FINANCIAL MATURITY Quarterly newsletter April 2015 Jacob Zuma is still at the head of the leading party. The longest strike in South African history has The key focus for the first quarter has been on central banks and their ever growing impact on financial markets. We cannot think of another time in history where markets have been so dependent on the next move by global policymakers, and we do not expect this to change in the near future as markets become increasingly driven by participant s expectations of the feds first rate hike. As always we will focus on what we can control, and that is sticking to our rigorous investment process and allocating capital to the best investment opportunities while ignoring the noise that arises day to day. Market Overview The effect of low rates on asset valuations Rand Hedges on the JSE Warwick Fund Overview: Warwick MET Managed Fund Warwick MET Managed Fund of Funds Warwick MET Enhanced Income Fund Market Overview The first quarter of 2015 has come and gone, and it has been another bumpy ride for global markets, where we continue to see policy divergences among the world s central bankers. On the one hand, you have China, Japan and Europe moving to greater monetary easing and on the other hand, you have the United States and the United Kingdom stopping their quantitative easing programs, and moving towards monetary tightening. One of the big talking points of the quarter was the rally in the US Dollar. The US Dollar index (DXY), which is a weighted average performance of the dollar against multiple currencies, surged 9% during the first 3 months of the year. Welcome to Financial Maturity, Warwick Fund Management s quarterly newsletter. The first quarter of 2015 has flown by. In this issue of Financial Maturity we look back over the first quarter of the year and the many goings-on within the financial market place both globally and abroad. We once again provide an update of our suite of unit trust funds which we hope you will find both interesting and informative. In particular we draw your attention to the launch of our Property Fund that was started in January of this year. We look forward to an exciting second quarter as we progress through the year. Look out for our new look publication when we next distribute this newsletter. Warwick International Managed Fund Warwick Met Property Fund Locally, the market performed strongly as the JSE recorded the largest quarterly foreign inflows seen in 6 years, driving home the point that the economy and the market are two separate beasts. Sidney McKinnon Managing Director Warwick Fund Management Page 1
The first quarter started with a bang as the divergence of global monetary policy really kicked into top gear and along with it, unprecedented volatility. It all started on the 15 th January when the Swiss stunned markets and scrapped the 3 year old peg of 1.20 Swiss francs per euro. In a chaotic few minutes after the announcement, the Franc soared over 30% against the euro and left a wake of destruction across global FX and equity markets. European equity markets were hit hard with the Swiss benchmark index falling over 10% and the German Dax falling over 250 points in a matter of minutes, FX brokers were also left reeling with multiple reports of heavy losses and even insolvencies. This preceded the official announcement of European QE from the ECB, although expected, it came in at a much larger than expected 60bln euros a month. The move by the ECB was necessitated to halt the deflationary forces in the Eurozone and to boost the flailing economies, and although rates are already low, this intervention by the ECB should have the desired effect of transferring wealth from the stock market to investment in the real economy. Recent history from the USA and Japan shows that easing by central banks does have an effect of pushing short term duration assets into longer term duration assets, pushing up riskier assets with real expected returns as real rates turn negative. Finally in the last week of January we had a steady US FOMC which was pretty much in line with expectations. Unlike other central bank meetings so far in 2015. Central banks outside the USA continued to surprise with dovish policy moves, the Australian Reserve Bank joined the list of countries unexpectedly easing policy. This now includes Canada, China, Denmark, Switzerland, Egypt, India, Singapore, Russia and turkey who all cut rates in Figure 1: The US has been creating 200k jobs on average per month since 2010. Q1. This is mainly due to this scary statistic over 76% of developed markets had inflation rates which are BELOW 1% and 16% of all developing market debt is trading at a negative yield (That s 3.6 trillion USD of government debt trading with a negative yield meaning investors pay sovereign countries for the privilege of buying their issuance). These steps taken by central banks have renewed the global search for yield, and have essentially given the EM carry trade another lifeline. Away from the central bank party, we are slowly seeing signs that the US and European recoveries are gaining traction. The February jobs report showed that the US is in the midst of a sustained upswing. Over the past 3 months, more than 1 million jobs have been created, the first time this has occurred since the 2007 economic boom. Furthermore, it was the 11 th straight month of job gains over 200,000.00, the longest streak since 1994. As the US recovery powers ahead, we are now starting to see green shoots emerging in the Euro area. Central bank easing, weakening currencies and low fuel costs are all contributing to this. Page 2
