e-piphanyn-e-fg.com/downloads/blogs/e-phiphany-vol-3-2016.pdf · erik du preez quarter ending...

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0861 409 409 | www.n-e-fg.com | [email protected]

INTRODUCTION

Erik Du Preez

Managing Director of N-e-FG Fund Management Group Executive Member B.Com Hons. (Econ)

MARKET SUMMARY

SS

This year there has been no rest from the pounding waves of volatility for South African investors. In the third quarter we have

seen a momentous showdown in the local elections, the continued political tug-of-war between top leadership, and social

unrest threatening our higher education system. Globally, the American presidential race is causing uncertainty and Europe is

still trying to stabilise itself in the midst of problems like Brexit, a troublesome debt market, and elusive growth. However, if we

look through the noise of sensation-centred headlines, we see rays of light rising over the South African economy.

In this edition of the e-Piphany, we start off with our usual walk through the major asset classes and how we see things

unfolding from here. Ruan investigates economic cycles in South Africa in order to gain an advantage in investing. Anton then

looks at how the South African Reserve Bank is juggling interest rates and inflation to stabilise the economy. Finally, Gerbrand

unpacks the pleasing performance of our portfolios for the past three months.

For the patient investor, the economic tide might turn sooner than many expect!

Enjoy the read.

Erik du Preez

Quarter ending Friday 30 September 2016

Index total returns as at 30 September 2016

Index Close YTD 3-month 6-month 1-year 2-year 3-year 5-year

FTSE/JSE All Share 51 950 4.9% 0.6% 1.0% 6.7% 12.1% 29.7% 105.4%

FTSE/JSE Resources 18 358 34.9% 8.1% 3.7% 9.7% -30.6% -24.8% -17.2%

FTSE/JSE Financials 40 419 2.5% 0.8% -3.5% -0.9% 18.1% 45.2% 143.1%

FTSE/JSE Industrials 46 167 15.5% 2.2% 7.4% 10.6% 8.8% 17.6% 100.5%

FTSE/JSE SA Listed Prop 631 8.8% -0.7% -1.1% 3.8% 30.4% 49.7% 126.0%

FTSE/JSE Mid-Caps 76 945 26.1% 4.0% 6.0% 23.3% 27.3% 47.9% 122.3%

FTSE/JSE Small Caps 62 016 20.3% 5.5% 8.0% 15.0% 23.3% 44.7% 142.0%

DJIA 18 308 5.1% 2.1% 3.5% 12.4% 7.4% 21.0% 67.8%

S&P 500 2 168 7.8% 3.9% 6.4% 15.4% 14.7% 37.3% 113.4%

NASDAQ 5 312 7.2% 10.0% 9.8% 16.5% 21.4% 46.5% 135.4%

FTSE 100 6 899 14.2% 7.1% 14.1% 18.5% 12.4% 19.2% 62.0%

Paris CAC 40 4 448 -0.8% 5.2% 4.5% 3.6% 7.9% 18.6% 78.5%

Frankfurt DAX 10 511 -2.2% 8.6% 5.5% 8.8% 10.9% 22.3% 91.0%

Nikkei 225 16 450 -12.1% 6.3% -1.0% -3.7% 5.4% 19.9% 107.1%

MSCI World Index $ 1 726 6.1% 5.0% 6.3% 12.0% 7.0% 20.7% 78.7%

MSCI Emerging Market $ 903 16.3% 9.2% 10.0% 17.2% -5.1% -0.7% 18.1%

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Commodity returns as at 30 September 2016

