Current context
Global equity markets recovered sharply in the first quarter of 2019. The MSCI World Index delivered a total return of 12.6% and the MSCI Emerging Markets Index returned 9.9%. The JSE’s recovery was more lacklustre: the FTSE/JSE All Share Index gained 8.0% and was dominated by rand hedges, especially resources and Naspers. Domestic counters were material underperformers. The FTSE/JSE Small Cap Index lost 3.4% and financials declined over the quarter.

Local fixed income assets experienced some tailwinds from Moody’s decision to keep South Africa’s credit rating unchanged. This has resulted in the sovereign yields reducing slightly, as local and foreign investors continue to see value in South African government bonds. Anchored inflation - well within the South African Reserve Bank’s (SARB’s) 3% to 6% target band - has further supported yields, as the SARB has taken a more neutral stance on interest rates and maintained the existing repurchase rate of 6.75%.

Our perspective
As we have noted for some time, there is pervasive fear in certain parts of investment markets. This is in complete contrast to other areas that are well owned and in which investors are inclined to be complacent. Markets therefore continue to be characterised by wide valuation divergences. We are finding far more opportunities in those parts where investors are fearful, especially in the SA Inc. part of the domestic market, which has endured tough economic conditions and aggressive selling by foreigners in recent years. In fact, our bottom-up analysis is indicating valuations usually seen in deep bear markets. For longer-term investors who can ride out the storm, the return profile from carefully selected securities at such low valuation levels is promising.

Short-term interest rates have declined over the quarter, with the rate on the 1-year negotiable certificate of deposit (NCD) reducing from 8.2% to 8.1%, and the rate on the 5-year NCD reducing from 8.8% to 8.6%. This implies that the market has built in even lower interest rate increases. Fixed income yields have declined marginally, but starting yields remain high. 20-year government bonds are offering yields of around 9.5% (down from 10%) and 5-year bonds are yielding 7.6% (down from 8.1%). We expect further market noise in the run-up to the May general elections but believe that local fixed income assets present the potential for strong returns in future.

Portfolio positioning
We continue to gradually reduce exposure to expensive corporate bonds and allocate cash to longer-dated NCDs. Over the quarter, the fund reduced its exposure to shorter-dated corporate fixed-rate bonds as spreads tightened. The 5-year government bond (the reference bond for these credits) is yielding around 7.6%, while bank 5-year NCDs offer close to 8.6%.

Cash levels remain healthy, with the fund holding 46.3% in cash and NCDs. This is dry powder that we expect to employ if the opportunities we currently see in many domestic securities become more widespread.