THE FED GOT COLD

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M AR KE T O VE R VI E W

Third quarter 2 015

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Contents

THIRD QUARTER IN REVIEW ....................................................................... 3

Global ....................................................................................................... 3

Local ......................................................................................................... 6

OUTLOOK .................................................................................................... 8

ASSET CLASS RETURNS ............................................................................. 11

CONTACT US ............................................................................................. 13

DISCLAIMER .............................................................................................. 13

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T H I R D Q U A R T E R I N R E V I E W

Global

The year started with investors worried about the strength of the US economy. This quickly

transitioned to the risk of a Greek default in the second quarter and, by the third quarter, the focus

fell squarely on China and the fear that a sharp slowdown could push the global economy back

into recession. In hindsight, the US was merely going through a weather-induced “soft patch” and

Greece was bound to accept the bailout terms to prevent it from defaulting, rendering these fears

obsolete. Could the same play out for China? The perceived magnitude of the risks and contagion

stemming from a Chinese hard landing loomed larger than the preceding concerns, pushing

financial market volatility to levels not seen since the financial crisis. At the same time, uncertainty

grew over when the US Federal Reserve would start hiking interest rates.

One market commentator noted that “China sneezed and the Fed got cold feet”. It was

anticipated that the Fed would hike interest rates at their September meeting. Instead, it kept rates

unchanged as global concerns, financial market turmoil and sluggish US inflation weighed against

an improving job market, delaying the country’s first rate hike since 2006. This left financial market

participants uncertain over whether the economy was strong enough to withstand higher interest

rates. Economic data was mixed. The second quarter GDP growth estimate received a massive

upwards adjustment to reflect an expansion of 3.9% and the first quarter’s contraction was revised

to show 0.6% growth. Most of the growth was driven by stronger consumer spending.

Source: Trading Economics

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Buoyant US consumer confidence was a sign that lower gasoline prices had trumped the impact

of financial market volatility and that households were spending the windfall from weak energy

prices. US job data started the quarter on a strong footing with the unemployment rate dropping

to 5.1%, signaling an economy that was close to full employment. But August and September’s

payroll data disappointed with only 136 000 and 142 000 jobs created respectively during each

month, falling short of expectations that were closer to 200 000. A further worrying sign was that

more people left the workforce. It pushed the labour force participation rate down to a low not

seen since 1977. But counter-intuitively, job openings increased. The manufacturing sector was to

blame for some of the job losses in September. The sector moderated amidst a slowdown in global

growth and the impact of a stronger dollar. In contrast, the services sector remained buoyant and

took up much of the slack caused by the manufacturing sector.

Source: Inet

In July, the Greek government succumbed to creditors’ demands and accepted their bailout

terms. This provided the struggling Greek economy with a life line to help recapitalise its stricken

financial system. Prime Minister Tsipras called a snap election following the bailout deal, the result

of which provided him with a stronger mandate to implement the necessary reforms. The Eurozone

in general seemed to be on a better path. Second quarter GDP growth came in at 0.4%, lifting

year-on-year growth to 1.5%. This was in line with the region’s average growth rate over the past

20 years. Due to downside risks to economic growth, the European Central Bank pledged its

commitment to supporting the economy through accommodative monetary policy and that it

stood ready to act with further stimulus.

Developments within China rattled global financial markets, with the region the biggest source of

anxiety for investors who were initially unsettled by the Chinese government’s direct involvement

to stem the slide in the local equity market.

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This was followed by poor communication about changes to exchange rate policy by the

authorities that would allow the currency to be in contention for inclusion in the International

Monetary Fund’s Special Drawing Rights currency basket. Weak manufacturing numbers brought

China’s growth prospects further into question, impacting confidence levels. The stabilisation in

China’s second quarter GDP growth numbers did little to alleviate concern due to the quality and

accuracy of the data being brought into question. The People’s Bank of China cut interest rates

on 26 August with the aim of supporting the nation’s slowing economy. The Chinese authorities

further assured that they would strengthen fiscal policy, boost infrastructure spending and speed

up tax reforms.

