Quarterly Review – Q2 2021
With appreciation to PortfolioMetrix
SOUTH AFRICAN PORTFOLIOS EDITION
Asset Class Returns
The second quarter of 2021 was notable in that markets began to shift away from the ‘reflation’ narrative of future high expected growth and high expected inflation. This narrative had been prevalent since the announcement of successful vaccine trials in November 2020 and had led to the expectation of a dramatic increase in global interest rates in the near future, which resulted in the outperformance of cyclical equities.
We saw some high inflation figures, with UK inflation the highest it has been since July 2019 at 2.1% year on year for May whilst the US figure jumped to 5.4%, its highest since 2008. However, markets largely took these numbers in their stride, attributing the rise to base effects and transitory supply bottlenecks. Market participants also gave central bankers the benefit of the doubt in their views that high inflation levels will be temporary and should revert closer to their targets of 2% by the end of the year. The US Federal Reserve meeting in June reinforced this as the committee indicated that it may bring forward interest rate rises to rein in inflation – accelerating a fall in inflation expectations (and bond yields) towards the end of the quarter.
At the same time, again in the face of strong recent growth numbers, investors have started to get more nervous about how strong the economic recovery really will be. This is partly due to fears around the looming withdrawal of fiscal support measures. From July, the UK is beginning to taper its furlough support scheme and is ending the stamp duty holiday on property purchases. Many US states are also winding down COVID-related unemployment benefits. Another worry is that China, after leading the world out of the COVID induced slowdown, has recently seen its recovery taper-off. Its most recent purchasing managers’ index (PMI) figures for both services and manufacturing have barely been above 50, the level which delineates between expectations of future economic expansion and contraction. In addition to these concerns, the highly virulent “delta” SARS-CoV-2 variant is causing a spike in cases in many western countries after having emerged from and wrought havoc in India. There is a real worry the variant will cause a delay in economic reopening in these countries or, if the openings do progress, stunt the willingness of citizens to go out and spend.
Inflation – A cyclical upswing or is it something more persistent?
Inflationary pressures have been building since vaccine rollouts have gathered pace and economies have slowly opened. After massive fiscal and monetary stimulus both households and firms sit on relatively healthy balance sheets with large amounts of cash. The system has been flooded with liquidity and the stimulus has successfully reached the pockets of ordinary citizens; this is in stark contrast to the quantitative easing (QE) introduced in the 2008/9 financial crisis. Markets have been battling with what it means to have such potential pent up demand in the hands of cash flush economic agents. Other issues have also stoked inflation across the world. The first is simply “base effects”. Inflation is read, and reported on in the media, as a rolling annual number. This time last year the globe was under various versions of hard lockdown which resulted in large price drops in the inflation basket generally. A bellwether for the level of demand in the economy has been the oil price. In the second quarter of last year the price of oil was as low as $20 and ended the month of June just over $40. Today we have oil prices above $70. With such a low base baked into the inflation calculation of today, and a reasonable recovery in prices since November 2020, it is unsurprising that inflation has run over target in several economies. However, base effects cut both ways which introduces a mean reverting nature to inflation.
Another reason for higher inflation has been a global shortage in microchips which have curtailed vehicle supply and raised prices for new and second-hand vehicles (amongst other things). This has a meaningful input to the inflation basket with second-hand vehicle price rises accounting for approximately 1/3rd of the CPI rise in the latest US release. Other supply bottlenecks have frustrated the situation with disruption in the global shipping industry and congestion at ports. Add to this a dearth of truck drivers in the U.S. and you have increased delivery times and with it the associated costs. A third risk to inflation is the shift of demand from consumer goods to consumer services as people look to return to normal lives and spend their money in bars, restaurants, and hotels etc.
The question over whether inflation is transitory is an important one. Spiralling inflation spells bad news for financial markets in general as it causes bond yields to rise (and bond prices to fall) which raises the discount rate for future cash flows on all assets, lowering their present value.
