exchange Market Overview Contents December 2016/ January 2017 Monthly Economic Indicators Analysts Contact us

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1 December 2016/ January 2017 exchange Market Overview Contents Market Outlook Big tobacco comes full circle Incorporating ESG in the investment process Monthly Economic Indicators Indicators 28 Nov 2016 m/m change y/y change USD/ZAR % -4.7% GBP/ZAR % -21.3% EUR/ZAR % -4.4% EUR/USD % 0.2% Gold (USD/oz.) % 12.9% Platinum (USD/oz.) % 10.6% Oil Price (USD/oz.) % 7.5% JSE ALSI % -2.8% FTSE % 6.7% S&P % 5.3% ALBI % 6.9% Analysts Mark Appleton Jason Forssman Chantal Marx Contact us Relationship manager: Dealing desk: Website: The US election was by far and away the major influencing factor on investment markets over the period. The Donald Trump victory and Republican control of the US Congress resulted in a significant sell-off of US Treasuries with money being rotated into the US Equity market. This switch in direction of fund flow was prompted by an expectation of fiscal stimulus via lower taxes and greater infrastructural spending.an anticipated increased borrowing requirement and a higher inflation expectation proved to be negative for bonds while a lower corporate tax expectation and scope for an improved economic growth outlook boosted equity market sentiment over the period. A more positive assessment of the US economic outlook and its potential higher interest rate implications also boosted the US Dollar which appreciated against most currencies. Notwithstanding firmer commodity prices on the back of greater expected infrastructure spending emerging market currencies were particularly weak following the election in response to concerns about potential protectionist trade policies being adopted by the incoming administration. The US Election aside, global economic indicators were slightly positive over the past month. The JP Morgan global manufacturing PMI increased to 52.0 in October from 51.0 the previous month which represented a two year high. In the US manufacturing PMI readings edged higher and existing home sales reached the highest level since February While non- farm payroll employment gains moderated to in October ( in September), the unemployment rate declined marginally to 4.9% (5.0% previously).headline inflation increased to 1.6% y/y in October from 1.5% in September suggesting a strong probability of a December Fed Fund rate hike. In the Eurozone the Markit manufacturing PMI rose to a 33 month high of 53.5 in October (52.6 in September). Headline inflation climbed to 0.5% y/y from 0.4% although core inflation remained unchanged at 0.8% y/y for the third consecutive month suggesting a likely extension of the ECB asset purchasing programme beyond March In China the Caixin manufacturing PMI reading increased to its highest level since July Headline inflation increased 2.1% y/y from 1.9% the month before but it remains well below the 3% target. In Japan economic growth for the third quarter was higher than anticipated on the back of higher external demand growth. Headline inflation made it out of

2 deflationary territory with a reading of +0.1%y/y although core inflation remained negative at -0.4% y/y. On the local front, indicators were fairly mixed over the period. On the negative side were a drop in manufacturing PMI readings, weak vehicles sales and a rise in the unemployment rate to 27.1% in the third quarter from 26.6% in the previous quarter. On a more positive note mining production expanded 3.4% year on year retail sales bounced back to 1.4% y/y, and credit extended to the private sector expanded 7.2% y/y from 6.2% the previous month. SA also posted a trade surplus of R6.7 billion from a deficit the month before. Headline inflation was a little higher than anticipated at 6.4% y/y from 6.1% y/y the month before. We anticipate inflation falling back below 6% in the second quarter of The SA Reserve Bank elected to keep interest rates unchanged as was widely anticipated. More recently two ratings agencies saw fit to retain SA s investment grade rating (we await the third) although the relatively fluid political situation remains a concern for these agencies in general. Market Outlook While it is acknowledged that potential fiscal stimulus is a positive for risky assets in a global context there is much to suggest that caution should not be thrown to the winds. This includes already very high debt to GDP ratios and potentially higher interest costs which present a headwind to both economic growth and valuations. In addition there is much uncertainty around protectionist and restrictive immigration policy which in and of itself presents a threat to growth. While higher commodity prices are a definitive positive from a local perspective the prospect of a rising interest rate environment globally could present capital flow challenges. The Rand has weakened back bond yields have moved higher and the equity market has struggled to get into positive territory. From a sectoral perspective Resources has been a clear outperformer. While forward dividend yields have improved, higher bond yields over the period and below average implied equity risk premiums (3.6%) suggests