Events of the past week will probably go down in the South African financial market history as our own internally induced financial crisis – on Wednesday President Jacob Zuma announced that he is replacing the Minister of Finance Nhlanhla Nene with the relatively unknown David van Rooyen, who was also subsequently replaced on Sunday by the ex-Minister of Finance Pravin Gordhan. These events sent our markets into a tailspin, with the currency depreciating to its worst evels falling 9% versus the U.S. Dollar, nominal bond yields rose around 1.5% and inflation-linked yields were higher by approximately 0.5%. Equity market’s reaction was somewhat mixed with all the rand hedge counters benefiting as a esult of the currency depreciation. The financial sector, in particular banks, was hammered by the change in sentiment in the stability of our financial markets. The latter (Minister Gordhan) announcement did settle the markets somewhat but they are still not back at the same levels pre redeployment of Minister Nene.

Impact on our Portfolios

Fixed Income Portfolios

The events at the Finance Ministry directly hit at what is important to debt investors – policy certainty on fiscal sustainability and accountability. These are normally priced into the level of yields so as to compensate investors for the perceived risk. Traditionally, this component of our local yields has been stable and consistent, i.e., our policy making institutions are lauded for the “developed world” like way in which they have long conducted monetary and fiscal policy. It is true that of late we have been slowly sliding towards the ill-named “junk” credit rating status, but this has principally been due to an incredibly poor hand that the current state of global affairs has dealt. The events of the last week have left fixed income investors floundering in a cocktail of disbelief, anger and defiance. They have had the very fixed income investment philosophy that has been applied consistently for so long shaken to the core. The risk premium referred to above has exploded, and indiscriminate “voting with their feet” has plunged the rand and bond yields into lows not modeled by even the most contrarian fixed income investor. These moves wiped billions of Rands off the local market cap of fixed income assets and were only moderated by the retracement seen once the decision had been reversed. Even with the reprieve, total returns across the fixed income board remain sharply negative for the month-to- date. We are facing a watershed moment as local fixed income investors – we are on the precipice of a fiscal cliff. It is during these uncertain times that our well established investment philosophy and portfolio construction process comes into its own. The focus on fundamental valuation, while taking into account risk and volatility allows for a diversified portfolio that is constructed to withstand dramatic episodes such as the one we have just been through. Our investment process generates alpha from various diverse sources which allows for a well-diversified portfolio that can withstand the impact of such volatility.

An objective assessment of the current state of affairs leads us to believe that credibility has been severely damaged, notwithstanding the reversal of the President’s decision. There are just too many unknowns for us to believe otherwise. We believe the risk premium in fixed income yields is set permanently higher, for now, and will only be reduced gradually as policy certainty is demonstrated. This likely means that fixed income markets will remain volatile, with yields at higher levels than previously expected. This impacts our appetite to run material risk positions in the portfolio and by choice we head into year-end marginally overweight in nominal bond funds and underweight in inflation-linked funds. This reflects our relative return expectation between the two asset classes.

Equity

The overall impact on the domestic equity market ranged from negative 7% for the All Share Index to almost 10% for the SWIX and SWIX 40 indices. Within those indices, Financials (Banks/Insurance and Property) stocks bore the brunt of the selloff, dropping as much as 25% before some recovery on Monday 14 th December. The index was pulled up by stocks that benefit from a weaker currency and by some of the big industrial stocks. Our equity portfolio positioning has a bias towards rand hedge stocks which served as an advantage during the Rand sell off, but the overweight in FirstRand and Standard Bank did hurt the portfolio. The sell-off was not all bad as we took
advantage of the lower prices in rate sensitive domestic retail stocks. We are still positive on both our banks position from a valuation perspective. From a portfolio performance point of view, the behavior of our domestic equity funds did not surprise us, registering alpha in the range of – 1% to + 1%. The portfolio is sufficiently diversified with independent alpha drivers to withstand such market turmoil. We remain comfortably ahead of benchmarks on a medium to long term basis, with an average alpha of 5% on a 1 year view. This is in line with our investment philosophy, which focuses on generating consistent risk adjusted performance over a full market cycle. We continue to place emphasis on active investing based on equity selection and a portfolio construction process that places emphasis on risk budgeting.

Multi-Asset Class Portfolios

We have been underweight domestic equities and property, with no holding in the inflation linked bonds (after being underweight for most of the year). We used the opportunity presented by higher bond yields to close our underweight in domestic bonds to a neutral position post the ratings downgrade but before the massive sell off of last week. We remain fully invested offshore to the maximum allowable limit, and are comfortable in our macro views and valuations.