European PMIs are ticking up and holding above 5. Any reading above 50 indicates growth in manufacturing; anything below marks contraction. During February the flash Eurozone PMI came in at 53.5. Eurozone economic surprise index is beating expectations, meaning that economic data coming out of Europe is increasingly beating economists forecasts. Eurozone consumer confidence has recently hit the highest reading in 7 years, indicating consumers are spending more. With the remainder of major central banks easing, we find ourselves in a situation where risk free rates are exceptionally low globally and have been on an accelerating trend towards the zero bound this year. This has been driven by both central banks buying bonds and the perception of slowing global growth in China and Emerging Markets(EM), as China struggles to make the transition from an infrastructure based economy to a consumer driven economy. Looking ahead, we expect the market to be increasingly driven by participant s expectations of central bank moves especially that of the feds first rate hike. Furthermore, in our article on page 6 we try to explain the effects of low interest rates on asset prices and what this means for future returns. Figure 2: Euro Area PMI at 3 year highs. As we end the first quarter, we now expect the Fed to start tightening policy in the second half of 2015 and to proceed at a fairly slow pace, as communicated at the March Fed policy meeting. By removing the language on patience, the Fed has given itself the flexibility to act without precommitting on the exact timing of the first hike, which will be data dependent. Figure 3: The underperformance of the Resources Index (orange) relative to the All Share index (dark blue) over the past quarter continued. Local Market Overview It is important to note that there is no existing precedent of a central bank successfully exiting the so- called zero bound and normalizing policy, thus the Fed is entering the unknown as it charters the next course for its monetary policy and will be vigilant of its actions. The JSE All Share Index started the year off strongly recording gains in both January and February and, although the market pulled back in March, it ended the first quarter of 2015 up 5.85%. The FINI 15 (+10.55%), INDI 25 (+5.99%) and SA listed property index (+13.69%) all performed well Page 3
over the quarter while the RESI 20 (-0.25%), which started the year brightly, ended the quarter in negative territory after a big sell off in the month of March. The quarter has seen a few different drivers of the Page local 3 market early on in 2015. In January, it was the gold miners who pushed the market higher with the gold mining sector ending the month 32.18% higher after a surge in the gold price (+8.1%). In the month of February, we saw the local bourse hit an all-time record level of 53 374.9, driven by resources as the RESI 20 finished the month up 8.7%. In March, the RESI 20 gave back all its gains for the year, while the FINI 15 and the SA listed property sector were the best performers, gaining just over 1% each. dollar strengthens, it makes US exports less competitive, and as US companies convert their offshore earnings back into US dollars, the strong dollar reduces the value of those earnings. Over the course of the quarter, the S&P 500 was down 3.1% in January, hit record highs in February, and was lower again in March. On the economic front, we have seen a mixed bag of data coming out of the US. At its latest monetary policy meeting towards the end of March, the Fed kept its interest rate at 0.25%, in line with market expectations. The Fed also trimmed its gross domestic product (GDP) estimates for the current year to between 2.3% to 2.7% and also expects inflation to likely fall below its earlier forecasts. The basic message from the Fed was that they will increase rates at a slower rate than previously forecast partly due to lower growth forecasts and very low inflation. Figure 4: The All Share Index had a strong quarter. Global Market Overview In the US, we saw the S&P 500 register its ninth quarterly again (if only just), as it advanced 0.4% in the first 3 months of the year. With the US Federal Reserve s having exited quantitative easing, volatility has risen as investors are concerned about sluggish growth and falling earnings. The strong dollar has a lot to do with the lower earnings expectations for US companies that either export goods or receive a large portion of earnings from offshore businesses. The reason for this is, as the Figure 5: The performance of the S&P 500 for the first quarter. A little closer to home, we have seen a lot of activity in Europe over the first quarter. The ECB launched its QE programme during February and judging by the recent data that has been released from the Eurozone, it would appear that recently launched stimulus programme was having desired effects on the Eurozone s economic growth, but they are by no means out of the woods. The ECB President, Mario Draghi, stated that latest data shows that growth in the Eurozone is gaining pace, the credit of which can be mainly attributed to the recent fall in global oil prices, improving external demand, the depreciation of the euro and the ECB's recently launched Page 4