If we focus in on the reasons given above for the rise in inflation it is relatively easy to argue that they are all transitory. Start with base effects. As already mentioned, base effects in their nature are transitory and for it to play a role you need sustained increases in prices over time. This also suggests that inflation requires sustained excess demand to supply. Secondly, supply shortages and bottlenecks are not expected to be permanent and will alleviate from here. Thirdly, governments and central banks are winding down their fiscal impetus which should pose a drag on growth and hence inflationary pressure.
There are also longer-term dynamics which make it difficult to see a return to high inflation periods such as those in the 1970’s as follows:
- High debt levels and low velocity of money
- Public and private debt is a major issue for the world in general.
- The “return” on debt is at its lowest in 70 years with each $1 of debt increasing GDP by less than 40 cents.
- Demographic drag
- This has been an issue for the developed world for quite some time and recent data suggests that China is nearing its peak population too.
- Technology and productivity
- Technological advancement is increasing and will only continue to do so.
- This is a boon for productivity in general.
- Both factors are inherently deflationary.
We are expecting inflation to be higher over the medium term than in the recent past as economies continue to open and pent-up demand is satisfied. However, we are also mindful of the longer term more structural headwinds to inflation which should effectively cap sustained increases and in turn global bond yields. So far, the bond market seems to agree with bond yields falling back down in June after rising quite strongly in the first quarter.
Source: Bloomberg and PortfolioMetrix
Chinese tech and how far the communist party will go
The regulatory risk to big tech has always been one of the primary concerns for investors in the sector. However, actions of the Chinese regulator and the government in general have stoked concerns and widened the discount of Chinese tech firms. First, the attack on Jack Ma which began with halting the listing of Ant Group (affiliate company of Alibaba) has seen the Alibaba share price limp along when compared to its U.S. counterpart Amazon. More recently, the IPO of Didi was targeted by Chinese regulators in a crackdown of Chinese firms looking to list on foreign exchanges. Subsequently, leaders of the Communist party announced guidelines which took aim at American depositary receipts, foreign companies use these instruments to list on U.S. exchanges, threatening stronger supervision of Chinese firms accessing capital in this way. Some fear of an outright ban on U.S. listings threatening almost 250 Chinese companies and a total market capitalisation of over $2 trillion.
The main issue behind this has got to do with data and the treatment of data as a national security matter. This was the primary concern highlighted in the Didi case after its $4.4bn IPO listing. This echoes with some of the concerns raised by other regulators which included data privacy and the way in which big tech firms extract and use data without explicit permission.
There is significant distrust between the U.S. and China and the trade wars started in the Trump era persist within the Biden era. Data protection aside, the recent events from Chinese regulators have been a wakeup call to western investors of the regulatory risk associated with the Chinese and the growing confidence they have in making these decisions with little concern of foreign perceptions.
The result of this has been a headwind to emerging market equities as Chinese stocks in general have suffered due to the elevated regulatory risk. China is still considered an emerging market by MSCI because of the openness of capital markets to foreign investors (or lack thereof). The opportunity set in China is massive and attractive to investors given the sheer size of the economy and its relative economic performance. However, as highlighted above this comes at a risk to investors.
Below we show the performance of the Nasdaq (U.S. Tech Index) against the Hang Seng Tech Index:
Source: Bloomberg and PortfolioMetrix
The Delta variant risk to economic recovery
The Delta variant has wreaked havoc globally and is attributed to much of the rise in global cases recently. In places with slower vaccine rollouts (much of the emerging world and Africa in particular) the delta variant has ripped through communities resulting in severely constrained health resources and significantly higher excess deaths relative to history. However, worryingly, the delta variant is also prevalent in those countries with successful vaccine rollouts. The exuberance of having discovered safe vaccines, mass production and distribution is starting to wane as countries look to contain the effects of the variant once again. Travel warnings and restrictions are being reimplemented in parts of Europe which is putting the economic recovery in the region at risk.
QUARTERLY MACROECONOMIC DATA
GDP figures released in the second quarter were for Q1 2021, a quarter which saw Europe and many emerging markets negatively impacted by coronavirus second waves, resulting lockdowns and thus weaker growth levels. Inflation picked up during the second quarter whilst unemployment was mixed, generally falling in developed markets as economic restrictions were lifted but increasing in emerging markets struggling with further cases.
