4Q16 Market Commentary
Global risk-on rally trumped by the reflation trade in the last quarter
2016 will be remembered as a choppy year for equities with the global risk-on rally supporting markets for most of the first three quarters of the year and with political surprises periodically wrong-footing markets in the latter half of the year.
Global markets experienced a seismic shift in investor psyche from the risk-off environment which had defined investment markets since 2011 to a risk-on world in 2016, where investors were more willing to invest in riskier assets. The peak in the US-dollar exchange rate in the last quarter of 2015 in anticipation of the US Federal Reserve Bank (US Fed) hiking rates in mid-December 2015 marked the turning point in investor risk appetite. From that point investors have preferred riskier over less risky assets; with developing markets beating developed markets; equities faring better than bonds; cyclicals shares outpacing defensive shares and value investing being appreciated at the expense of growth investing.
The political landscape in 2016 was rocked by two non-consensual events that sent global markets reeling. In the last week of June, UK citizens surprisingly voted to exit the European Union, a move that saw the UK pound weakening 10% to hit 31 year lows whilst global markets lost $2.5 trillion of their market value in the aftermath of the vote. Investors flocked to buy safe-haven assets with the US-dollar strengthening; the gold price rallying and developed market bond yields falling to negative yielding territory. In late November, real-estate tycoon Donald Trump was surprisingly elected the President of the United States of America, fueling the reflation trade which had begun to take shape from the month of August as markets began anticipating the next US Fed interest rate hike. Rising US government bond yields and the concomitant US-dollar strength led to a sell-off in global bonds in the final quarter of 2016 which spilled over into equities as emerging market currencies fell and defensive shares came under pressure as they are seen as bond proxies within the equity space.
Equities were the worst performing asset class dragged lower by high offshore exposure
Whilst SA markets were largely in sync with the global market backdrop described above, the most telling feature of SA equity markets in 2016 was the local currency. The rand strengthened from the intra-day low Rand/US-Dollar exchange rate of 17.99, at the height of the infamous Nenegate incident, to end the year at 13.69. For foreign investors, the tailwind of the rand was an additional windfall over and above the impetus from emerging market equities, having the best year over their developed market counterparts since 2010. For local investors however, the strength of the rand was a drag for the SA equity market which earns over 60% of its profits offshore and now having to translate back into rands at a lower exchange rate. Whilst foreign investors enjoyed US-dollar returns of 18.4%, local investors had to settle for paltry rand returns of 2.6%.
From a local asset class perspective, SA bonds led the charge spurred on by the currency strength and falling bond yields, to deliver returns of 15.5% followed by SA cash which gave investors a return of 7.4%. 2016 was the first year that bonds have beaten equities since 2011; so convincingly so that bonds actually outperformed cash and equities in every quarter in 2016.
The sectoral performance of the SA equity market largely emulated the trend evident globally, with commodity-led sectors significantly outperforming financial shares and industrial shares.
Commodity shares benefited from the combination of US-dollar commodity prices, soaring in the wake of a weaker US-dollar for the better part of the year and the low valuations of commodity shares; which gained favour as value investing came back in to vogue.
The resources sector posted spectacular returns of 34.2% for the year with iron-ore plays, Assore (300.3%) and Kumba Iron Ore (285.9%) leading the pack; following iron-ore prices surging 101.5% to close at $77.91 per ton by the calendar year end. General miner shares rallied 61.6%, led higher by Anglo American and African Rainbow Minerals which returned 182.8% and 133.3% respectively; also beneficiaries of having some exposures to iron-ore. Platinum and Gold shares closed the year with returns of 50.5% and 30.4%, respectively, following a stellar 1st half where they almost doubled in value but consequently lost over one-third of their value in the 4th quarter as a consequence of the reflation trade.
The fortunes of financial shares through the year were influenced by local bond yield’s dependency on the currency and also by the impact that Brexit has on those shares which have an exposure to the United Kingdom (UK). Financials were 2nd best performing sector, delivering returns of 5.4% for the year.
Banks, as interest rate proxies, were sold off significantly during the Nenegate debacle, providing a welcome entry point for investors and delivering 33.6% returns for 2016. UK exposed financial shares came under pressure on concerns that the UK Pound exchange rate will continue to weaken beyond multi-decade lows as well as the impact of a negative feed-through from a weaker UK economy following Brexit. UK-domiciled property counters fell materially with London-focused property developer Capital and Counties shedding 51.4% of its value, Redefine International falling 38.6% and retail-focused Intu Properties declining 33.5%. Holding company, Brait, which has the predominant portion of its value attributable to numerous UK assets, was also a Brexit casualty. Old Mutual and Investec were least affected amongst the UK exposed financial shares, falling 13.0% and 13.9% respectively, given that, despite their UK-listings, the majority of their earnings are in fact from outside the UK.
Industrials was the worst performing sector for 3 of the 4 quarters of 2016, largely due to a high exposure to shares with offshore earnings but also shares which are considered defensive in nature. The combination of the strength of the rand and a global sell-off in defensive shares on the back of rising bond yields contributed to industrial shares declining 6.1% by year end. Further compounding these factors was R126.6bn of foreign selling of SA equities which was concentrated in both dual-listed shares and shares with offshore earnings within the industrial space.
The hospital sector sold off 15.3%, dragged lower by the newly constituted Mediclinic International which fell 33.0% as an offshore, defensive share that continued to revise its guidance lower on disappointments in the Middle-East business. The pharmaceutical sector fell 6.3% with Aspen Pharmacare dropping 7.6% in 2016, despite announcing a successful debt restructure as well as a significant deal with global pharmaceutical company AstraZeneca. Following a good performance in the earlier part of the year, British American Tobacco fell out of favour following the announcement of its proposed buy-out of its US-listed associate Reynolds Tobacco to finish the year down 7.5%.
Another contributing factor to the industrial underperformance was the poor showings from cyclical industrials, namely the local retailers and offshore luxury goods player, Richemont. A slew of disappointing earnings updates from the local retailers led to Woolworths and Mr Price reporting share price declines of 26.3% and 17.3% respectively. Richemont was plagued by a continuation of negative Swiss-watch sales around the globe compounded by the strength of the rand, resulting in its share price falling 16.3%.