quantitative easing programme. It was further hinted that consumer price inflation in the Eurozone is expected to remain low or negative in the short term, however the region's inflation is anticipated to pick up gradually towards the end of 2015. Eurozone consumer confidence has also recently hit the highest reading in 7 years, indicating consumers are spending more. Looking at the equity markets, we see a completely different picture compared to that of the US. The German DAX has been the star performer advancing by 22% over the quarter and recording its strongest quarter since June 2003. In France, we have seen the CAC 40 also enjoying the benefits of easy money and the index recorded a gain of 17.8% for the period. economy to continue its moderate recovery. The Chinese economy has had a bumpy ride as a property downturn along with slower growth in foreign and domestic demand has taken its toll. Policy makers have cut interest rates twice since November, and in February they reduced the amount of cash that banks need to hold as reserves, to help stimulate the economy. Growth in China's investment, retail sales and factory output all missed forecasts in January and February and fell to multi-year lows, leaving investors with little doubt that the economy is still losing steam and in need of further support measures. The Asian markets have had a strong start to 2015, and much of this has to do with government intervention where investors are flocking to markets where governments are taking steps to fire up economies. Figure 8: Nikkei up 10.1% over the quarter. Figures 6 and 7: German and French Index performances. In Asia, the Minutes of the Bank of Japan's latest monetary policy meeting indicated that they would continue to ease monetary policy until 2% inflation is stable, and that they expect the nation's Figure 9: Shanghai was up 15.9% over the quarter. Page 5
Continuing on from 2014 as the Shanghai Composite ended the first quarter up 15.9%. Investors have looked past the country s sluggish economy and bet Beijing will take further stimulus measures. The Japanese Nikkei has also had a solid start to the New Year, registering gains of 10.1% over the first three months. This has been its best quarterly performance since the end of 2013. The rally means Japan is on pace for a fourth year of gains as the government introduces measures to stoke the economy while the central bank pushes down the yen which assists many of Japan s exporters. One of the other major reasons for the robust performance of the Nikkei has been the purchasing of stocks by the Bank of Japan and more recently by government and quasi-government pension funds. The effect of low rates on asset valuations The direct consequence of this low rate environment is mispricing in certain asset classes (as risk assets are all priced off the back of risk free rates, low rates result in inflated present values) and it is vital to understand the investment implications thereof. While we are aware that yields can remain near zero for longer than we can remain sane, we believe it is important to make capital allocation decisions on the basis that yields will normalize in the future. Bonds and cash Despite the low current returns offered by long term fixed income securities around the globe, investors have been well compensated over the past five years with returns well above the annual coupons one could earn on the bonds due to the global compression in yields. According to a study conducted by Glenview Capital management, US 30 year bonds have returned over 10% (annualized over the medium term), well in excess of the 4% starting yield on these bonds. The major point Glenview makes referring to the US 30 year bond is vital to understand: In order to earn a 10% total return in the subsequent 12 months from the current 2.2% starting point, investors would need to make 7.8% from capital appreciation on top of the yield. With an approximate duration of 20 years in the 30 year bond, this implies 39bps of tightening, placing the 30 year yield at 1.8%. Extracting this track record forward would imply a landing spot of 0% in the middle of 2020. A yield of 0% with 24 years remaining on the bond. As investors it s very hard to get excited over the prospect of earning 0% for the remaining 24 years of the bond. This example illustrates how low the probability is of enjoying a repeat of the past 5 year s strong returns in bond markets. Due to central bank easing and the escalating search for yield, we have essentially borrowed from future returns. Furthermore, we find no margin of safety in bonds if inflation and growth were to exceed current low expectations priced into the market. We are presently cautious on bonds as an asset class and do not expect a repeat of the pasts robust returns. Similar to bonds, expected real returns on cash are low. However, cash does serve as an insurance policy and allows us to take advantage of volatility and market corrections to purchase quality companies when they become cheap. We like having cash in the current environment. Page 6
Equities Equity valuations are affected by the same drivers as bonds. With rates at generational lows, discount rates being utilized to calculate fair values are almost universally too low. We are mindful of this and value equities on the basis that interest rates will normalize in the future, incorporating a margin of safety into our calculations. Comparing bonds to equities, we can see that equities have not experienced the same re-rating (earnings yield compression). The important takeaway from this is that yields, although at very low levels now, may not go back to the historical levels seen in the 80s and 90s, and that the new normal as coined by Pimco is closer to 3-4% long term. The outcome is that equities could easily continue rerating given a structurally lower long run bond yield in developed markets. At Warwick, we are still able to find quality companies with strong management, growing earnings and distributions ahead of inflation and trading on multiples below the overall market. These companies are generally trading at 15-20x forward earnings and growing these earnings at 15-20% per year, resulting in valuations that are attractive, even if rates were to normalize from current low