MONETARY POLICY (RATES & EXTRAORDINARY MEASURES)
There was very little change in developed market central bank action over the quarter as rates were kept low and central bankers maintained quantitative easing. Certain emerging markets began to tighten as inflation ticked higher.
The economic recovery continues although central bankers have guided towards earlier tightening than previously expected. Scaling back of fiscal support on the back of the recovery should also introduce risk to the downside for economic growth. The following summarises some consensus thinking on the path ahead and should guide a cautiously optimistic outlook for 2021:
- The IMF expects global growth of 6% in 2021 and 4.4% in 2022. However, the IMF warned of large risk to these numbers as uncertainty abounds. Also, divergence in performance across countries is expected to be wide given the path of the pandemic, the effectiveness of policy support to provide a bridge to vaccine-powered normalization, and the evolution of financial conditions.
- Rich valuations have been supported by loose monetary policy and fiscal stimulus. As the economic cycle matures and fiscal impetus reduces, risks of pullbacks increase.
- Inflation should remain relatively high in the short to medium term, on a combination of base effects, higher oil prices, supply bottlenecks and strong demand. However, this is forecast to be transitory for now and inflation expectations remain anchored.
- Core central banks remain committed to look through higher inflation data prints, although have guided to tightening sooner than previously expected. Some central banks (Bank of England, Bank of Canada, Reserve Bank of Australia and New Zealand) have already begun scaling back on their QE programs which will be followed by interest rate increases.
- The US dollar remains strong. In the “taper tantrum” of 2013, the surprise announcement sent bond yields soaring, the US dollar powering ahead and EM countries suffered major outflows. This time round the Fed has been careful to signal intentions in the hope of preventing a similar fate. It remains a fine balancing act.
- The pandemic is still far from over despite highly successful vaccination programs in the developed world. Uneven paths to herd immunity across the globe mean that risks persist. Covid mutations such as the Delta variant poses risks to normalisation.
- High valuation starting points and elevated risks calls for maximum diversification within portfolios given the number of paths markets can take and the elevated extremities of the distribution.
Building Block Commentary
Building Block Performance Table
Note: All returns provided are in SA rands (ZAR)
South African Equity Commentary
The PortfolioMetrix BCI SA Equity fund outperformed by 6.0% over the past 12 months (26.9% vs 32.9% for the fund) relative to its FTSE JSE Capped SWIX benchmark,
- Over the quarter the fund underperformed by 0.4%, as the index returned 0.5% and the fund generated 0.1%
Underlying funds over the quarter produced the following relative returns (vs FTSE JSE Capped SWIX):
- Ninety One SA Equity: underperformed by 0.6%
- 36ONE BCI SA Equity: underperformed by 0.2%
- Matrix SCI Equity: outperformed by 1.1%
- Fairtree Equity: underperformed by 2.9%
- Coronation Top 20: underperformed by 2.2%
- Satrix Mid Cap Index: outperformed by 5.3%
- South African Equities took a breather in the second quarter after very strong performance in the beginning of the year.
- Although the asset class produced positive performance for the quarter (+0.5%) it still underperformed cash.
- Interestingly, the performance of various South African equity indices had materially different performance over the quarter highlighting the stark differences in these indices:
- ALSI +0.05%
- SWIX -1.83%
- Capped ALSI +1.62%
- Capped SWIX +0.51%
- A large contributor to the relative outperformance of the Capped benchmarks to their uncapped counterparts would have been the 15% fall in both the Naspers and Prosus share prices over the quarter.
- The Small and Mid-cap sectors significantly outperformed over the quarter with returns of 8% and 5.9% respectively. The Top 40 index (Large caps) fell 0.84% for the quarter.
- The relative underperformance of the Resources stocks was a large contributor to the slight underperformance of the PMX building block. This has been a large overweight from our active managers in general and posed to a drag to active performance.
- That said, our strategic weight to the Satrix Mid Cap index fund was a strong contributor to performance and once again showed its diversifying attributes to a building block that is dominated by active implementations.
