Blue Quadrant MET Worldwide Flex comment - Jun 16
US economic growth slowed in 1Q 2016 and was below the average growth rate of 2.4% reported for 2015 and 2014. The slowdown was driven by a further reduction in private domestic investment as non-residential fixed investment spending contracted further. Personal consumption expenditure also slowed due to a drop in durable goods spending and vehicle sales. The collapse in energy prices and a stronger US Dollar have acted as key headwinds for the US economy, impacting negatively on the US manufacturing sector as well as broader export sector.
On the positive side, disposable income growth has remained robust and remains above personal consumption expenditure growth which suggests current consumer spending remains quite restrained. As such, we expect household consumption to recover over the course of 2016 supported by continued job growth and historically low debt servicing burdens. Consumption accounts for over 70% of the US economy and a recession without a retrenchment in consumer spending is a very unlikely prospect.
Growth in the broader Eurozone remained resilient in 1Q and recent indications suggest this trend has remained intact during 2Q. Stabilisation in key emerging economies such as China, accommodative central bank policy and accelerating German property prices, could see overall growth in the region remain positive in 2016.
The most recent Chinese PMI data for June shows further signs of a potential recovery, however manufacturing sector activity appears to have weakened during the latter half of the quarter. Substantial longer-term risks remain for China. The aging demography suggests that the total number of employed workers in the economy is likely to remain flat going forward. China has also lost substantial competitiveness as wages increased and its currency (nominally pegged to the US Dollar) gained relative to regional competitors.
Stagnant job and wage growth coupled with a political system that is unsustainable in the long-term represents the major risk for China. As USD liquidity tightens over the next few years, the Chinese currency will likely be forced to devalue further, while capital outflows are also likely to persist.
Recent GDP data for 1Q16 showed that the economy contracted mainly due to a sharp contraction in the mining and agricultural sectors. Mining output was likely impacted by declining output in key segments such as coal and iron ore, as international prices for these commodities plunged in the final quarter of 2015. The demand-side of the economy also appeared to weaken in 1Q16, with growth in the trade sector slowing. Recent and possible further rate hikes, as well as stagnant job growth, is likely to see consumer demand, and by implication, the trade sector, remain under pressure.
Already retail confidence in 2Q16 according to the EY/BER survey has plunged even further, pointing to weaker growth ahead. The reading this quarter also represents a new 15-year low, taking the compiled confidence index to the lowest levels since 2001 and lower than those that prevailed during the last recession in 2009.
Although recent PMI data for the local manufacturing sector has shown some improvement since the first quarter, the indications suggest that the activity in the trade and services sector are likely to show some deterioration in the second quarter compared to the first quarter. This will make it difficult for the SARB to further raise interest rates, despite lingering concerns regarding the inflation outlook.
On the positive side, recent trade data has surprised to the upside and indications suggest the country may, in fact, run a trade surplus in the second quarter of the year. The rebound in mineral commodity prices, particularly gold and platinum, has helped support export prices and revenues, while depressed oil prices will further help contain the country's import bill this year. The decline in oil imports has been the major factor helping to contain the overall trade deficit. However, a secondary and also important factor is depressed domestic demand for new vehicles, and other imported durable goods, as well as capital investment driven equipment imports.
As such and coupled with the continued decline in global bond yields, the local bond market (political risks aside) has seen renewed inflows this year which may continue for the rest of the year. This dynamic will help support the currency over the short to medium-term and will provide further support for the central bank to keep its benchmark lending rates unchanged for the foreseeable future. This could provide some much-needed relief for the economy and provided the currency does not appreciate too much and/or commodity prices resume their decline, South Africa will probably avoid a technical recession this year.
Global equity indices finished the quarter little changed, but subject to significant volatility within the month of June and in particular following the surprise outcome of the UK EU membership referendum. Global markets declined precipitously in the days following the vote, while perceived 'safe-haven' currencies such as the US Dollar and the Yen gained. Local equity indices largely mirrored the move in international indices, first losing ground in the days following the UK referendum but largely recovering these losses into the end of the quarter.
The expectation for more Central Bank stimulus and a further delay in any future US tightening served to further underpin the renewed risk appetite for emerging market assets and currencies. The Rand, in particular, performed well during the quarter despite some temporary weakness in the month of the May and finished the second quarter stronger versus a basket of currencies and notably stronger versus the Pound and the Euro.
Commodities remained resilient during the quarter despite the continued uncertainty with regard to the global economic outlook. Specifically, oil prices moved higher amid growing signs that the supply glut which had led to the large decline in prices in 2014 and 2015 now appears to be easing. More broadly, the resilience in commodity prices, despite the lingering uncertainty regarding global growth, is perhaps indicative of continued supply-side reductions which could ultimately support prices in the longer run.
During the second quarter of 2016, the Blue Quadrant MET Worldwide Flexible Fund generated a positive return of 0.78% return, while the MSCI World Index generated a positive 0.29% in Rand. The fund performed well during April and May as the Rand weakened and the core thematic positioning generated positive alpha.
The surprise UK referendum outcome and the disproportionately negative reaction in financial counters negatively impacted the fund during the final two weeks of June. The recovery in the Rand was largely associated with renewed inflows into emerging market assets and currencies and this further suppressed the fund's returns in local currency terms during the quarter.
During the course of the quarter, we took advantage of the relative outperformance of the fund's gold equity holdings as well some other commodity-related equity holdings by rotating those positions into additional energy sector exposure specifically, companies with more exposure to natural gas prices in North America. Natural gas prices in this region remain substantially lower than the global average and well below the thermal equivalent price level when compared to current oil prices.
We continue to believe that global growth will ultimately surprise on the upside in 2016 and that interest rates in the US will still move higher as the year unfolds. This is a favourable backdrop for US financials, which continue to trade near or at a discount to their tangible book values. Furthermore, economic and monetary conditions in the US suggest little reason for a sharp decline in equity markets. Current valuations and profit margins, on the whole, do point to limited upside over the next few years from current levels. Nevertheless, most of the 'overvaluation' in the US equity market is concentrated in certain sectors, particularly defensive sectors like consumer staples, non-cyclical sectors or those sectors that have benefitted from the 'search for yield'. By contrast, sectors deemed more cyclical or sensitive to the economic cycle such as energy and, commodity producers in general, as well as financials still appear to offer value.
The fund continues to have a significant allocation to US financials including banks, insurers, and investment companies. There is also meaningful exposure to energy producers and select commodity producers. Japanese equities have also received an allocation and the fund has some cash on hand to take advantage of any additional price declines and increase the core holdings.
The investable universe of the portfolio includes interest bearing securities as well preference shares, equity securities, property securities, convertible equities, derivatives and non-equity securities and assets in liquid form. The portfolio may from time to time invest in listed and unlisted financial instruments in order to achieve the portfolio's investment objective. The manager may also include forward currency, interest rate and exchange rate swap transactions for effecient portfolio management purposes. The manager may also invest in participatory interests or any other form of participation in portfolios of collective investment schemes or other similar collective investment schemes as the Act may allow from time to time, and which are consistent with the portfolios investment policy. The trustee shall ensure that the investment policy is adhered to, provided that nothing contained in the investment polcy shall preclude the manager from varying the proportions of the aforementioned securities and assets in liquid form, or the assets themselves, should changing economic factors or market conditions so demand.