levels. Figure 10: Earnings yield spread to bond yields near highs. We view equities as the best prospective investment in the current low yielding environment and believe investing in companies with the above characteristics will outperform both bonds and cash in the medium term. Most investors looking at the above relationships will argue that bonds are in the mother of all bubbles, and that it is bond yields which are too low, and when these yields normalize and rise closer to their long term average of 4%, the relative attractiveness of equities will disappear. It is our contention that due to permanent structural changes in the global economy, that USA and developed market inflation will be structurally below long term trend for years to come i.e. the 4% long run average inflation rate experienced since the 80s has now permanently shifted to a 2-2.5% rate for the foreseeable future. Rand hedges on the JSE In South Africa, portfolios invested according to prudential guidelines or Regulation 28 are limited to having 25% of their total portfolio invested offshore. However, one tends to overlook the fact that many South African listed blue chip companies that we invest in earn the majority of their revenue offshore. By selectively investing in so called rand hedge stocks we can gain increased access to growing offshore markets and diversify away from the slowing South African economy, while still being invested within our regulation 28 limitations. Page 7
JSE Code Name Sector Offshore Revenue % BTI British American Tabacco Tobacco 95 CFR Richemont Luxury Goods 94 SAB SABmiller Beverages 77 SHF Steinhoff Household Durables 74 MTN MTN Mobile Telecoms 63 NPN Naspers Media 60 MDC Mediclinic Healthcare 57 APN Aspen Pharma 50 BVT Bidvest Industrials 44 Figure 11: JSE Listed companies with large % offshore revenue. Source: Company Reports, Warwick Invest All of the above shares provide a shield against the depreciation of the rand, acting as a hedge against declines in the local economy and protecting local investors from a weakening rand. A second feature of these companies is that they have strong management teams who are actively diversifying revenue streams away from South Africa and deploying capital into faster growing global economies. A case in point is Medi-Clinic, the South African hospital group which we own on behalf of our clients. In 1983 the Rembrandt Group commissioned a feasibility study on private hospitals in South Africa. The result was the purchase of four facilities in Cape Town and Johannesburg and the listing of Medi-Clinic on the JSE in 1986. Over the next 20 years, through a series of acquisitions and building a selection of new hospitals, Medi-Clinic grew to own nearly 50 hospitals across the country, but still earning 100% of its revenue from South Africa. In 2007 management started the groups push offshore, taking a controlling interest in Emirates Healthcare in Dubai. The same year, it acquired 100% of the Hirslanden private hospital group in Switzerland. Today, Medi-Clinic generates 57% of its revenue outside of South Africa and has proven to be an excellent investment due to its growing offshore earnings and managements excellent capital allocation. MDC has delivered total annualized returns of 25% since 2007, far outperforming the market. Warwick Funds Overview Warwick MET Managed Fund At the end of the first quarter, the Warwick MET Managed fund top 10 holdings were as follows: Top Ten holdings Exposure Warwick International Managed Fund 19.10 Warwick MET Property Fund 11.70 Warwick Enhanced Income Fund 10.08 Discovery 3.40 MTN 3.15 Naspers 3.07 Firstrand 3.06 Pick n Pay 2.99 SABmiller 2.96 British American Tabacco 2.92 Table 1: The top 10 holdings in the Warwick MET Managed Fund at the end of March. Source: Metropolitan We used some of the early strength in the quarter to trim and take profits in Mr Price, Mediclinic, Woolworths and Naspers. The volatility that then arose during March allowed us to deploy some cash and we topped up positions in British American Tabacco, SABmiller, MTN, Nedbank and Pick n Pay. As a result of these changes our total equity allocation was reduced from 51.05% at the end of Page 8
Q4 to 50% at the end of Q1. Our listed property exposure remained at 11.70% over the quarter. The Warwick MET Managed Fund returned 4.63% for the first quarter of the year, which is above that of the funds peer group. Warwick MET Managed Fund of Funds The Warwick MET managed fund of funds was rebalanced during February to align to the balanced growth risk model. As is the case with the Warwick International Managed Fund, we will control the asset allocation of the fund and pick the best of breed managers within the various asset classes. The rebalancing involved selling out of our balanced fund managers and utilizing the proceeds to invest with specialist managers within the various asset classes. New investments were made into the Foord equity fund, Coronation top 20 fund, Warwick international managed fund and the Warwick met property fund. The resulting asset allocation is as below: Asset Allocation Exposure Local Equity 51.21 Foreign Equity 21.09 Local Property 11.38 Local cash and Money Market 10.58 Foreign Property 4.62 Foreign Cash 0.83 Other 0.29 Local Bonds 0.00 Foreign Bonds 0.00 Table 2: The underlying asset allocation for the Warwick MET Managed Fund of Funds at the end of March. Source: Metropolitan With the Warwick MET Managed fund of funds, we are now able to offer investors a unitized product which tracks the asset allocation of the balanced growth risk model, while also allowing access to top fund managers such as Foord, Coronation, PSG and 36one. An added benefit of the fund is that investors are able