- The Top 10 holdings of the fund vs benchmark is shown below:
- The switch from Laurium Capital to Matrix Fund Managers that officially took place on 1 April 2021 proved to be well timed as the manager outperformed the Capped SWIX benchmark by 1.6% and was the only active underlying manager to outperform.
South African Bonds Commentary
The PortfolioMetrix BCI Bond FoF fund underperformed by 0.3% over the past 12 months (13.7% vs 13.4% for the fund) relative to its FTSE JSE All Bond Index benchmark,
- Over the quarter the fund outperformed by 0.3%, as the index returned 6.9% and the fund generated 7.2%
Underlying funds over the quarter produced the following relative returns (vs FTSE JSE All Bond Index):
- Coronation Bond: outperformed by 0.95%
- Ninety One Gilt: outperformed by 0.2%
- Stanlib Bond: underperformed by 0.01%
During the course if 2021 Q1 the Stanlib Bond Fund was reintroduced to portfolios. Further changes were implemented during the course of 2021 Q2, these changes have brought about efficiency in the implementation of the PortfolioMetrix SA Bond Fund. The target weightings are as follows:
- Coronation Bond Fund 19% (prev. 33%)
- Stanlib Bond Fund 19% (prev. 33%)
- Ninety One Gilt Fund 19% (prev. 33%)
- Ninety One Corp. Bond Fund 19% (new)
- PMX Core Bond Seg. Mandate 24% (new)
- From a global macro perspective market we saw a rise in risk appetite. Evidence of this includes the US dollar which weakened 1.1% (trade weighted dollar); confirmation of a risk-on environment. This was especially favourable following the 2021 Q1 bond sell-off amidst expectations of rising inflation (and thus yields). Additionally, Emerging Market bonds saw their spread compress from 3.24% to 3.11%. The SA rand was not forgotten and strengthened by more than 3% versus the dollar.
- Looking closer to home, the SA fixed income market benefitted from the global risk appetite, but local factors contributed to further gains:
- The strengthening of the rand to 14.29 versus the US dollar indicated more than just dollar weakness, perhaps the strongest driver of this was how SA Terms of Trade continued its strong run. On an index basis it improved by 11% in the face of many forecasts underestimating its persistence – this alone has many positive implications for the local economy
- the local CDS moved to 186bps, a compression of 50bps over the quarter
- Specifically looking at the South African bond market, our 10-year benchmark yield recorded a quarter-end yield of 9.26% (2021Q1: 9.50%), and a slight flattening of our very steep yield curve
- The longer dated bonds provided the best returns over the quarter:
- 20-year bond (R214): 92%
- 10-Year bond (R213): 35%
- 5 Year bond (R186): 2.26%
- The longer dated bonds provided the best returns over the quarter:
- The SA Reserve Bank remains accommodative despite rising inflation fears (globally) and higher oil prices.
South African Cash and Stable Income Commentary
The PortfolioMetrix BCI Income fund outperformed by 2.5% over the past 12 months (5.0% vs 7.5% for the fund) relative to its STeFi + 1% benchmark,
- Over the quarter the fund outperformed by 1.0%, as the index returned 1.2% and the fund generated 2.2%
Underlying funds over the quarter produced the following relative returns (vs STeFi + 1%):
- Coronation Strategic Income: outperformed by 1.5%
- Ninety One Diversified Income: outperformed by 0.8%
- BCI Income Plus: outperformed by 0.70%
- Nedgroup Investments Flexible Income: outperformed by 0.7%
- Matrix NCIS Stable Income: outperformed by 0.8%
- Monetary policy continues to be accommodative, keeping financial conditions supportive of credit demand as the economy recovers from the pandemic and associated lockdowns.The South African Reserve Bank unanimously voted to keep its benchmark repo rate unchanged at a record low of 3.5% during its May 2021 meeting. Looking forward, the SARB’s Quarterly Projection Model indicates two rate hikes of 25bps each by the end of the year.
- SA government bonds performed strongly over the second quarter of 2021, rising 6.9% following a sharp sell-off in March. This benefitted our managers as they have steadily increased duration exposure, taking advantage of the steep yield curve.
- Property had another strong quarter, continuing its recovery following the initial lockdown, up 12.1% for the quarter. However, managers in the Income space are exercising caution when allocating to the sector due to its recent volatility, limiting exposure to a few high-quality counters.