that the bond market should continue to remain a favoured asset class. Money market yields in excess of 8% means that the opportunity cost of remaining cautious is not very high. On the currency front there are increasing signs that the current account deficit is likely to continue diminishing based on weakening import demand. Risks to forecasts are significant on both sides of the forecast given the fluid political dynamic and substantial event risk. Offshore investment continues to retain investment merit from a diversification perspective. Mark Appleton, Chief Investment Officer (mappleton@fnb.co.za) Big tobacco comes full circle Big tobacco is all about brands, scale and the ability to increase prices at a rate greater than any structural decline in demand. All these factors are boosted, rather that constrained, by anti-smoking legislation. British American Tobacco was formed in 1902 as a joint venture (JV) between the United Kingdom s Imperial Tobacco Company and the United States American Tobacco Company. While the parent companies agreed to not trade in each other s respective jurisdictions, trademarks, export businesses and subsidiaries were developed in the joint venture. In 1911, the US Supreme Court upheld the decision of a lower court in United States v. American Tobacco Company, ruling that American Tobacco had violated the Sherman Act (Anti-Trust legislation) and ordered it to divest from the JV. The lower court acknowledged that American Tobacco was efficient, had not raised consumer prices nor depressed tobacco prices, did not constrain suppliers or coerce competitors. Yet it found that as any merger of material competitors reduces competition, such merger was by nature anti-competitive and therefore illegal. Following the Supreme Court decision of 1911, American Tobacco was split into American Tobacco, R. J. Reynolds, Liggett & Meyers, and Lorillard, while the relationship with Imperial was ended when American Tobacco divested from the British American Tobacco JV. Imperial gradually sold out of British American Tobacco and eventually fully divested from the company in the early 1980 s. The 1911 decision resulted in the world tobacco industry becoming much more fragmented. Post 1994 however, the tobacco industry began entering a period of renewed consolidation. A new (old) global tobacco landscape 105 years after the initial company was disbanded, British 2

3 American Tobacco announced its intention to acquire the remaining 58% of RAI (R.J. Reynolds) it did not already own. The company will basically take on the form of the initial group pre the 1911-ruling with the exception of Imperial s ex-jv assets. It could be the largest tobacco company on the planet by market capitalisation, and combining low debt costs and the ability to extract some cost synergies, the deal has the potential to drive further earnings growth for shareholders. Market analysts have begun contemplating whether it would make sense for Altria and Phillip Morris to reunite after having been separated as recently as Should this occur, global tobacco will essentially be in the hands of two companies with market capitalisations of, $150 billion (British American Tobacco and RAI) and $274 billion (Altria and Phillip Morris), leaving Japan Tobacco in third place with a market capitalisation of $75 billion. For many, perhaps the great irony is that the industry was far more competitive at the time of the antitrust ruling in 1911 than today. The second and even greater irony is that other legislation set out to curtail the tobacco industry has inadvertently fuelled its success. Legislation driving re-consolidation Big tobacco is all about brands, scale and the ability to increase prices at a rate greater than any structural decline in demand. All these factors are boosted, rather that constrained, by anti-smoking legislation. Given the persistent and potential threat of substantial legal liability, only companies with large balance sheets and an existing footprint are able to participate in the tobacco industry. A near complete ban on the marketing of tobacco products compounds this, and makes it almost impossible for a start-up to enter the market and build a brand. Without the ability to build a brand, there is no hope of success and thus an impenetrable barrier to entry is created by legislation protecting the very industry it was designed to curtail. While legislation has been successful in driving a structural decline in developed market cigarette sales volumes, this volume decline, in turn, justifies industry consolidation. The re-consolidation of the industry which began in the mid 1980 s has led to substantial scale benefits. In 2015, British American Tobacco produced 663 billion cigarettes in 44 factories, reduced from 50 factories in With the aid of technology and modern supply chain management, the industry has consistently been able to maintain below inflation constant currency cost growth. With no new entrants in the market and the cost benefits of scale, the last ingredient to mega profits lies in the unique ability of the industry to increase prices at rates above inflation and thus ensure that revenue continues to grow despite reduced demand. Aside