Currency appreciation as at 30 September 2016

Currencies Close YTD 3-month 6-month 1-year 2-year 3-year 5-year

ZAR/USD R 13.72 11.3% 6.8% 7.1% 1.0% -21.6% -36.8% -69.5%

ZAR/GBP R 17.80 21.9% 9.2% 16.0% 15.1% 2.7% -9.7% -41.1%

ZAR/EUR R 15.43 8.3% 5.5% 8.1% 0.3% -8.3% -13.8% -42.4%

USD/EUR $ 1.12 -3.4% -1.2% 1.3% -0.5% 11.1% 16.9% 16.1%

USD/JPY $ 0.01 -18.7% -1.8% -11.1% -18.3% -8.2% 3.1% 24.0%

USD/GBP $ 1.30 12.0% 2.5% 9.7% 14.3% 20.0% 19.9% 16.8%

Commodity Close YTD 3-month 6-month 1-year 2-year 3-year 5-year

Oil Brent Crude Spot $ 50.19 13.0% -1.7% 16.2% -9.1% 47.7% -45.7% -43.0%

Gold $ 1 315.87 24.0% -0.5% 6.7% 18.0% -8.9% -1.0% -19.0%

Platinum $ 1 027.35 15.2% 0.3% 5.3% 13.2% 21.0% -26.8% -32.6%

Silver $ 19.17 38.5% 2.5% 24.2% 32.0% -13.0% -11.6% -35.9%

Aluminum $ 1 673.00 11.0% 1.5% 10.1% 6.1% 14.6% -9.3% -22.4%

Copper $ 4 865.00 3.4% 0.4% 0.4% -5.7% 27.0% -33.4% -30.7%

Corn $ 336.75 -6.1% -6.1% -4.2% -13.2% -5.0% -23.7% -43.2%

Sugar $ 22.53 47.8% 11.8% 46.8% 85.1% -45.5% 28.9% -14.5%

Iron Ore $ 57.77 33.1% 7.8% 8.6% 1.0% 28.5% -56.2% -57.4%

Economic indicators as at 30 September 2016

Repo Rate 7.00% South African 10-year Bond 8.66%

Prime Rate 10.50% US 10-year Treasury Bond 1.60%

PPI Inflation 7.20% US Fed Fund Rate 0.40%

CPI Inflation 5.90% Euro Area REFI 0.00%

Funds returns as at 30 September 2016

Funds YTD 3-month 6-month 1-year 2-year 3-year 5-year

Stable Portfolio 5.14% 1.99% 2.75% 9.37% 15.73% 26.41% 62.77%

Multi Asset Low Equity 4.07% 0.91% 2.31% 6.94% 14.64% 24.88% 59.40%

Benchmark: CPI + 3% 6.83% 2.18% 4.45% 8.90% 17.37% 27.92% 51.44%

Moderate Portfolio 7.19% 2.51% 2.80% 10.47% 14.17% 27.32% 80.90%

Multi Asset Medium Equity 3.30% 0.66% 1.54% 6.47% 13.69% 25.96% 69.58%

Benchmark: CPI + 5% 8.30% 2.65% 5.40% 10.91% 21.75% 35.13% 65.92%

Aggressive Portfolio 14.28% 4.67% 4.85% 10.69% 7.79% 22.25% 98.77%

SA - Equity - General 5.65% 0.59% 1.07% 6.62% 9.71% 25.20% 87.60%

Benchmark: CPI + 7% 9.76% 3.11% 6.35% 12.91% 26.21% 42.60% 81.48%

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Compound Annual Growth Rate of Portfolios since Inception**

0

100

200

300

400

500

600

700

800

900

1000

1100

Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15

N-e-FG Model Portfolio Performances (March 2003=100)

CPI +5% N-e-FG Stable Portfolio N-e-FG Moderate Portfolio N-e-FG Aggressive Portfolio

14.6% CAGR*

12.3% CAGR*

* CAGR: compounded annual growth rate since inception.

18.6% CAGR*

**The Aggressive, Moderate and Stable Portfolios were back-tested with the relevant holdings data where applicable, but some of the data contained in this fact sheet is an approximation of the past. The proxy

data expires on 31 July 2005, thereafter the actual Aggressive, Moderate and Stable data were used. The proxy has a very high correlation to the actual manager performances.

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POSITIONING AND VIEWS ON ASSET CLASSES FOR THE 3RD QUARTER OF 2016

INFLATION CURRENCY INTEREST RATES

Inflation is expected to remain inside the

SARB target band but will remain on the

high-end of the band for the foreseeable

future. There remains considerable

upward pressure on inflation. Apart from

the depreciation of the Rand, the impact

of negative base effects pose upside

risks to inflation. These negative base

effects are higher food prices due to

drought (maize prices doubled in 2015

and sustained culling will lead to meat

shortages), increases in electricity

prices and other administrated prices

(such as water etc.).

