Fund Q4 2019 Return YTD 2020
Obsidian SCI Balanced Fund (B1) 3,5% 13,3%
Obsidian SCI Equity Fund (B3) 3,7% 14,2%
Obsidian SCI Multi Asset Retail Hedge Fund (A1) 3,4% 16,8%
Obsidian SCI Long Short Retail Hedge Fund (A2) 3,5% 17,4%

Highlights

  • Risk assets surged as uncertainty around the Trade War and Brexit tapered off.
  • Platinum exposure and a bias toward emerging market equity drove our performance during the quarter.
  • We expect a global manufacturing rebound in 2020 to spur performance from select risk assets.

The quarter that was

Risk on. There is no other way to summarise Q4 2019, particularly the latter moments. Developed market bonds sold off as investors went in search of risk; the US dollar lost ground, being used to fund trades in territories with more attractive asset valuations; commodity prices rose across the spectrum (the all-important Dr Copper finally chiming in); and emerging market equities (see our first chart below), bonds, and currencies rallied.

Emerging market equity bounces

Source: INet, Obsidian Capital, January 2020

By their very definition, risk assets don’t like uncertainty. Political instability, stressed foreign relations, and recessionary concerns have seen these excitable investments periodically peep over the parapet throughout 2019, but duck straight back down because of the threatening landscape.

There is little doubt in our minds that their impressive performance in Q4 was as a result of the de-escalation in Trade War and Brexit tension. However, the domestic assets tied to the health of our economy produced another underwhelming performance, apart from some self-help stories like Mr Price, Lewis, and Momentum.

Without earnings and dividend growth, most of the SA Inc. shares are going to struggle to forge a sustainably higher path for their prices. This has big ramifications for money managers.

Until growth picks up again, owning the market as a whole is not advisable. This is because you’ll be investing into too many shares that don’t have earnings growth. And you only own equity for one reason – growth in their profits.

How we fared

Early in Q4 2019 our investment team galvanised around a quite contrarian idea. The severe global manufacturing slowdown was not the beginning of a recession, as many were touting, but a typical destocking cycle.

The success of any manufacturer is dependent on them balancing the demand for their goods with the amount they are producing. Too little manufacturing and they risk losing out on sales; too much and they could end up sitting on costly stock. Our next chart shows just how drastic the fall in global manufacturing has been, measured by our Global Economic Indicator (in blue) which incorporates industrial production data from the world’s manufacturing centers.

Production and confidence fell through 2019

Source: INet, Obsidian Capital, January 2020

A destocking cycle happens when manufacturers believe they have too much stock given the demand they foresee. Looking at the red line in the above chart – a composite of German and US business confidence – developed market businesses were increasingly pessimistic about said demand during the passage of 2019.

To run down excess stock, they stop ordering raw materials and mothball their machinery. As the year progressed, these global manufactures were given little reason to kickstart their plants as the Trade War ratcheted up.

However, putting ourselves in their shoes, we didn’t (and don’t) think they can continue to sit on their hands any longer.  As we discussed in our previous quarterly, developed market consumers, chief among them the Americans, are confident about their future (see next chart) and spending strongly as a result. They are still going to the shops to buy fridges for their bars in their newly renovated houses.

As long as consumer demand remains in tact (our base case), retailers must keep ordering stock from manufacturers who’ll oblige.

US consumers supremely confident

Source: INet, Obsidian Capital, January 2020

A reacceleration of global manufacturing into 2020 has profound consequences for portfolio construction, namely a heightened need for assets linked to the manufacturing cycle.

We were arguably already positioned for this outcome. Since early 2016, our portfolios have been heavily populated with emerging market (EM) assets, normally beneficiaries in a manufacturing upturn. But there was room to better align our portfolios with our heightened conviction.

Accounting for market movements, we increased our total equity by roughly 8-10% during Q4 in our multi asset strategies. Both domestic and offshore equity allocations were increased, importantly staying consistent with the prevailing theme in our funds.

EM Counters Added / Increased During Q4 
iShares Emerging Market Equity ETF
Netcare
Motus
Mr Price
Euro and UK Banks
Antofagasta (copper miner)

Another notable change was the removal of currency futures that were in place to benefit from rand weakness against the pound and euro. These positions made sense in a falling manufacturing cycle as the rand normally weakens against hard currencies during such an environment, and because the rand was fair to overvalued against both.

Positioning our portfolios for a stronger rand is not easy. In fact, it is often nauseating. We see our country’s problems, and we share the fear of where we are headed if drastic changes aren’t made. High and rising debt coupled with low and falling growth is a bad and unsustainable combination.

But South Africa is still considered an emerging market, and when conditions turn in favour of EM territories, our assets will benefit. A recent example of this conundrum was the mid-term budget speech delivered at the end of October. In short, it painted a dark picture of our fiscal future and offered no demonstrable solution to rectify it.

It was just another piece of bad news on top of an already rotting pile. Our initial reaction was to question how the rand could possibly hold up, let alone strengthen, with these dire fundamentals coming down the track. This exact thinking was evident in the market, with the rand kicking from R14,50 to R15,00 per USD as it digested the speech.

What happened next – illustrated in the following chart – is precisely the reason you need to step back from our often-pessimistic micro view of SA and look at the bigger picture. As the uncertainty around the Trade War and Brexit dispersed, emerging market assets responded.