from the fact that, the addictive nature of tobacco makes the price relatively inelastic, anti-smoking legislation and sentiment has allowed governments to place hefty excise duties on tobacco products, these duties are in general increased annually, at rates higher than inflation. As excise duties are increased and publicised for political effect, manufacturers are able to increase their prices in tandem and consumers simply bear the burden of their habit. Higher prices and lower costs translate to expansions in margins and profitability, and provide a solid investment in an otherwise highly competitive and uncertain world. Figure 1: British American Tobacco vs the FTSE 100 Index (rebased) British American Tobacco TR (GBp) Source: Bloomberg, FNB Securities Jason Forssman, Fund manager - Ashburton Investments FTSE 100 Index TR (GBp) Incorporating ESG in the investment process The incorporation of environmental, social, and governance (ESG) factors in investment decision making has become mainstream over the last decade or so. Deviating from traditional finance theory where value creation is targeted at shareholders only, a broader stakeholder approach is now demanded by investors and society at large. This means that complying with King III is no longer enough for investors. Society wants to know that a company is taking care of the environment and conducting its business with a constructive social agenda. For example, in South Africa it should be known that a mining company not only subscribes to good corporate 3

4 governance and protects its shareholders, but that it is not polluting water resources close to its operations, has a rehabilitation programme in mind for when operations reach end of life, and employs and empowers women and historically disadvantaged individuals. Will the mine make the lives of people living in surrounding communities better by bringing employment, infrastructure and sustainable growth to the area or will it bring migrant labour, a ruined environment, and long term community health issues? Besides the warm and fuzzy feeling that a focus on ESG factors can give investors, more recently it has been suggested that companies that focus on the softer issues could offer better risk adjusted returns (relatively speaking). It is argued that companies addressing ESG issues are better geared towards sustainable growth which will positively impact valuations (and share price returns), and that a focus on these issues can also reduce risk not only operationally, but also from a market return perspective. The rise in popularity of factoring ESG in the investment decision making process could also result in a good corporate citizenship premium being assigned to the company s share price also leading to higher returns. When exploring the hypothesis that companies which address ESG issues provide a higher risk adjusted return to investors in the stock market, we find divergent outcomes from studies conducted both offshore and locally. Specifically, many earlier studies found no significant difference between ESG influenced portfolios (indices) and conventional funds (market indices). More recent studies have been more conclusive and uniform in finding a positive influence on performance. This confirms the assertion that the rising importance and incorporation of ESG factors in the investment process may have resulted in a rerating of companies with good ESG track records. We reference some of the more recent academic papers (<5 years old) written on the subject. Short term influence: In a news-based study on the market reaction to ESG factors in Swiss, US, and UK stocks findings were inconsistent and irregular (Pasquini-Descomps & Sahut, 2014); Arpana (2013) however found that a simple trading strategy based on SRI and ESG screens produced abnormal returns in the Indian stock market. Long term influence: Nagy, Kassam and Lee (2015) found that ESG tilt and momentum strategies were effective in generating alpha over an eight year period against the MSCI World Index; Chelawat and Trivedi (2013) found that in India ethical investment yielded superior performance versus a benchmark portfolio over five years. While the literature is mostly confirmatory of the positive impact the factoring of ESG factors has on investment returns in recent times, it must still be determined how sustainable this positive impact is. Bebchuk, Cohen and Wang (2013) found that, in-line with the Efficient Market Hypothesis, strong ESG metrics are not associated with abnormal returns after the initial incorporation of new information (disclosure/research thereon) into stock prices. This means that some of the results quoted above may have just been distorted by an initial rerating impact as ESG information was incorporated into valuations. After the fact, the difference in performance could have been insignificant. That being said, none of these studies focus on risk adjusted return or operational sustainability over the very long term. Risk and expected return are considered key factors in any investment decision the return on an investment made must justify risk taken. One of the most basic measures used to assess risk-adjusted return is the Sharpe