FUND PERFORMANCE SUMMARY – Q3 2018
Battling the macro
It’s quite clear that the abounding uncertainty we bore witness to last quarter hasn’t yet subsided. Risk assets, bar US equity, have in general performed poorly again in Q3.
We’ve been at pains to point out this anomaly; global growth measures suggest we’re at a stage in the economic cycle where riskier assets, like those in emerging markets (EM), tend to revel. But a strong USD is extremely problematic for EM investors, even if global growth fundamentals are simultaneously solid.
Chart 1 talks to this reality, showing us that when the USD strengthens against the euro (indicated by a downward sloping red line), emerging market equity underperforms relative to world equity (indicated by a downward sloping blue line). The latter index is dominated by US equity.
We think the red line above should be moving upwards, the USD depreciating against the euro. The stage of the economic cycle is in favour of a weak dollar, AND it’s also an overvalued currency on a purchasing power parity (PPP) basis, a chart we’ve rehashed too many times to put up again!
Countering these fundamentals, we have nervous investors – shaken by escalating trade wars, a crisis in Italy, Russian sanctions, a Turkish dictatorship, et al. – and US economic growth that is streets ahead of its first world contemporaries. The latter dynamic is more measurable and can be illustrated by Chart 2.
The red line is the yield differential between the German 10-year bund and the US 10-year Treasury; reading off the left axis, the US bond currently offers 2.7% more than the German equivalent. The gap between these two bond yields has been widening for a decade because growth has supposedly been better in the US, which means it can raise interest rates, which in turn pushes up their 10-year Treasury yield.
The German economy is likely strong enough on its own to raise interest rates, but it is hamstrung by the complexities of having multiple economies, each with their own growth profiles, tied to the Single Currency.
Overlaid in blue is the USD/EUR. The relationship is not perfect, but the case can be made that the yield differential (red line) is exerting a gravitational pull on the exchange rate in favour of the US dollar (downward sloping blue line signals USD strength against the euro); this mechanism is otherwise known as the ‘carry trade,’ where a higher relative yield attracts investors and leads to currency appreciation.
How does this relationship impact emerging market assets? The euro is a bellwether for EM currencies; when it weakens against the USD, it normally drags the rand, rouble, lira, real, and the like, with it. There is evidence of this in Chart 3. The historical drivers of the Brazilian real – a basket of commodities it exports – have trended higher since 2016, the trajectory still being upward. Yet the Brazilian real has dislocated from the performance of those commodities, arguably to an extent not seen in recent history.
Counter-cyclical macro like this one have caused us considerable angst. A prerequisite for the investments we make is that the environment in which they operate must be supportive. Our view of that environment (namely a weaker USD) has not materialised through 2018 and has therefore impacted the risk associated with our positioning.
But we’re sticking to our guns
The reality of managing money is that the market will move against your positioning from time to time, despite you standing on your head. If you chase its gyrations, instead of nailing your colours to the mast, you risk destroying value.
We have chosen to hold our view that global growth is still above trend, that the USD will be a weaker currency, and that cyclical assets will show performance leadership.
As a result, our portfolios continue to hold only a sprinkling of US dollar assets. Instead, our offshore exposure is dominated by a spread of EM equity (which we increased into recent weakness) and EM local government bonds. We also own a decent chunk of SA government bonds. And we have material equity positions in select SA Inc. and resource counters. We also ramped up our long rand position using currency futures after it sold off. Sitting on the fence we are not.
The next two charts provide the necessary valuation support for some of our holdings mentioned above. Chart 4 is a PPP analysis of the rand, showing that, at current levels, it is the 4th most undervalued against the USD during the 30-year period in question.
Of course, the rand can weaken further from here. But we are big proponents of mean reversion and at the current valuation, we feel more comfortable making investments that’ll be beneficiaries of a stronger rand, not a weaker one. The same goes for other EM currencies. This gives us poise when the alluring performance of US equity enters the fray – if the rand strengthens, US equity may perform poorly (in rands).