A key development for the oil market was the lifting of sanctions against Iran in exchange for the

country easing its nuclear ambitions. It is expected that Iran can double its oil exports from current

levels. The rebound in Brent oil prices in the second quarter was reversed during third quarter as oil

contracts slid to their lowest levels in over six years to trade at $40.74 a barrel in late August as

supply levels remained robust. A late spike helped the oil price to recover somewhat, but it still

closed down -23.2% for the quarter.

Global equity markets suffered their worst quarterly performance since 2011. The MSCI Global

Equity Index lost 8.9% during the quarter and was down 7.5% for the year to date. The S&P 500

Index broke its run of nine consecutive quarters of positive performance to decline sharply by 6.9%

during the third quarter. The worst performing developed market equities were from Europe and

Japan. The Euro Stoxx 50 lost 9.5% and the Japanese Nikkei 225 Index tumbled by 14.1%. The

Nikkei’s loss was despite the index experiencing its biggest one day gain (8%) since October 2008

after Prime Minister Abe signaled a potential cut in corporate taxes. Investors pulled an estimated

$40bn out of emerging markets – the fastest pace since the height of the global financial crisis. The

MSCI Emerging Market Index lost 18.5% during the three months. Local equity market declines were

compounded by currency losses against the dollar.

The drop in the oil price and concern over global growth caused inflation expectations to fall to

such a degree that they were at post-recession lows in the US, UK and Europe. The yield on US 10-

year treasuries fell by more than 20 basis points, and those of German 10-year bunds by close to

20 basis points. As a result of lower bond yields, the JP Morgan Global Government Bond Index

rose by 2.0% during the quarter. Following substantial strength over the preceding 12 months, the

dollar moved sideways against the euro during the third quarter.

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Local

Global financial turmoil manifested in the local market through currency depreciation and further

weakness in the share prices of mining related companies. The rand depreciated sharply and on

a trade-weighted basis touched its worst level on record. Whilst currency weakness on its own

should improve the country’s competitiveness, structural shortcomings caused economic growth

estimates to be revised lower for the next three years. The economic backdrop remained gloomy

and any rebound will come off a low base. Despite economic weakness, the Reserve Bank

maintained a tightening bias in its monetary policy.

The Reserve Bank hiked interest rates by 0.25% to 6% in July – a move that was not fully discounted

by the financial market. Following that meeting, Governor Lesetja Kganyago received some

breathing space from the US Fed that held off on their first interest rate hike and he kept local rates

unchanged at the Monetary Policy Committee’s September meeting. Despite the deteriorating

growth outlook, his tone turned decidedly more hawkish and he warned that the Reserve Bank’s

monetary policy remained on a gradual normalisation path. Growth forecasts were also revised

lower and the Reserve Bank now sees economic growth coming in at 1.5% for this year and 1.6%

for 2016.

The release of second quarter GDP numbers caused quite a stir as these were lower than even the

most pessimistic forecasts. Economic growth contracted by 1.3% during the quarter and year-on-

year growth was a disappointing 1.2%. The slowdown was broad-based, but the largest detractors

were agriculture, mining and manufacturing. Mining and manufacturing productivity did rebound

going into the third quarter, but the data came off low bases and growth was not expected to be

sustained. Alongside the deteriorating growth outlook, business confidence fell to a 16-year low.

Source: Statistics South Afirca

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The drop in business confidence largely reflected concern over the retail and wholesale trade

sectors. Consumers remained under substantial pressure from a poor employment backdrop,

lower disposable income growth, high debt levels and restricted access to credit. The

unemployment rate did inch lower to 25% in the second quarter, but job growth took place in the

informal and public sectors and was absent in the private sector. Another indicator that pointed

to consumer stress was vehicle sales growth that suffered from seven consecutive months of

negative annual growth. September’s decline of 9% was the biggest in more than a year when

almost 5 000 fewer cars were sold than a year ago. Retail sales growth found some reprieve,

seemingly propped up by the drop in petrol prices.