With political sentiment at its lowest in

years the currency remains vulnerable to

these external shocks. We still caution

that the local fundamentals for the

currency remain bleak. So we don’t

anticipate a substantial improvement

from current levels over the short-term.

However, the Rand remains extremely

oversold in relation to its long-term

purchasing power parity valuations, and

should we see better economic data

coupled with less noise on the political

front, the Rand could surprise most

investors.

There remains considerable upward

pressure on inflation. Combined with the

weak domestic economy, these

pressures are creating a stagflationary

environment, leaving the SARB in an

extremely difficult position. We believe

the rate hiking cycle is over but don’t

expect any sudden cutting to emerge

soon. A political shock might cause

another small hike, but we are not

pricing this in at the moment.

CASH BONDS PROPERTY

With the interest rate hiking cycle in full

swing, current cash returns look enticing

in both absolute terms and relative

terms. A risk free rate of return of more

than 7% per annum is still better than

inflation and provides more breathing

space for income focused investors like

pensioners. Cash is also attractive in

relative risk-adjusted terms against the

low returns expected from the other

domestic asset classes. Cash is always

King in volatile times!

SA bond valuations have improved after

the recent sell-off. However, the

fundamental risks posed by possible

higher global yields against the

backdrop of improving global economies

and tighter US monetary policy, together

with rising domestic inflation and higher

local policy rates, remain. The high

probability of a credit rating downgrade

to “junk” could still cause increased

volatility in the short term. We trade this

sector actively in these volatile times.

For the first time in years we find local

quality counters trading at attractive

levels. These levels offer an attractive

entry point over the medium to longer

term, potentially presenting investors

with double-digit returns over the next

three to five years. We foresee positive

dividend growth (above inflation)

despite the weaker economic

environment. However, investors should

focus on the income offered by listed

property, and view capital appreciation

as a bonus.

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LOCAL EQUITIES (OVERALL) INDUSTRIALS FINANCIALS

South African equities are expensive

relative to historical levels. Furthermore,

the seeming disconnect between a

weak domestic growth environment and

strong SA equity market performance

can be attributed to the rapidly

expanding contribution of foreign

generated profits to the earnings base of

the overall SA equity market. We are

avoiding this toxic triple cocktail: High

earnings, high valuation, high foreign

ownership. The banking and retail

sectors currently provide good buying

opportunities currently.

Industrial shares have had a very volatile

year due to poor SA economic

conditions. Higher inflation has

increased the pressure on the revenue

and earnings of consumer discretionary

stocks, and share prices have

depreciated accordingly over this year.

In this volatile environment, even

defensive stocks seem expensive. The

current price tag for defensive equities

is way too lofty for our liking.

The Financials Index has been heavily

punished by the rising interest rate cycle

of late. We believe that the market is

pricing in too bleak a picture for the

sector, and for this reason we see some

of the best valuations unfolding here. SA

banks are trading at a discount. Insurers

like Old Mutual present attractive

valuations, coupled with an unbundling

process likely to unlock more value for

shareholders.

RESOURCES GLOBAL EQUITIES GLOBAL BONDS

Commodity prices are unsustainably

low, but with a global slowdown driven

by China, prevailing prices could remain

lower for longer. Despite the uncertainty

in the resource sector, we are finding

compelling value in some of these

companies. Mining shares have been

under pressure and are currently trading

below our assessment of normalised

levels. As suppliers cut back their

output, we expect commodity prices to

revert to normal. Platinum and global

diversified miners currently provide the

best opportunities.

Global equities should continue to be

underpinned by abundant liquidity, with

on-going quantitative easing in Europe

and Japan which is supportive of a

further rerating of these equity markets

from their continued undervalued levels.

Furthermore, more capital returns to

shareholders in the form of dividends

and share buybacks and reasonable

valuations should underpin global equity

returns. We see more opportunities in

emerging markets than in first world

countries, but a somewhat weaker US

Dollar could spell opportunities in US

equities.