ratio. The Sharpe ratio considers excess return (expected return over the risk free rate) per unit of risk (as measured by standard deviation). So in basic terms, investors want to select vehicles that offer them the highest possible Sharpe ratio. In the context of equity selection, investors will therefore look at companies that are expected to outperform and, while diversification remains the best way to reduce risk in a portfolio, the risk profile of the individual instruments chosen will also have an influence. We use the MSCI South Africa ESG Index as a proxy for ESG factors being considered in the investment decision making process, and consider its absolute and risk-adjusted returns to the MSCI South Africa Index as benchmark. Figure 2: MSCI South Africa Index versus MSCI South Africa ESG Index risk adjusted return (rebased) MSCI South Africa GR Source: Bloomberg, FNB Securities MSCI South Africa ESG GRTR Over a five year period, the ESG Index outperforms the benchmark both on an absolute and risk adjusted basis. We confirmed the statistical significance of the outperformance 4

5 in both cases using a paired t-test two sample for means. Over the last year, the ESG index outperformed again but over the shorter period the outperformance was not statistically significant. From the graph below it can also be seen that the initial outperformance seemed strong but the performance differential has been more or less maintained recently. Results from more recent studies and indeed our own assessment confirm that incorporating ESG factors into the investment process could add value. Although we are unsure if initial gains from incorporating ESG in making investment decisions will continue over the long term, we are reasonably confident that shorter term/initial gains can be made. And even if it proves to not be a sustainable value creator over time, as long as it does not destroy value - warm and fuzzy will be good enough for most investors. In building long term portfolios, consideration can be made for ESG issues in company valuations either by incorporating operational impacts in forecasting or including an ESG factor when calculating the discount rate. Investors could also take a less scientific approach and consider simply tilting their portfolios to include more ESG focused companies. Reference List Arpana, D. (2013) A Study on SRI & ESG Investing. Asian Journal of Research in Business Economics and Management, 3 (11), pp Bebchuk, L., Cohen, A. & Wang, C. (2013) Learning and disappearing association between governance and returns. Journal of Financial Economics, 108(2), pp Chelawat, H. & Trivedi, I.V. (2013) Impact of Ethical Screening on Investment Performance in India. IUP Journal of Financial Risk Management, 10(4), pp Gladysek, O. & Chipeta, C. (2012) The impact of Socially Responsible Investment Index constituent announcements on firm price: evidence from the JSE. The South African Journal of Economic and Management Sciences, 15(4), pp Nagy, Z., Kassam, A. & Lee, L.E. (2016) Can ESG Add Alpha? An Analysis of ESG Tilt and Momentum Strategies. The Journal of Investing, 25(2), pp Pasquini-Descomps, H. & Sahut, J. (2014) ESG Impact on Market Performance of Firms: International Evidence. Ipag Business School, Working Paper Chantal Marx, Head of Research (cmarx@fnb.co.za) Disclaimer: The valuations, calculations, prices, opinions and all other information (the information ) contained in this document is issued by FNB Securities (Pty) Ltd (Reg no: 1996/011732/07) ( FNB Securities ) - a part of the FirstRand Group. An Authorised user of the Johannesburg Stock Exchange (JSE) and Financial Services Provider (FSP182). Whilst all care has been taken in the provision of the information in this document, this information is provided without liability to us, our affiliates or any officers or employees of ours. The information expressed in this document is done in good faith and is not intended to constitute any form of advice, including but not limited to financial, legal or tax advice. Some of the information may have been provided or sourced from third parties and we do not in any way guarantee its accuracy or correctness. At all times we will endeavour to ensure that information obtained from any third party is accurate and reliable. FNB Securities and its affiliates disclaims and assumes no liability for any loss or damage (direct, indirect or consequential) that may be suffered from using or relying on the information contained herein. Investment in shares may cause exposure to certain risks, including market risk, and may therefore not be suitable for all clients. Please contact your relationship manager for a personal financial analysis prior to making any investment decisions. FNB Securities and its affiliates disclaims and assumes no liability for any loss or damage (direct, indirect or consequential) that may be suffered from using or relying on the information contained herein without seeking professional advice. All rights in the FTSE/JSE Africa Index Series vest in the JSE and in FTSE International Limited ( FTSE ) jointly. FTSE is a trade mark of the London Stock Exchange Group of Companies ( LSE ). JSE is a trade mark of the JSE. 5