The slowdown in domestic demand had a bigger than expected impact on consumer price

inflation which moderated from 5% in July to 4.6% in August. In addition, fuel price deflation

countered the exchange rate and food price inflation. The slowdown in domestic demand and

growth in exports, which were boosted by the rand’s depreciation, helped the current account

deficit shrink more than expected to 3.1% of GDP in the second quarter from 4.7% in the previous

quarter. The better-than-expected current account deficit provided some short-term support to

the rand, but this faded quickly as global developments dominated.

Source: Statistics South Afirca

The rand lost 13.6% against the dollar during the quarter and has depreciated by 20.7% against

the greenback since the start of the year. During the quarter, foreign investors bought R3.1bn worth

of domestic equities and sold R5.5bn worth of bonds. The FTSE/JSE All Share Index lost 2.1% during

the three months ending 30 September 2015 and is now only 3.4% up for the year to date. The

Resources sector struggled most in the third quarter as companies suffered from earnings

downgrades due to the sharp drop in commodity prices. Resources share prices were 16.7% lower.

Financial shares also ended the quarter in the red with a decline of 2.9% while industrial shares

bucked the trend and closed 1.6% higher.

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Industrial shares benefitted from speculation about the take-over of SABMiller by Anheuser-Busch

Inbev, which caused SABMiller’s share price to soar by 27% in September alone.

Despite foreign selling, the local bond market found support from domestic investors who bought

bonds as interest rates were kept unchanged in September, inflation readings were lower than

expected, and risks of an imminent sovereign credit rating downgrade receded. The All Bond

Index gained 1.1% during the quarter, but underperformed cash that delivered a return of 1.6%

over the same period. For the year-to-date, the All Bond Index’s return of 2.7% also

underperformed cash’s return of 4.8%. Listed property gained 0.8% during the third quarter which

lifted its year-to-date return to 13.3%.

O U T L O O K

It was always known that recovering from the Great Financial Crisis would be a slow process as

excess leverage was unwound. But the liquidity glut from global central banks pushed asset values

higher and kept volatility levels at extraordinary low levels, until four months ago. Investors have

been spooked by the pace and magnitude of recent financial market turmoil, but we view this as

a mid-cycle correction that was necessary to extend the duration of the current business cycle.

The turmoil left financial markets overly bearish with weak economic growth already priced in. A

stabilisation in Chinese economic growth over the coming months is key and will probably be the

swing factor to help sustain ongoing global expansion.

Global growth projections have been revised lower and in the latest International Monetary Fund

(IMF) World Economic Outlook (October 2015), global growth for this year was revised down to

3.1% and next year’s growth to 3.6%. This was due to slower emerging market growth projections

that were driven by the decline in commodity prices. Soft global growth conditions will keep the

global monetary policy bias towards easing. More importantly, the Chinese authorities have further

scope to ease their monetary policy to prevent growth from softening any further. With policy

support currently in the pipe-line, China should start to regain some momentum over the coming

months. It should also be taken into account that China’s share of world GDP has risen dramatically

in the past 15 years. As a result, China’s contribution to global growth has held up well even though

its own growth rate has slowed.

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Source: International Monetary Fund World Economic Outlook October 2015

Since the US Fed’s September meeting, rate hike expectations have moved out, although US

economic conditions still provide the Fed with the right backdrop to increase rates before the end

of the year. It will be important for the Fed to lift rates from zero as soon as possible as this will

remove lingering uncertainty about when rates will rise. The US economy is expanding strongly due

to rising household consumption following the financial windfall from lower energy prices. The

recent slowdown in employment data should not be the start of a sustained deterioration in the

labour market as it is not consistent with rising job openings. The euro area economies are stronger

and more durable than investors currently appreciate. The region is strengthening and showing

signs of a broad-based expansion.