- Inflation linked bonds continued to strengthen, returning 3.2% over the three months. This has been a positive contributor to the fund as most of our managers have meaningful exposure, viewing the asset class as having relatively attractive real yields.
South African Property Commentary
The PortfolioMetrix BCI SA Property fund underperformed by 3.0% over the past 12 months (25.2% vs 22.2% for the fund) relative to its FTSE JSE SA Listed Property benchmark,
- Over the quarter the fund underperformed by 1.8%, as the index returned 12.1% and the fund generated 10.3%
Underlying funds over the quarter produced the following relative returns (vs FTSE JSE SA Listed Property):
- Sesfikile BCI Property: underperformed by 1.0%
- Absa Property Equity: underperformed by 4.5%
- The SA listed property sector maintained its momentum from the first quarter of 2021 into the second quarter, delivering a return of 11.1% for Q2 2021, rounding off a pleasant half-year.
- The sector continued to benefit from economic recovery, notably from improvements in economic activity and confidence in South Africa.
- Recovery in collection rates have been faster than anticipated as the economy re-opened. The retail sector particularly recovering well since last year’s COVID-19 induced slump. Business confidence has been rising over the quarter, with strong demand in the Retail space.
- Liquidity, both from debt and equity sources, have been robust and balance sheet repair faster than expected.
- Sesfikile are positioned underweight to Office, Industrial & Logistics and Hospitality. The biggest overweight is in Retail. They have played defence over the first half of 2021, employing a cautiously optimistic stance, looking for opportunities to deploy cash via unique off-market deals.
- The Absa property fund benefitted as they significantly increased their position in Redefine Properties which has shown strong performance from deleveraging and moving toward a more sustainable base.
Global Equity Commentary
The PortfolioMetrix BCI Global Equity FoF fund outperformed by 0.8% over the past 12 months (14.4% vs 15.3% for the fund) relative to its MSCI ACWI benchmark,
- Over the quarter the fund underperformed by 0.2%, as the index returned 3.8% and the fund generated 3.6%.
The performance of the underlying funds (versus their respective regional indices) for the quarter is shown below (in ZAR). Strong outperformance in the Emerging Asia region through Matthews Asia Pacific Tiger fund contributed to strong alpha in the broader EM region. This was negated somewhat within the Trigon New Europe fund as it explicitly excludes Russian equities which are heavily driven by the oil price. This would have posed a drag to the fund’s performance in the region. European implementations in Jupiter European, Miton European Opportunities and Liontrust outperformed their regional indexes whilst Invesco European would have negated active performance in the broader European region.
- Developed markets (+4.2%) continued to outperform emerging markets (+1.6%) in the quarter as the risk on environment persisted.
- Regionally, within the developed equity building block, there was stark differences in performances with North America (+5.3%) once again comfortably outperforming the other regions and Japanese stocks (-3.6%) performing the worst.
- Although a risk on environment, emerging market (EM) equities lagged developed equities due to the dominant Asian region underperforming. Much of this can be attributed to the pressure being felt by Chinese Tech stocks from a regulatory perspective (this is discussed in the opening sections of the write-up). These stocks are a significant weighting in the EM universe.
- China forms approximately 38% of the EM index and 47% of the EM Asia index. Interestingly the performance of the MSCI China and the MSCI China A Onshore index were quite different with the A Onshore Index outperforming the offshore listed MSCI China index by 6.5% over the quarter.
- Growth and Quality stocks outperformed Value (cheap) and Small cap stocks over the quarter with US large cap Tech stocks re-establishing their dominance over other sectors. Interestingly, growth stocks outside of the U.S. underperformed the broader market suggesting that allocations to the U.S. dominated the factor allocation.
- As energy prices continued rising, the Energy sector continued to benefit from strong performance over the quarter, joining Real Estate, Information Technology and Communication Services as the outperforming sectors in the U.S.
- There were no fund changes over the quarter.