There are also better equity valuations in our domestic market compared to the S&P 500. Chart 5 plots the dividend yield of the US market over that of Standard Bank. During the sample period, Standard Bank has historically offered 50% more yield (i.e. 50% more dividends) than the S&P 500. That has now moved to 65% more, taking us back to the dark days of 2015 where EM assets had pariah status.
One of the changes we did make during the last quarter was to sell out some domestic equity that had both questionable earnings prospects and average to expensive valuations. Where did the proceeds go? The previous chart precludes us from switching into US equity. Instead, the funds were largely used to increase our SA government bond holding. Domestic shares that we deemed particularly expensive, that also had questionable earnings prospects, were shorted in our hedge funds.
The general lack of earnings is a serious problem for our domestically exposed businesses. Chart 6 is another reminder that the SA economy is not functioning at a level that allows for big listed corporates to generate satisfactory earnings growth. Real credit growth (in blue) is pitted against the earnings of our domestic banks (in red).
One of our core beliefs is that you only invest in equity when there are earnings tailwinds, so switching into bonds – where there is no earnings risk and a punchy yield – is something we may do more of going forward, assuming the rand doesn’t blow of course!
Stock selection to the rescue
With the macroeconomic variables again moving against us in Q3 2018, we draw small consolation from the marginally positive returns in our long-only funds and the slightly better result from our hedge funds. Our stock selection can take most of the credit for this upshot.
From an offshore perspective, our Mexican equities chipped in nicely as the peso strengthened some 22% against the USD during the quarter. Similarly, Banco Itau in Brazil rebounded from its precipitous sell-off in the previous quarter. We believe there is more runway for these EM equity counters.
Domestically, Amplats and Sasol (both in our Top 10) made an impact, while a timely switch from Standard Bank into Old Mutual added value; this trade is worth expanding on to get a feel for our selling discipline.
Standard Bank occupied one of the top three equity spots in our portfolios from early 2016. But toward the end of Q2 this year there were signs that their future profitability (the most important valuation variable in our stock selection process) would come under pressure.
In addition, SBK’s dividend yield (dotted blue line in Chart 7) was hovering around the 4% mark, which is about average. We also use the dividends they pay (solid red line) to estimate a fair value for the share. The actual share price (black line) was, at the time, near fair value. Those of you familiar with Obsidian will know our investment mantra: Marry valuation with the cycle. Without valuation support, we decided to sell Standard Bank to zero. Since then it has de-rated significantly.
However, after the rather violent moves we’ve seen recently, Standard Bank again looks interesting. We know their earnings aren’t going to be punchy, but the share is now pricing in a 30% fall in earnings which looks like a knee-jerk reaction. Our prevailing macro view (stable to stronger rand, with range bound inflation) should be supportive of interest rate sensitive shares like our banks, and the valuation is again compelling. We can “marry valuation with the cycle.” While its weighting will be lower than before given the question around earnings, Standard Bank is a holding of ours once more.
Turning briefly to our hedge funds, select short positions – Famous Brands, Blue Label Telecoms, Clicks, Tiger Brands, and Cashbuild – added significant value over the quarter.
What didn’t work for us? Several defensive consumer staples have been added to our portfolios, premised predominantly on very attractive valuations and an acknowledgement that we are late in the economic cycle. AB InBev and BTI have been particularly disappointing. We have also held a material weighting in ABSA, largely because of its appealing valuation metrics – but we’ll need to see an improvement of its earnings prospects before it rerates.
Stock selection may have allowed us to eek out a positive return in Q3. But we are under no illusions about what we need for our portfolios to produce satisfactory absolute returns. We need a weaker USD and the continuation of global growth. If these are not forthcoming in the medium term, then our portfolio positioning needs attention. We do, however, believe that our investments have a healthy valuation underpin which should provide support even if the timing of the macros proves to be challenging.