The recent correction in financial markets has left global developed market equities about 10%

cheaper and emerging market equities 25% cheaper. This removed a lot of the valuation froth that

was evident. We expect that global equities will be supported by continued accommodative

monetary policies, soft inflation and a moderate global economic recovery. We are overweight

global equities and expect them to deliver solid returns over the next 12 months. The drop in

developed market bond yields looks set to reverse as economic growth firms, deflation fears

unwind, and the Fed begins the slow process of normalising interest rates. We remain underweight

global bonds, with a preference for absolute return orientated global fixed interest strategies.

Where the sluggish South African economy is concerned, there are no catalysts on the horizon to

prompt stronger growth. Instead, recessionary risks for next year have risen as depressed

commodity prices, poor power supply, labour strikes and deleveraging consumers all weigh

against the economy. The continued lacklustre performance will prevent employment,

consumption and private sector investment spending from recovering. The IMF, in its most recent

revised forecasts, predicted that the South African economy will grow by 1.4% this year and that

growth will slow down to 1.3% in 2016.

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The moderation in economic activity will limit the extent of interest rate hikes and the Reserve Bank

will probably come under pressure to ease monetary policy towards the end of 2016. Inflation is

expected to breach the targeted band early next year, but this should be temporary and it needs

to be kept in mind that most of the upside risks to inflation are largely exogenous. Exchange rate

pass-through effects will be the largest contributor to higher inflation rates. The Reserve Bank

Governor has noted that he won’t use interest rates to defend the currency from depreciating

further.

The rand is expected to remain on the back foot given the local economy’s weak growth

backdrop, low real interest rates, large fiscal and current account deficits and continued risk of a

sovereign credit rating downgrade. The pullback in the domestic equity market has not been big

enough to unwind excessive valuation levels and, going into the final quarter of the year, the

FTSE/JSE All Share Index had already recovered most of its losses. This has once again placed the

equity market in expensive territory with a price-to-earnings ratio of 19 which is close to historical

peaks. We remain underweight domestic equities due to expensive valuations, the weak

economic backdrop and concern over companies’ earnings expectations.

We have lightened underweight positions to domestic bonds and listed property due to the

weaker growth outlook and subsequent downward revisions to interest rate hike expectations.

There are still risks which prevent us from going back on-weight with these two asset classes. They

include downside risks to South Africa’s credit rating, the pass-through effects of rand weakness

on inflation and the lift-off of US interest rates. Financial markets have entered a period of

increasing volatility and we expect this to continue as global growth remains uneven. Given

expected volatility, we believe it is important to keep a maximum allocation to offshore assets to

benefit from the diversification benefits of currency movements.

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A S S E T C L A S S R E T U R N S