From a starting point of view expensive

historical valuations, global bond

returns are fundamentally at risk from

dissipating deflationary risks amid

recovering global economies and

continued tightening of US monetary

policy this year. We see this asset class

as the most risky one at current

valuations.

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Ruan Yacumakis

Senior Investment Analyst M.Sc. Business Mathematics and Informatics Passed level III of the CFA Program in 2016

ECONOMIC ANALYSIS

How to benefit from economic cycles

Anyone paying attention to the news would have heard words like GDP growth rate, unemployment rate, and recession, but what

do these terms really mean? More importantly, how can a person invest to benefit from these ups and downs? In this insert we

will explore different aspects of the economic cycle, and how one can invest in the stock market to profit from every swing.

Although no-one can predict the future with perfect accuracy, we can assess the economic environment and hold investments

with the most potential to flourish from the current point in the business cycle.

What is a business cycle?

Economists have been tracking the ups and downs of economic activity for a long time now. A man named Wesley Mitchel first

defined a business or economic cycle in 1927, and these are the most important elements of his definition:

Business cycles are fluctuations (or variations) in the total amount of economic activity in a country or region.

A cycle is formed when increases occur in many economic activities at the same time, followed by similarly broad decreases.

The former phase is called an economic upturn, while the latter is called a recession.

These cycles occur repeatedly throughout time, but they are not equal in intensity and length. Cycles can last from one year

to twelve years.

Although economic growth can wobble a little during an up or down swing due to external shocks, the business cycle refers

to the big-picture movements of the most important economic indicators.

The four main areas of economic activity that are used to measure economic cycles in a country or region are: gross domestic

production (GDP), employment (as a % of the population), income (total salaries paid), and sales (or spending).

The following graph traces the economic cycles experienced in South Africa, and we will now discuss it in more detail.

-40%

0%

40%

80%

-4%

0%

4%

8%

'96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17

Real GDP growth vs ALSI return (1 year)

Rising interest rates Falling interest rates Real 1 year GDP Growth (left axis) JSE ALSI 1year Total Return (right axis)

Country South Africa

Latest 1-year real GDP growth rate 0.6%

Latest 1-year employment growth rate 0.3%

Economic leading indicator growth -1.2%

Estimated point in the business cycle Mid-late recession

Estimated point in the equity market cycle Late bear

Economic numbers reported in the media can be confusing

and overwhelming to investors. The important question

remains: “Will my investments be safe, and hopefully

grow?!” Here we consider how to monitor the ups and downs

of the economic cycle and invest to profit during each phase.

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The dark blue line on the left axis tracks the most popular number used in measuring business cycles, namely the real 1-year GDP

growth rate. It effectively measures the percentage increase in the goods and services produced within the borders of a country

during a year, adjusted to remove the effects of inflation. As mentioned above, 3 other indicators of the business cycle are also

used (employment growth, income growth and spending growth), but we will focus on the GDP growth rate since the other factors

mostly move in tandem with GDP. Notice that South Africa’s GDP growth mostly fluctuated between 0% and 5% for the past 20

years, with the exception of a very high growth period in 2006 followed by negative growth during the Great Recession in

2008/2009. The ups and downs of the business cycle are clear to see throughout the entire period. Also notice how the periods

from late recession to early upswing usually coincide with falling interest rates, and vice versa. A more detailed discussion on

interest rates can be found in the Quarterly Graph section of this publication.

The reasons behind these fluctuations are quite complex, but the core cause is the over and under-extension of the 4 factors

mentioned above. For example, in a recession, people are fired (less employment), leading to less income and therefore less

spending, and ultimately companies respond by producing less products and services (GDP growth falls). These recessions can

spread like wildfire between sectors and regions, and even across the globe in today’s environment of international trade.

Economic upturns or recoveries occur in a similar way: At some point people start buying more goods and services, and industries

have to produce more, which leads to more people being hired, which in turn increases income. These 4 economic factors feed

on each other to create a snowball effect, and this motion is what drives the business cycle.

Cycles and the stock market

The tan line in the above chart tracks the 1-year return of the JSE All Share Index (ALSI), with values shown on the right axis.

