ex-SA Fixed Income index was up 5.6% over a similar period. Both our equity and fixed income portfolios delivered positive alpha relative to the respective indices mentioned here.