to access discounted institutional fee classes not normally accessible when investing directly. The Fund returned 5.89% for the first quarter of the year which is above that of the peer group, and places the fund in the top quartile. Warwick MET Enhanced Income Fund The fund continued to invest in quality instruments over the quarter with investments made in entities such as Nedbank, Investec, Firstrand, ABSA and Delta. The current one year forward yield of the fund is now close to 7.5% (excluding equity exposure) as we source investments with higher yielding properties. The biggest exposure remains with floating rate notes representing our current view that there is a greater potential for higher interest rates in the medium to long term. The short term outlook remains neutral. Asset Allocation Exposure Floating Rate Note 62.96 NCD 12.06 Call Deposit/Cash 5.98 Participatory Interest - Equity 6.22 Participatory Interest Money Market 1.60 Conduits 1.12 Commercial Paper 3.38 Credit Linked Note 3.53 Fixed Deposit 3.08 ILB s 0.07 Table 3: The asset type breakdown of the Warwick MET Enhanced Income Fund. Source: Metropolitan Page 9
The Warwick MET Enhanced Income Fund has a benchmark of Stefi Call + 1%, offering protection of clients capital in volatile markets. The return over the quarter was 1.66%, outperforming its benchmark over the period. The Warwick MET Enhanced Income Fund remains a good choice for investors seeking higher than cash returns with a low risk profile. Warwick International Managed Fund The geographical spread of the fund was adjusted over the quarter, reflecting an increasingly positive outlook for the European economy. At the end of March, the Americas now represent 48.32%, Europe 24.54%, Asia 16.14% and other regions 11% respectively. The currency exposure of the fund at the end of December was 94.88% in US Dollars. valuation concerns. As a result the fund now holds 90% in equities, 5% in property and the remainder in cash. Over the last quarter the fund delivered a USD return of 2.16% and a positive 4.49% when reported in local currency. The fund outperformed its benchmark over the first quarter. Warwick MET Property Fund The Warwick MET Property Fund officially launched on the 2nd January 2015, offering investors access to an actively managed property unit trust fund. The primary objective of the fund is to achieve long term capital growth whilst producing a steady income stream for investors by investing in the SA property market, sector listed shares and property unit trusts. 5% 5% Equities 90% Property Cash Bonds Figure 12: Asset allocation for the Warwick International Managed Fund at the end of March. Source: Warwick Funds During the first quarter of the year an active decision was made to increase the funds exposure to European equities, in order to take advantage of our increasingly positive view. This move has proven to be prescient as European equities were the top performing asset class in Q1. Furthermore we also reduced global property exposure to 5%, due to Over the long term, listed property has proven to be one of the best asset classes available to investors, returning 21.5% per annum over the last 10 years. Q1 2015 served to reiterate this track record, with listed property delivering a total return of 13.69%, outperforming equities, bonds and cash. It was also a very active year for corporate activity in the listed property sector, with multiple capital raises, especially among the offshore focused property counters. At the end of Q1, the listed property sector is trading on a historic yield of 5.5% and a projected forward yield of 6.0%. Although the forward yield is below the long term average, the sector is still Page 10
April 2015 FINANCIAL MATURITY Quarterly newsletter Jacob Zuma is still at the head of the leading party. The longest strike in South African history has expected to deliver positive real returns due to a number of factors: Rent escalations in the counters we own are at inflation or higher, with the average contractual escalation being between 7-9% per annum. This results in distribution growth above the rate of inflation, capturing real returns for investors. The quality of our portfolio holdings are high, which feeds through to lower vacancy levels and strong demand. This leads to positive operating leverage and inflation beating rent reversions Finally, we are starting to see a rerating of the listed property space as equity investors are being attracted to the strong returns, consistent distribution growth and defensive characteristics. Warwick Wealth Presentation Video Click to watch Warwick Wealth Testimonial Compilation Video Click to watch Warwick Wealth Sponsor of the Spirit Foundation Click to view the website Disclaimer: Performance: Securities (shares) are generally medium- to long-term investments. Investments in listed equities contain some risk as the value of shares may go down as well as up. Past performance is not necessarily a guide to the future performance of the investments. Returns are not guaranteed. This document is for information purposes only and does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe for or purchase any particular investment. Opinions expressed in this document may be changed without notice at any time after publication. We therefore cannot be held liable disclaim any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of or reliance upon the information. Warwick Wealth Limited, registered in Mauritius is an owner of Authorised Financial Services and Registered Credit Providers in South Africa, Mauritius and Guernsey, who operate under the titles: Warwick Invest (Pty) Ltd FSP no. 1218; Warwick Specialists FSP no. 44731; Warwick Funds FSP no. 45442.