These returns fluctuated between minus 30% and plus 50% for the past 20 years. Notice that the stock market looks 6 to 18

months into the future to anticipate what the business cycle will do, and the two therefore move in step with one another. Let’s

consider this phenomenon in a bit more detail.

The picture shown below is a theoretical representation of the stock market cycle and economic cycle shown together. Notice

where the first interest rate cut and first interest rate hike appears in each cycle. The first cut usually occurs just after the stock

market bottoms out and just before the economy’s trough (or low point). Similarly, the first interest rate hike usually occurs just

after the stock market top and before the economic peak. After carefully identifying these points in the first chart, we notice that

the first interest rate hike in the current cycle happened two and a half years ago. The economy has been in a recession for a

while now, and at the moment we await the first interest rate cut. This will coincide with an upward movement in the stock

market, and economic growth will likely recover into an upswing phase as well. So in summary, it seems that we are nearing the

end of a recession in the economy and a bear market on the

JSE. Note, however, that it is very difficult to identify the

exact point in the cycle since there are so many moving parts

in the process, and the intensity and length of cycles differ

each time around.

In conclusion, the numbers shown in this chart (1 to 12)

indicate which business sectors in the economy are best

positioned in each phase of the cycle. These are the

companies you want to hold at these points, since their stock

prices are usually depressed due to the nature of their

business but they will benefit the most in the upcoming phase

of the cycle. In the current Late Bear phase of the stock

market cycle, we find Utilities [10], Financials [4] and

Consumer cyclicals [2]. Looking ahead, Technology [5] and

Capital goods [7] companies will also come into play as soon

as the first interest rate cut occurs. The conclusion is that

there are opportunities in every phase of the stock market and

economy. We constantly aim to position our client portfolios

to profit under all circumstances.

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Anton van Niekerk

Investment Analyst B.Com Hons (Financial Risk Management) Passed level II of the CFA Program in 2016

QUARTERLY GRAPH

Interest rate hikes and inflation explained

In the graph above the solid line represents South African inflation. Inflation can be described as the rate at which the general

level of prices for goods and services is rising. Two of the most common ways to measure inflation is by using either the consumer

price index (CPI) or the producer price index (PPI). In the graph we used CPI as a measure of inflation as it measures price changes

from the perspective of the purchaser and not from the perspective of the seller as with PPI.

The dotted line in the graph represents the repo rate which is the rate at which the South African Reserve Bank (SARB) lends

money to commercial banks. This repo rate influences our pockets on a day to day basis through its influence on the prime rate

(rate charged to the banks most credit worthy customers). The prime rate is usually determined as the repo rate with an added

premium for credit risk and is used in calculating home and car loan calculations.

If the SARB increases the repo rate it leads to increased interest on virtually all loans and deposits made. This would make the

average South African save more as interest earned on savings would increase and spend less as debt becomes more expensive

to finance. Decreased spending by consumers will lead to producers decreasing prices such that demand will increase. This

eventually leads to lower prices and thus lower inflation (CPI).

Next, suppose the SARB decreases the repo rate leading to lower interest on virtually all loans and deposits. The average South

African would save less as interest earned on saving would decrease and spend more as debt financing becomes less expensive.

Increased spending by consumers lead to producers increasing prices as demand may outweigh supply. Eventually prices go up

and thus inflation rises.

Now that we know the effects of an increase or decrease in the repo rate by the SARB we can analyse the graph above. The

SARB set its target band for inflation in 2002 at between 3% and 6% as seen by the dotted lines in the graph above. Whenever

the SARB expects inflation to rise (fall) above (below) the target band the repo rate is increased (decreased) such that inflation is

maintained within the target band. The SARB is always trying to adjust the repo rate on expected inflation.

South Africa has been in a rising interest rate environment since the first repo rate hike in January 2014. The repo rate has been

adjusted upward from 5% to its current 7% to mitigate inflation. Since the start of 2016 inflation has been decreasing toward the

SARB’s target band and with the SARB Governor indicating that we might be near the end of the repo rate hiking cycle we could

see an end to increasing debt repayments.

Over the past two years we have seen

interest rates increase at a steady pace.

