• Quarter in review
• Asset class returns
• Portfolio Changes

We entered the first quarter of 2023 with the following broad expectations:

1. A peaking of US interest rates as growth falters and inflationary pressure ease.
2. Anticipating a continuation of a weaker US dollar environment that had broadly started since late October 2022.
3. A weaker global economic backdrop held back by weaker US growth but against that supported by a sharply recovering Chinese economy (due to its Zero-Covid exit) and a slight recovery in the EU’s economy (due to an easing in its energy supply crisis).
4. A strong performance from EM equity and bonds as the USD weakens.
5. An expectation that the Rand would benefit from a weakening USD
6. A supportive SA bond market that would participate in the onset of lower (long duration) global bond yields.

With this broad framework, we expected domestic assets to be competitive against offshore assets.

Looking back on Q1 23 – how wrong our bet on domestics has been. But first let’s revisit our broad framework above and whether they are still in play.

The chart below highlights our Obsidian Global Economic Indicator (in blue), our JSE All Share Index relative to Cash (in pink) and the Dollar index (in red). Since October 2022, all of these indicators have started moving up, supporting a weaker USD, a stronger global economy and leadership within equities as a preferred asset class.

Source: Iress (26^th April 2023)

The US economy has significantly increased their interest rates, inverting their yield curve at a time where consumption has run materially above trend. As a result, we think the US economy will face a sharply softer economy for the remainder of 2023.

We also recognise that post a sharp rebound in European sentiment indicators, on the back of a significant easing in their energy crisis, the higher interest rates and contracting money supply may now also begin to exert pressure on further upward momentum within the European economy. A caveat to a weakening EU economy is a strengthening services sector that has shown a recent resurgence.

China continues to recover from their draconian Zero-Covid policies. This should provide further momentum for the economy into 2023, but we are less certain as to whether this will translate into stronger commodity demand to offset the slower growth from the rest of the world as the Chinese recovery appears to be more geared to a consumer-driven one rather than an industrial recovery (that enjoyed some stimulus during the Zero-Covid era). Indeed, after a sharp rebound in manufacturing PMI’s in China, further upward momentum could be questioned as the chart below suggests?

Source: Bloomberg (26^th April 2023)

Interest rates in most of the world are now well above pre-Covid levels and as we move further into 2023, this impact will exert downward pressure on consumption. We are therefore more cautious on further positive economic momentum than we were at the start of 2023.

A softer US economy and easing inflation should eventually usher in lower interest rates in the US. Should this occur, the “carry-trade” should begin to reverse and the USD could begin to weaken. Indeed since October 2022 this appears to have begun as the yield curve appears to have peaked.

Chart below shows that remarkably the Rand has not yet materially broken down from the broader USD index, despite a relatively weaker Q1 performance amidst a litany of “own-goals” and mounting evidence of endemic government maladministration.

Whilst it is a fact that the Rand has lagged YTD against almost all the crosses the chart below does not (yet) suggest that the ZAR is dislocating from the USD cycle any more that other competing currencies.

Source: Iress (26^th April 2023)

The Rand has been weak against its peers after being quite overvalued a couple of years ago. From these levels, and especially after last quarter’s underperformance, the Rand is increasingly undervalued against many of its EM peers.

The chart below highlights just how much the Rand has weakened YTD against EM currencies and we would anticipate that, from these levels, going forward it may reverse this underperformance or at least not weaken further.

Source: Iress (26^th April 2023)

A weaker USD going forward should see EM equity benefitting both in absolute terms and relative terms. As such, we remain constructive on EM assets.

The chart below illustrates EM equity participation with the direction of the USD.

Source: Iress (26^th April 2023)

We believe that we are approaching the end game as far as global interest rate hikes are concerned and this will in turn be critical to shore up EM bonds in addition to deeply discounted ratings of domestic equity – especially the SA Banking sector.

The chart below illustrates how global interest rates have reversed the Covid lockdown-induced rate cuts and are now all meaningfully above pre-Covid levels. It is likely that the US economy will weaken first as they have been the most aggressive in hiking. It is early days, but their economy is unquestionably losing momentum while inflationary pressures have narrowed to services inflation and home equivalent rent specifically. We believe this should begin to dis-inflate going forward and further economic weakness should sow the seeds for an interest rate cutting cycle in due course.

Source: Iress (26^th April 2023)

The critical question is will South Africa participate in the next global rate cutting cycle?

We believe it will and this will be a critical driver for the rerating of already deeply discounted domestic counters; chart below highlights SA Banks ratings with the prevailing SA interest rate cycle (red line shows an average of short and long-term interest rates).

We have admittedly been too early on this, but we believe now is not the time to capitulate on domestic equities that are still growing profits, specifically SA banks.

Source: Iress (26^th April 2023)

The table below shows a list of asset returns over the last quarter.

The first take away is that the Rand has been weak against all major crosses over the quarter, weakening between 2 and 6%.

DM equities have broadly outperformed SA’s JSE All Share by approximately 2 to 6% (in local currency)

Global and local bonds are up similarly in the order of approximately 3% YTD (in local currency)

Domestic equities (shown below as interest rate sensitives – IRS) have underperformed both the JSE All Share and offshore equity.