3 Months 6 Months Ytd 12 Months

Headlines Indices

Africa All Share -2.13% -2.32% 3.39% 4.79%

Africa Top 40 -1.47% -0.73% 4.88% 4.89%

Africa Mid Cap -5.90% -11.88% -5.20% 3.16%

Africa Small Cap -3.85% -2.45% 0.62% 7.22%

Africa Fledgling -0.39% -1.46% 1.21% 1.07%

Africa Resource 20 -16.72% -20.51% -20.71% -36.42%

Africa Industrial 25 1.63% 3.67% 9.89% 17.77%

Africa Financial 15 -2.89% -5.51% 4.46% 15.29%

Africa Financial and Industrial 30 0.75% 2.09% 9.29% 17.70%

Africa Capped All Share -2.13% -2.32% 3.38% 4.89%

Africa Shareholder Weighted -4.22% -4.34% 2.24% 6.07%

All Share Economic Group Indices

Africa Oil & Gas Index 25.15% 200.00% 172.53% 95.87%

Africa Basic Materials Index -14.42% -15.16% -13.13% -26.43%

Africa Industrials Index -3.05% -6.76% -6.06% -1.96%

Africa Consumer Goods Index 16.11% 16.84% 19.11% 25.31%

Africa Health Care Index -7.94% -15.82% -13.13% -0.79%

Africa Consumer Services Index -7.60% -5.67% 11.17% 32.11%

Africa Telecommunications Index -16.78% -9.04% -11.27% -15.76%

Africa Financials Index -1.06% -3.32% 7.46% 19.11%

Africa Technology Index -4.41% -2.50% 22.70% 33.45%

All Share Sector Indices

Africa Chemicals -14.01% -5.40% -11.43% -16.20%

Africa Electronic & Electrical Index -11.26% -5.19% -9.04% -20.38%

Africa Industrial Engineering Index -15.84% -13.78% -7.27% -11.24%

Africa Beverages Index 25.11% 24.37% 30.71% 26.94%

Africa Food Producers Index 3.89% -0.08% -3.77% 10.95%

Africa Health Care Equipment Index 0.00% -10.70% -1.10% 8.23%

Africa Pharmaceuticals & Biotech Index -17.72% -22.60% -26.35% -11.76%

Africa General Retailers Index -8.95% -5.52% 8.95% 23.07%

Africa Media Index -8.35% -7.07% 14.59% 39.36%

Africa Industrial Transportation Index -6.54% -12.06% -13.78% -8.97%

Africa Food & Drug Retailers Index -3.55% 1.01% 5.36% 26.76%

Africa Fixed Line Telecommunications Index 8.11% -12.46% -0.96% 26.91%

Africa Banks Index -8.47% -11.05% 0.20% 16.04%

Africa Non-life Insurance Index 6.24% 1.50% 8.91% 11.22%

Africa Life Insurance Index -2.07% -7.82% 5.96% 13.41%

Africa General Financial Index -0.51% 10.97% 13.97% 26.20%

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Africa Equity Investment Instruments Index 6.10% 4.50% 7.70% 13.07%

Africa Software & Computer Services Index -4.41% -2.50% 22.70% 34.52%

Africa Gold Mining -8.19% -23.60% -17.71% -25.40%

Africa Platinum & Precious Metals -36.65% -41.81% -50.40% -54.97%

Africa Property Unit Trusts - (PUT) #N/A #N/A #N/A #N/A

Africa SA Listed Property - (SAPY) 6.24% -0.38% 13.26% 25.82%

Bonds, Cash & Inflation

All Bond Index 1.11% -0.31% 2.67% 7.04%

Stefi Composite 1.60% 3.18% 4.76% 6.38%

CPI - New Headline (Previous Month) 1.49% 4.13% 4.59% 4.59%

CPI - History Rebased (Previous Month) 1.49% 4.13% 10.15% 4.59%

Currencies

Rand Dollar Exchange Rate 13.56% 13.89% 20.70% 22.52%

Rand Pound Exchange Rate 9.56% 16.29% 16.38% 14.28%

Rand Euro Exchange Rate 14.20% 17.65% 10.48% 8.54%

Dollar Euro Exchange Rate 0.03% 2.80% -7.98% -11.85%

Dollar Yen Exchange Rate 2.44% 1.20% 1.20% -7.69%

Naira Dollar Exchange Rate -1.32% -1.34% 7.70% 21.95%

Commodity Prices

Brent Oil (USD/Barrel) -23.38% -13.07% -15.33% -48.77%

Gold (USD/oz) -4.94% -5.76% -5.76% -7.76%

Platinum (USD/oz) -15.91% -20.66% -25.02% -30.35%

Copper ($/Ton) -10.98% -15.83% -19.91% -24.39%

CRB Index -14.69% -8.52% -15.72% -30.41%

Global Bonds & Equity

Global Bonds (R) 16.73% 14.14% 19.76% 19.54%

MSCI Global Equity (R) 3.53% 3.52% 11.71% 14.15%

Global Bonds 2.77% 0.20% -0.80% -2.46%

S&P 500 -6.94% -7.15% -6.74% -2.65%

Nasdaq -7.35% -5.73% -2.45% 2.82%

MSCI Global Equity -8.86% -9.13% -7.47% -6.86%

MSCI Emerging Mkt -18.53% -18.73% -17.18% -21.21%

FTSE -6.57% -8.94% -5.57% -5.60%

DAX -10.13% -17.11% 0.70% 4.87%

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C O N T A C T U S

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D I S C L A I M E R

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