We are an emerging market and the 7,5% appreciation of the rand against the US dollar during Q4 – despite the public deterioration of our fiscus – should not come as a surprise to any fund manager worth their salt. Plot any of the other major EM currencies and you’ll see they appreciated alongside the rand during November and December.

Rand takes direction from global forces

Source: INet, Obsidian Capital, January 2020

Reflecting on our performance during Q4, we were fortunate to have a healthy allocation to our domestic resource counters, Impala and Anglo Platinum in particular. The commentary around platinum and its gargantuan run is heavily infused with supply deficit rationalisations.

This was not the sole rationale behind our investment in platinum as the price can fall even with a deficit in place (the platinum strike in 2014 being a good example). Instead, we held these shares because we expected a rebound in economic growth at the turn of 2016, a scenario where vehicle sales, and the demand for autocatalytic converters should rise.

The draconian European emission standards now in play further add to the need for more PGM metals. We do not, however, refute the deficit argument and believe the lack of new supply will provide an underpin for PGM prices going forward.

Another contributor to our return was our broad exposure to EM equity, which, using the MSCI EM Index as a proxy, was up 11,4% (measured in USD) during the quarter. In addition to our domestic interest rate sensitive stocks – think Momentum, Mr Price, Motus, CMH, and Lewis – the lion’s share of our offshore allocation is also domiciled in EM, with a sprinkling of Euro and UK Banks.

Detracting from performance during the quarter were a handful of SA Inc. counters that produced underwhelming earnings growth and guidance, to the point that even the broad EM rally could not save them. This included shares like Barloworld and ABSA.

When talking detractors, we think it appropriate to discuss what we missed out on. The glaring omission from our portfolios during the quarter, and for the year, was an exposure to US equity.

The next chart shows the USD remains in overvalued territory against the currencies of its major trading partners. The threat of the greenback weakening from such levels has, for some time, made it difficult for us to invest into the S&P 500. The valuations of the equities themselves also look full, especially when compared to other global equities.

Expensive greenback makes investing in the US hard

Source: Alpine Macro 2020

From a product perspective, it is worth noting the performance of our hedge funds in 2019. As a reminder, they successfully protected capital through a very tough 2018. The Obsidian Investment Team was able to do something that requires conviction in one’s skill; capture the upside after avoiding recent downside. Importantly, our Multi Asset Hedge fund is now available on leading platforms. Hedge funds aren’t for everyone; please ask us about them if you are not everyone.

What next?

We are optimistic about 2020. A rebound in global manufacturing should be a boon for risk assets. But not all of them. The reality is that large swathes of equity have already run very hard; the MSCI World Equity Index was up 25.2% measured in US dollars. That is a big number for an index.

More than anything else, our longstanding, bullish view on emerging market assets needs a weaker US dollar to cut loose the returns. If the growth differential between the US and the rest of the world narrows like we’re expecting, then valuations of assets outside of the US look very appealing and should provide the foundation for sustainable greenback weakness as investors use the dollar to fund trades into other territories.

We have built an investment toolkit for the likes of Russia, Brazil, Turkey, Chile, and Mexico and will continue to look for opportunities in such countries. A weaker US dollar won’t be enough on its own though. EM equity must deliver earnings growth if it is to produce the legendary returns it is capable of.

The need for growth to unlock value is problematic for our SA Inc. shares. With unemployment on the rise and business and consumer confidence in the doldrums, we find it very difficult to see how they can deliver sustainable earnings growth. Short-term opportunities may arise when these shares see their valuations drop way below their long-term averages, but on a buy-and-hold basis your money is probably better deployed elsewhere.

We still hold a material portion of SA Government Bonds in our multi asset portfolios. It’s no secret that they have some of the most attractive real yields in the world. But there is likely a downgrade to junk on the horizon which we need to deal with.

In short, we think it’s priced in, and that under the global growth environment we’re expecting in 2020, there will be buyers to pick up any supply that comes from forced selling, and then some.

The next chart shows that this exact dynamic played out in Brazil post its downgrade, importantly, under a falling inflation environment similar to what we’re currently experiencing.

Brazil’s bond yields FELL post downgrade

Source: INet, Obsidian Capital, January 2020

What are the risks for our portfolio construction? We think it unlikely until the US Presidential election is behind us, but any escalation in the Trade War between the US and China will be detrimental for our pro-EM positioning. An upside surprise to inflation in any of the major economies would also be problematic as rising interest rates would unearth the menacing debt monsters that have feasted on easy money the world over.

There is also the possibility that the US economy retains its mantle as growth leader and investors continue to ignore the valuations in Europe, the UK, and emerging markets. Under this scenario the US dollar will probably remain resilient, dulling the returns from other geographies.

Summary

The returns we saw in Q4 2019 offered a glimpse into what can happen when attractive asset valuations are coupled with the right macroeconomic environment and limited uncertainty.

If these conditions remain in place, there should be attractive real returns on offer in 2020. However, investors will need to be careful about which risk assets they pick as many do not have valuation on their side post 2019. The returns from our domestic assets are likely to be disparate. Portions of our equity market should be able to capitalise on our proposed rebound in manufacturing. But anything that is reliant on a reacceleration of the SA economy for growth will remain challenged.

Besides, you don’t need to take on earnings risk with domestic bonds yielding 9%, with what we believe to be a real possibility of capital growth once the downgrade comes and the uncertainty is removed.