Global Bonds Commentary
The PortfolioMetrix BCI Global Bond fund underperformed by 1.0% over the past 12 months (-15.7% vs -16.6% for the fund) relative to its Bloomberg Barclays Global Aggregate benchmark,
- Over the quarter the fund outperformed by 0.2%, as the index returned -2.0% and the fund generated -1.8%
Underlying funds over the quarter produced the following relative returns (vs Bloomberg Barclays Global Aggregate):
- iShares Global Govt Bond: underperformed by 0.33%
- iShares Global Corp Bond: outperformed by 1.20%
- Global Bonds performed relatively well over the quarter, following the first quarter sell-off. The reversal was however not enough to offset the losses of the first quarter. Global fixed income segments performed as follows (total return in USD):
- Global Treasuries 9%
- Global Corporates 7%
- Global High Yield 1%
- EM (Local Ccy) 5%
- The positive performance (reflected above) is the result of a combination of income and capital return; bond prices recovered slightly as yields fell in the US, UK, and Japan.
- Further evidence of a settling global investor (post-Q1) can be seen in the compression of spreads (Corporate, High Yield, and EM option adjusted spreads)
- The Federal Reserve’s commitment to a data driven “full-employment” and average 2% inflation was reaffirmed at its meeting in June. From that meeting it is expected that the Fed will continue to purchase Treasuries at a rate of $80bn and $40bn of agency MBS per month.
- The road to “normalization” will require full employment and sustained inflation.
- At this juncture the Fed will likely trim its MBS purchases, followed by a taper of its US Treasury purchases. Current expectations see this taking place over 2021/22.
- Thereafter 2023 will see two rate hikes of 25bps.
- The market implied path is more hawkish (50% chance of one hike by the end of 2022 and nearly three full hikes by the end of 2023)
- The weaker US dollar and flattening US yield curve was a slight correction of the 2021 Q1 overshoot, and reflective of the perceived inflation tolerance the Fed will display, however inflation and growth are both expected to persist, with risks associated with a sooner-than-expected hike from the Fed.
- The iShares Global Government Bond ETF has a yield to maturity of 0.54% and a duration of 8.7 years whilst the iShares Global Corporate Bond ETF has a yield to maturity of 1.50% and a duration of 7.3 years.
Global Property Commentary
The PortfolioMetrix BCI Global Property fund underperformed by 4.4% over the past 12 months (11.6% vs 7.1% for the fund) relative to its FTSE EPRA Nareit Developed Rental benchmark,
- Over the quarter the fund outperformed by 0.4%, as the index returned 6.6% and the fund generated 7.0%
Underlying funds over the quarter produced the following relative returns (vs FTSE EPRA Nareit Developed Rental):
- Catalyst Global Real Estate: outperformed by 2.2%
- Sesfikile BCI Global Property: outperformed by 0.2%
- Global Property has been the laggard risk asset over the past year and has posted return’s comparable to Global Equity over the quarter. There is significant diversity across the asset class’ sectors & jurisdictions, positioning to benefit from lockdown easing and vaccine rollout is critical.
- Sesfikile have focused on holding stocks deemed to be Covid beneficiaries, such as single family residential, industrial and manufactured homes. Whilst avoiding hotels, malls, retail & student accommodation. They have also reduced the funds overall risk, by reducing active share, increasing cash and disinvesting from small cap REITS with single rental streams.
- Catalyst are currently seeing global real estate as being attractively priced based on expected total return spreads. Their fund is positioned underweight diversified, hotels & office property. Whilst they are significantly overweight residential.
- Millennials are now the biggest economically active population group in the US and they have a predilection for renting their home. Due to their stage of life (married with kids), there is a natural shift from apartment living to single family residential properties.
- Ecommerce is underpinning the industrial sector with a surge in online sales being clearly evident when the pandemic hit. This is believed to be another structural shift in human behaviour.
- Work from Home is the shadow overhanging the office sector, there have been many high-profile lease terminations directly attributable to this change in work/life balance. Pinterest for example have cancelled a $90 million lease in San Francisco. Catalyst are cautiously positioning around this new regime.
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- PortfolioMetrix BCI SA Property Fund
- PortfolioMetrix BCI Global Property FoF
- PortfolioMetrix BCI Global Bond FoF
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