Investor risk appetite waned in the first quarter of 2014. This was largely driven by concerns over shrinking global liquidity as the US Federal Reserve gradually ends quantitative easing; weak economic data out of China; and political instability which culminated in the annexation of Crimea by Russia. The net result saw capital flows redirected from emerging markets to developed markets. For the quarter, the MSCI World Free Index was up 1.4% while the MSCI Emerging Markets Index was down 0.4%, both in US dollars.
Locally, the JSE All Share Index bucked the trend and returned 4.3% for the quarter, reaching a new all-time high. The rand weakened by 1.8% against the US dollar and is among the worst performing emerging market currencies. While the rand is likely to be oversold at current levels, it remains vulnerable given the continued deterioration in the country’s fundamentals: an uncompetitive manufacturing sector; an inflexible, militant labour force; and lack of progress on fiscal and structural reform.
Over the quarter, resources were the best performer with a 10.6% return. Financials returned 6.1% and industrials lagged with a 0.8% return. Despite the slight reprieve, resource stocks have lagged financials and industrials significantly over 3, 5 and 10 years. In our equity and balanced funds, we maintain a healthy exposure to resources. The weighting – albeit meaningful – is, however, not portfolio defining given that China remains an imponderable. China is the world’s largest consumer of commodities, and any slowdown in demand will have serious ramifications for commodity prices and the earnings of resource companies. It is an opaque, command-driven economy, and our ability to accurately forecast whether or not it will continue to grow strongly, or have a hard landing, is limited.
Our preferred resource holdings remain Anglo American, Mondi Limited and Sasol. We continue to favour platinum over gold producers and our preference remains the low cost platinum producers, Impala Platinum and Northam. Gold equities were among the best performers over the quarter, returning 42.6% in rands, comfortably outperforming both the market and the gold price. We remain of the view that these are inherently poor businesses. They are price-takers that face enormous cost pressures (labour, electricity and increased mining depths) and require significant capital investment to maintain production in the face of declining grades. The key driver of earnings for these businesses is the rand-dollar gold price, which is impossible to forecast with any degree of conviction. Based on a sensitivity analysis under various gold price scenarios, we do not find value and have virtually zero exposure to gold equities.
Domestic equities, in general, remain fairly valued. We continue to favour the quality global stocks that happen to be domiciled in South Africa, such as MTN, British American Tobacco, Naspers and SABMiller. Although these shares have performed extremely well relative to the broader market, they remain attractive based on our assessment of their intrinsic value and relative to pure domestic businesses. That said, we have taken healthy profits on some of these counters to fund recent purchases.
We have owned very few domestic businesses, especially those that are consumer-facing, on the basis that valuations were not attractive. This view has been vindicated thus far, with retailers down significantly from their highs. While we remain concerned over their ability to defend their earnings base, ratings are now attractive after the correction, and provide an adequate margin of safety to build a position. Our main retail exposure remains The Foschini Group and Clicks Group.
Banks returned 6.3% for the quarter, outperforming real estate investment trusts, but marginally underperforming short- and long-term insurers (6.7% return). The recent interest rate hike should be positive for net interest margins. We believe the current interest rate hike cycle will be shallow with an expected 2% hike in rates from trough to peak. This view is predicated on inflation, while experiencing upward pressure from currency weakness, being relatively well contained and credit growth being muted when compared to the last hike cycle. As a result, we believe that credit loss ratios will remain well contained. Also, each of the large commercial banks has entered the current cycle with healthy general provisions, which will buffer future credit loss. Valuations are reasonable and we maintained our weighting. Life insurers, on the other hand, trade on premiums to their embedded value and do not offer value.
In terms of asset allocation, our global balanced portfolios remain close to the maximum 25% offshore limit. We did, however, use the futures market to lock in some of the rand weakness earlier in the year. The withdrawal of monetary stimulus is likely to be protracted and interest rates are likely to remain low for some time. In such an environment, equities remain our preferred asset class for producing inflation beating returns. We continue to favour global over domestic equities on the basis of valuation. Given the divergence in performance coinciding with the reduction in investor risk appetite, we prefer emerging market to developed market equities, especially selected consumer-facing businesses in Brazil and Russia.
The bond market returned 0.9%, underperforming the cash return of 1.3% for the quarter. Inflation-linked bonds outperformed nominal bonds, with a return of 1.7%. We believe the real returns from cash and bonds are likely to be relatively poor over the long term, both from a local and global perspective. As a result, we hold zero exposure to global government bonds in our portfolios, but have used the sell-off in the final quarter of 2013 to build a small position in local government bonds. We continue to hold a significant position in inflation-linked bonds and also maintain a good exposure to local corporate bonds.
Listed property returned 1.8% for the quarter. The returns from this asset class over the last decade have been phenomenal as yields declined in line with falling interest rates and property re-rated relative to nominal bonds. At current levels, we believe property yields, in general, are too low and do not offer substantial value. However, following the sell-off in sympathy with nominal bonds, we have established positions in some of the higher-quality property stocks where we believe the returns will be superior to bonds and cash over the long term.
We maintain a high cash holding across our balanced portfolios, probably more so than at any time in Coronation’s history. As long-term investors, it is important not to allow cash to burn a hole in one’s pocket. One should remain disciplined when markets are expensive. Our current cash holding provides us with the flexibility to act when fundamentals change and markets eventually correct.
Looking forward, the investment environment is likely to remain challenging. The exit from QE and concerns over a slowdown in China will add to volatility. Our ability to forecast macro events is limited and, as such, we remain committed to our proven investment philosophy of focusing on valuation and investing for the long term. We believe this will provide the greatest reward for our clients.