The gold price and gold equities performed strongly, but resources, PGM’s, SA Banks and SA Properties performed poorly over the quarter.

Source: Iress (31^st March 2023)

From an asset allocation perspective, the overriding message is that we did not have enough offshore versus our domestic positioning. We liked Emerging markets at the expense of Developed markets, and this was not wrong, but South Africa (as an Emerging market) did particularly poorly over the quarter.

Below we have provided an attribution of our Obsidian SCI Equity fund vs the JSE All Share Index for the quarter:

See PERFORMANCE TABLE DISCLOSED in FOOTNOTE

Source: Bloomberg (31^st March 2023)

See PERFORMANCE TABLE DISCLOSED in FOOTNOTE

Source: Bloomberg (31^st March 2023)

From an equity selection perspective, we underperformed the JSE All Share Index by 4.4% over the quarter. This is significant underperformance and mainly attributed to two positions: underweight Naspers & Prosus (12% of the ALSI) and not having a position in Richemont (16.5% average weighting in the ALSI). The two positions detracted 5.15% relative to the All Share over the quarter.

Excluding these two positions, the SCI Equity fund outperformed the ALSI by 0.7%. This is scant consolation but at least highlights that our poor stock selection over the quarter was at least not broad based and, despite getting two very large positions wrong, we got quite a lot right.

Looking at the performance over the quarter, we cannot “sugar-coat” the poor performance both in terms of asset allocation and stock selection. It is very rare in our history to be on the wrong side of both calls. I hope we have demonstrated that the performance of South African bonds and our currency have not dislocated from offshore peers (despite incredibly poor developments on the ground, specifically around government failures) and as such the potential for a period of “bounce-back” relative to EM and DM assets is possible. We believe that SA assets offer better relative valuations post this underperformance and as such we are not making wholesale changes to the portfolio.

The chart below highlights the relative valuation of European equity (the top performing equity market over the last quarter) versus Standard Bank (as a proxy for domestic equity). We started the year with the relative P/E of the two on an average rating. Post the significant quarter of outperformance, EU equity is now approaching a standard deviation-expensive rating relative to Standard Bank.

Source: Bloomberg (28^th April 2023)

Over this period Standard Bank has outperformed on earnings while its recent trading update further supports the view that Standard Bank can remain competitive on relative earnings. We recognise that Standard Bank and other SA domestics will struggle to grow meaningfully post the Covid earnings recovery, but that applies even more so to EU equity since their earnings base is at cyclical highs.

Source: Bloomberg (26^th April 2023)

In addition to the above rerating of EU equity vs domestic equity (which we concede we have largely not participated in) the Rand has weakened 6% vs the Euro over the quarter. After this weakness the Rand is no longer at fair value (based on purchasing power parity, shown in the chart below) against the crosses and against the Euro it is approaching some 15% undervalued.

Whilst the Rand may weaken further in the short term, this observation together with the charts above, discourages us from aggressively shifting our positions in favour of offshore equity at this juncture.

Source: Iress (26^th April 2023)

Mention also needs to be made of our lack of position in Richemont, a share that has benefitted largely from stronger sentiment in Europe on the back of an easing in its energy crisis (a temporary tailwind for European consumers) as well as the sudden Chinese reopening which has sparked a release of pent-up consumer demand which has benefited luxury sales. Indeed, the Eurostoxx Consumer Discretionary sector has led the Q1 rally within European equity but tighter monetary policy (within the US & EU) should put a dampener on discretionary consumption.

From the charts below what is apparent is that jewellery sales are elevated compared to recent history. As the global economy now feels the strain of a combination of sharply higher interest rates, lingering inflation as well as contracting money supply, the flip side of stimulatory conditions experienced since the Covid onset, it is hard to imagine jewellery sales growing strongly off the current base as implied by expensively priced luxury companies.

The EBITDA margin of Richemont below demonstrates that margins are already elevated:

Source: Iress (26^th April 2023)

Source: Bloomberg (26^th April 2023)

Changes over the quarter include:

• Selling of Old Mutual and Quilter in favour of All Share futures.
• New positions were established in Gold Fields, Super Group, Santam and Alibaba.
• We added to Sun International, Spar and iron ore producers.
• We sold remaining positions in Transaction Capital and Truworths
• Reduced positions in global property, global energy and EU equity.

^{Copyright © 2023, Obsidian Capital, All rights reserved.}

^{PERFORMANCE TABLE DISCLOSURE
Source: Morningstar, March 2023
Launch dates: Balanced (01 October 2013), Equity (28 December 2015), Multi Asset Hedge (25 October 2007), Long Short Hedge (01 July 2008)}

Annualised performance since inception available on MDD’s found on website.

*Annualised return is the weighted average compound growth rate over the period measured

Income reinvested on ex-dividend date. The lowest and highest annualised performance numbers are based on 10 non-overlapping one-year periods or the number of non-overlapping one-year periods from inception where performance history does not exist for 10 years.

^{Disclaimer: Obsidian Capital (Pty) Ltd (FSP number 32444) is an authorised Financial Services Provider in terms of the FAIS Act.}

The information contained in this article does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act, and should be read in conjunction with a minimum disclosure document (MDD) and the Upfront Disclosure Document. Use of or reliance on this information is at own risk. Independent professional financial advice should be sought before making an investment decision.

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