It seems this rate hiking cycle is nearing

its end when considering latest inflation

figures. Interest rates and inflation is

explained below along with how the

South African Reserve Bank uses

interest rates to move inflation to the

stated target band. 0%

3%

6%

9%

12%

15%

'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17

Rising interest rates Falling interest rates CPI Inflation Inflation Target Bands Repo Rate

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DISLCLAIMER

Collective Investment Schemes (CIS) or Unit Trusts are generally medium to long-term investments. The value of participatory interests may go down as well as up and past

performance is not necessarily a guide to future performance. Collective Investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments

are calculated on a net asset value basis, which is the total value of all assets in the portfolio including any income accrual and less any permissible deductions from the portfolio.

Portfolio performance is calculated on a NAV to NAV basis and does not take any initial fees into account. Income is reinvested on the ex-dividend date. Total return performances

are published. The source is FactSet, Bloomberg and MoneyMate. Actual investments performance will differ based on the initial fees applicable, the actual investment date and

the date reinvestment of income. A schedule of fees and charges and maximum commissions is available from the manager / scheme. Commission and incentives may be paid and

if so, would be included in the overall costs. Forward pricing is used. The following charges are levied against the portfolio: Brokerage, auditor’s fees, bank charges and trustee fees.

Commissions and incentives may be paid and if so, are included in the overall costs. A schedule of fees and charges and maximum commissions is available on request from N-e-FG

Fund Management. Forward pricing is used.

N-e-FG Fund Management is a member of the Association for Savings and investment South Africa (ASISA).

Please note: Past Performances is not a good indication to future performances.

Gerbrand Smit

Chief Investment Officer BBA, MBA

MANAGER COMMENTS

What has kept us awake over the last quarter? Surely the Brexit aftermath and the plunging Pound comes to mind. The liquidity

of European banks especially in Italy and most certainly the weakening of the Chinese currency. Not to mention the all-important

US presidential showdown taking place. Locally, the ANC infighting between our president and finance minister continues to

steal the ever present media headlines.

Our responsibility as custodians of client’s wealth is to cut out the noise and focus on long term asset class and company specifics

predominantly in order to outperform certain benchmarks and achieve specific goals for our clients.

If we delve into the numbers for the quarter it is surprisingly positive for the funds. Over the quarter the N-e-FG Aggressive

Portfolio, N-e-FG Moderate Portfolio and the N-e-FG Stable Portfolio all performed satisfactorily. They returned 4.67%, 2.51% and

1.99% respectively thus, the latest 12 month rolling figures are almost returning to normality. Over the last 12 months the figures

are as follows, N-e-FG Aggressive Portfolio returned 10.69%, N-e-FG Moderate Portfolio Returned 10.47% and the N-e-FG Stable

Portfolio returned 9.37%.

Closer to home our own funds within the portfolios also enjoyed a decent quarter. N-e-FG BCI Equity Fund, N-e-FG BCI Flexible

Fund and N-e-FG BCI Income Provider Fund returned 5.54%, 4.14% and 3.14% respectively. The last twelve month rolling figures

also getting back to normality with the funds in the same order returning 11.36%, 11.15% and 7.44%.

In our own funds for the quarter we gained some government bond exposure at attractive rates and during the end of August

these bonds rerated. We then sold out of our position at the end of September. We sold our local property exposure during

September and after local property retracted we increased exposure at a lower prices.

On the equity side we completely sold out of our RMI exposure in August. This is because RMI was trading at a premium when

compared to its sum of the parts (SOTP) valuation. We also lightened up on our exposure in Anglo Platinum. Consumer stocks

came under pressure with Mr Price’s dismal trading update. All retailers were treated similarly and value is starting to emerge in

the sector selectively. Thus, we have bought Foschini, Truworths, Woolworths and Spur shares. We are also of the view that the

recent rise in interest rates should be close to an end which should bode well for local SA Inc. stocks in the not too distant future.

We still hold well diversified and well-priced assets in our funds and are of the opinion that our funds will be able to deliver the

required returns as set by our benchmarks over the timeframes.

e-piphanyn-e-fg.com/downloads/blogs/e-phiphany-vol-3-2016.pdf · erik du preez quarter ending...

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