|Obsidian SCI Balanced Fund||-0,3%||9,5%|
|Obsidian SCI Equity Fund||-0,8%||10,1%|
|Obsidian SCI Multi Asset Retail Hedge Fund||1,4%||12,9%|
|Obsidian SCI Long Short Retail Hedge Fund||1,3%||13,7%|
The quarter that was
In the three months ended September 2019, the broad asset classes performed as follows;
Q3 2019 was a period where the concern around slowing global growth escalated, an environment in which we shouldn’t be surprised to see bonds outperforming equities. How bad was the slowdown?
Measuring economic activity can be done in several ways. Most metrics consider the prevailing levels of manufacturing. For the US economy, the most respected indicator is the US Institute of Supply Management’s Purchasing Managers Index (PMI). It’s a mouthful, sure. But what it foretells is simple – do the people working within the manufacturing industry think things are getting better or worse?
This index is in blue in the graphic below. Anything below 50 signals a contraction in manufacturing activity. Scary, but not as scary as the red line. New export orders is a constituent of the PMI index, measuring the export orders American companies are receiving; if you want evidence that the trade war is having a negative impact, this is it.
52% of the S&P 500 is sensitive to the levels of manufacturing in the US economy. With an inverted yield curve and a record-breaking bull market, surely this latest PMI print is motivation enough to sell US equity? And, in addition, to limit exposure to other equity given it usually falls when the S&P 500 has a major correction?
Man, if only this ‘game’ was that easy. The conundrum we all face is that the US consumer – making up the other half of their economy – has probably never felt richer. Remember that the last recession was essentially a result of a consumer so strapped that they couldn’t pay the interest on their mortgages.
As you can see in the next chart, only 9% of disposable income is required to service the American consumers debt. This is lower than it has been in 40 years, and substantially below the levels that preceded the previous recessions.
Of course, this dynamic above changes quickly if interest rates rise sharply. But that looks very unlikely in the current environment – central banks around the world have caged their hawks and set free the doves.
Add into the mix record low unemployment levels, rising house prices, falling interest rates, the wealth effect of profit laden equity portfolios, and you can understand why the US consumer is strutting about, chest out. Nowhere is their sprightliness more evident than in retail sales data. The year-on-year change of retail spending in the US is close to 5%, illustrated in the next chart.
No one spends like the US consumer, but their European counterparts are also swiping plastic enthusiastically. If developed market consumers are not stressed and continue to spend, there will be a fair number of businesses that can still generate earnings. Earnings, it pays to reiterate, are the number one reason any investor should own equity.
Further strengthening the case for equity are the returns on offer relative to other asset classes. An investor in the US can quite easily find a share that has earnings growth, with a dividend yield of 2,5-3%. If they are to embrace an imminent recession, the natural alternative to equity would be US bonds. But that’s a problem because the yields are half that on offer from equity, with no possibility for growth – such is the nature of a fixed income investment.
We illustrate this dilemma in our last chart where we have the US 10-year bond yield in yellow, and the dividend yield of the US consumer staples index in white. At the last yield curve inversion in 2006, US investors could exchange a 2.5% dividend yield for a 5% yield on their bonds; no brainer if you think a recession is coming. The choice today is so much harder, and one we don’t think makes sense at this juncture.
How we fared
It was not a quarter that rewarded index exposure; the SWIX returned -4.3%, the ALSI lost slightly more at -4.6%, and the equal weighted index, which is a far more relevant for those not willing to hold the cowboy weightings in the big index constituents, retreated a hefty -7.0%.
The quarterly returns of the products we manage were slightly down for our long-only funds, and slightly up for our hedge funds, the latter benefiting from our short positions in Discovery, Telkom, Curro, and Famous Brands.
Our commodity exposure (mainly platinum and gold) contributed nicely during the quarter. Transaction Capital, a long-standing holding across our portfolios, again came to the party.
Material holdings in ABSA and Standard Bank hurt our performance across the strategies we manage. A kick in our bond yields – very uncharacteristic given that bond yields all over the globe fell during the period – played a part in their underperformance. To be sure, there are persistent concerns over whether these institutions will continue to deliver earnings in such a low growth environment. On the balance of probability, our view is that their attractive dividend yields, combined with mid-single digit growth and a favourable view on our bond yields, warrants an exposure to these counters.
Our relatively large exposure to emerging market bonds (both SA and other EM bonds) continues to anchor our multi asset portfolios. These instruments offer real yields without the earnings risk that many equities currently face, particularly those on our domestic bourse. With inflationary pressures well contained at this point, this remains a relatively high conviction asset allocation call.
We’ve made the case upfront that developed market equities, particularly those that face the consumer, may have further to run. This is important not because we own US equity – we haven’t held any since the beginning of 2016 on the view that the greenback is very overvalued. Instead, it is important because decent S&P 500 performance can provide a stay of execution for other equity around the world (which we do own) that may fall in sympathy with an S&P 500 correction.
Without the imminent threat of a global equity meltdown, we think the earnings prospects and valuations of select domestic equities still warrant an exposure.
However, during the quarter we moved, incrementally, toward a more barbell approach across our portfolios because of the sharp decline in global manufacturing. More specifically, we decreased our exposure to European equity – after a notable rerating – in favour of offshore cash, namely the British pound, the euro, and the Australian dollar.
Despite the recent commentary about how the rand has weakened against the US dollar, it has been very resilient against other hard currencies. In fact, the rand has strengthened, and is now expensive, against the Ozzie, and fair value when measured against the pound and euro on a purchasing power parity (PPP) basis. Buying these currencies with rands is therefore acceptable to us from a valuation perspective.
This switch from European equity to cash reduces the earnings risk in our portfolios, while maintaining exposure to the hard currencies that would likely appreciate against the rand if the global economy continues to weaken further.
An interesting development in our hedge funds has been the addition of Richemont as a short position. With elevated margins, demanding valuation, and deteriorating watch sales, it ticks the major boxes in our investment process to be included as a short. We did not foresee the extent of the current unrest in Hong Kong; it will however put further pressure on their earnings.
There are several contradictory signals currently weaved into the fabric of global financial markets. We don’t believe there enough to pre-empt a recession, but there is certainly enough to exercise caution. The prospects and spending behaviour of the first world consumer will need to be monitored closely for signs of weakness. Trade relations between the US and China will also remain front and centre; the damage the existing tariffs have undoubtably wreaked will form the basis for more risk-off sentiment should the trade war escalate further.
On the domestic front we don’t expect fireworks, either on the upside or downside. As uninspiring as our growth may be, it is usually quite stable. We’ll continue to look for domestic opportunities when the market gets overly pessimistic and strive to avoid the shares that disappoint on earnings.