Macro overview

Global economic growth remains healthy, having plateaued at 3.5% - 4% in 2018, supported by extremely aggressive monetary policies adopted by central banks since the global financial crisis. Inflation has been well contained against many predictions, although it has edged up to around 2% in the US. Monetary policy in the US has started to normalise and the Federal Reserve has hiked interest rates a number of times. The Fed is also expected to continue the hiking cycle during 2019. Monetary policy in Europe is expected to follow suit, with the European Central Bank anticipated to start hiking interest rates during 2019.

But not everything is positive. A stronger dollar, rising global bond yields, trade wars and some self-inflicted injuries - such as uncertainty about land reform in South Africa and Turkey's president showing dictator-like tendencies - have negatively affected emerging markets. Turkey, Argentina, Brazil and South Africa have borne the brunt of the contagion. Brexit is another major global uncertainty affecting not only the UK and Europe, but also all the UK's trading partners, of which South Africa is one. The possibility is increasing that the UK will leave the European Union without a deal.

In South Africa, the short-lived 'Ramaphoria' phase following the ANC elective conference in December is over and has been overtaken by 'Ramarealism'. JSE-listed shares which generate their earnings from the domestic economy have given up most of the earlier gains (related to the election of Cyril Ramaphosa as ANC president) now that the economy has slipped into recession. The emerging market crisis has put the rand under pressure which, together with a higher oil price, has caused fuel prices to rise. Fortunately, the South African Reserve Bank chose not to raise interest rates at its September Monetary Policy Committee meeting.

However, not all is negative either. The Zondo commission is investigating state capture, acolytes of former president Jacob Zuma, such as National Prosecuting Authority head Shaun Abrahams and head of SARS Tom Moyane, have been removed from their positions, and some of the boards of state-owned enterprises have been reconstituted. We also have a revised Mining Charter and the nuclear deal is off the table. These are steps in the right direction, but unfortunately years of corruption and poor governance is not remedied overnight. On the upside we think the current period of rand weakness is overdone and we would not be surprised to see the currency recover some of its losses.

Fund performance

The fund has the dual mandate of beating inflation by 4% over time and protecting capital over all rolling 18-month periods. While we were able to protect capital, the fund unfortunately did not achieve its inflation plus 4% target in the recent past (longer term returns are still ahead of benchmark), which has been disappointing.

Portfolio activity

We took advantage of the market sell-off during the quarter (Capped SWIX declined by 1.7% for the quarter and 7.4% year-to date) to increase the fund's allocation to domestic equity by adding to our positions in Anglo American, Nedbank and Shoprite.

Standard Bank remains one of the fund's top holdings. We have used the recent share price weakness on the back of concerns around the slowing domestic economy to add to our holding. We believe that on a 9x forward price earnings ratio (8x our assessment of normalised earnings) and 6% dividend yield, the valuation is attractive and already reflects many of the market concerns.

The local property sector was again under pressure, declining -1.0 % for the quarter and 22.2% year-to-date. We expect domestic properties to show muted nominal growth in distributions over the medium term, however, combined with an attractive initial yield, offers an enticing holding period return.

The rise in government bond yields to levels between 9% and 10%, depending on its duration, is particularly attractive to funds such as this with a target of beating inflation by 4%. Inflation is expected to average between 5% and 6% over the long term. Buying bonds at these attractive real yields was therefore an opportunity that we did not want to miss out on and have further added to our South African bond holdings during the quarter. To buy these bonds, we used the rand weakness to lighten our global holdings.

Outlook

Five years ago, we warned investors to expect lower market returns. Unfortunately, we were reasonably accurate. We have emerged from a tough five-year period which we have made worse by not delivering alpha within the domestic equity component of our income and growth funds. Going forward, we see a far more attractive investment environment in which it will be easier to reach our inflation-plus targets. We believe our portfolios are appropriately positioned for the upturn, though we will never lose sight of the need to be defensive. We think our portfolios are well diversified, our asset allocation is prudent, and we have sufficient exposure to growth assets to take advantage of the attractive upside in many high-quality shares.

The past quarter was marked by a major reversal in investor sentiment towards emerging markets. Emerging currencies, bonds and equities all succumbed to immense pressure as global investors derisked their portfolios. It is not easy, even in hindsight, to say exactly what triggered the exodus. But it is likely the stronger US dollar, higher US bond yields, an expectation of further rate hikes in the US, as well as in Europe, and all the talk of trade wars started by the Trump government combined to generate enough bad news flow to spook investors.

South Africa did not escape this global trend. The rand lost 14% of its value relative to the dollar and bond yields surged as foreigners offloaded a massive R65bn of government bonds over the quarter. The JSE saw a major shift in sentiment too with domestic orientated shares under selling pressure while rand hedges were protected as expected in turbulent times.

In terms of the fund's mandate to achieve an inflation plus 4% return while at the same time preserving capital, we manage the portfolio as though some bad news may always occur. The offshore holdings of 26% at the start of the quarter, a healthy exposure to rand hedged shares and a low modified duration in the bond portion of the portfolio all helped to protect the fund against the selloff. The result is a credible return of 4.1% over this eventful quarter. The one year performance is 6.0%, the three-year return is 4.6%, over five years it is 7.1% and the 10-year number is 10.0% per annum. Inflation ranged between 4.8% over the past year to 5.5% over the last 10 years. Our aim to beat inflation by 4% per annum was therefore attained over the long term but not over the three- and five-year periods.

The wild gyrations in the market gave us the opportunity to make some meaningful changes to the composition of the fund. The rise in yields of government bonds to levels between 9% and 10%, depending on its duration, is particularly attractive to funds such as this with a target of beating inflation by 4%. Inflation is expected to average between 5% and 6% over the long term. Buying bonds at these attractive real yields was therefore an opportunity that we did not want to miss out on. We added to our South African bond holdings taking it from 15.7% to 18.8% of the fund (excluding inflation-linked bond exposure of 9.2%). In order to buy the bonds we used the rand weakness to lighten our global exposure from 26% to 23% as we sold units in the Global Capital Plus Fund.

Within the domestic equity portion of the fund, we trimmed our position in Mondi as this high quality company's share now offers limited upside following its stellar performance. We added to Standard Bank, Naspers, Bidcorp and added newly-listed share Quilter ahead of its unbundling from Old Mutual. Quilter is a UK focused integrated wealth manager. The UK savings market is attractive due to recent pension reforms which gives individuals more control over their retirement savings. This has increased the need for financial advice. Quilter is well placed with the second largest advice force and platform in the UK.

Over the short term, the negative attitude to emerging markets may well persist for a while. However, the high real yields available in the bond market as well as the derating of many domestic shares to attractive levels make us more optimistic of reaching our goal of beating inflation by at least 4% over rolling three-year periods.