Africa ex-SA Portfolios

African markets and our portfolios (both fixed income and equity) were largely sheltered by the events that unfolded, as they benefited from the effects of a weaker rand and alpha within the local markets. While 2015 has proven to be a challenging year for Africa ex-SA asset classes, our underlying investment case of diversification and favourable valuations (in the case of equity) and yields (in the case of fixed income) remain intact. We remain of the opinion that an investment into African markets offers South African investors a compelling diversification opportunity. This view was strongly supported by the events of the last week, with SA bonds, equity and property asset classes reacting in unison to the developments in the Finance Ministry. The MSCI Africa ex-SA equity index was up 9.4% in ZAR month to date while the Standard Bank Africa ex-SA Fixed Income index was up 5.6% over a similar period. Both our equity and fixed income portfolios delivered positive alpha relative to the respective indices mentioned here.

Commodity prices capitulated to negative sentiment across the board and the Bloomberg Commodities index lost 25% in 2015, led by energy (-39%), precious metals (-27%), agricultural commodities (-16%) and industrial metals (-12%). Risksspreads rose across all asset classes. The VIX Index rose to a four year high of 40 points in August, before moderating as we approached the end of the year. The Fed did not hike in September2015 as fears of the contagion from global financial market instability led to caution but the FOMC did raise rates in December, and the market took this in stride.

Early 2016 has just been an extension of the H2 15 themes, with volatility being the order of the day. Uncertainty about the Chinese economy is front and center for financial markets. EMs look weaker than ever before in the post-crisis period, with much of the weakness focused on commodity exporting countries and those which compete with a devaluing China. The World Bank has revised its forecasts for global growth weaker yet again, and the deflationary impulse of weaker commodity prices is being felt across the globe. The UK is threatening to leave the EU, and prospects of further instability in Europe make markets nervous. The lack of visibility with respect to how key factors are likely to evolve has created a toxic environment for markets. Flight to quality is the trade and risky assets have had a horrid start to the year.

The key question is whether we have seen the worst? The investment community is split between those who believe that markets are pricing in too negative a scenario for the globe, China and EM and those who believe that we are staring over the cliff and that we are likely to go over the precipice. While things are finely balanced, we would tend to go with the middle ground. When things are this uncertain, it is often beneficial for investors to adopt a wait and see attitude. The challenges facing the global economy and thus financial markets now include:

1. China – growth here is no doubt slowing and economic rebalancing is underway. Academics argue that the Chinese economic model had to necessarily reach a phase where infrastructure investment slowed and demand was reoriented towards household consumption expenditure. The negative impact of this rebalancing on global growth has been reinforced by slowing global demand and tightening global liquidity conditions. Moreover, because of the command and control nature of the Chinese political system, much of this rebalancing will see policy action along the way spurring increased concerns that there could be a policy mistake. Just like the Chinese growth story spurred strong growth across global economies, most notably commodity exporting EMs in the pre and immediately post-crisis periods, it is no surprise that pain is expected across much of the beneficiary countries in the coming years. The argument goes that many EMs in this position needs new growth models, and there is no doubt that there is much “Dutch disease” type effects coming home to roost around the world. We expect that China could keep investors uncertain for years to come. In the near-term we expect this uncertainty will come on the back of ongoing deterioration in some large EM’s fundamentals, and in the longer term on the back of questions about Chinese growth itself.

2. The Fed – As was the case last year, disconnect between what the FOMC predicts for rates and what the market is discounting is a point of vulnerability for markets. Fed funds futures are predicting one 25bps hike this year vs the FOMC dot’s four. Markets have consistently predicted a more dovish path for rates relative to the FOMC but there was some convergence between the market and the FOMC in December. That convergence has now unwound and markets will look to the FOMC meeting on 27 Jan for further guidance. We believe the path outlined by the FOMC in its dots is too hawkish. The employment and consumer spending picture supports tighter policy, but the inflation dynamics do not. The Fed has to contend with a sharply stronger USD amid weak commodity prices and global demand. These factors are likely to maintain some downward pressure on inflation. Ongoing global financial market devaluation could also be perceived as dovish. Insofar as the recent retracement in equity prices could be negative for consumer wealth and confidence, we see equity market turmoil as negative for US rates. The FOMC is likely to delay tightening until markets stabilise, and could continue to pull back policy rate expectations. That said, uncertainty around FOMC decisions could remain a key source of volatility in markets in 2016.

3. The EU and Brexit – The ECB continues to be very dovish and has maintained a growth supportive stance. Consequently the Euro Zone is now less of a risk to global growth and markets compared to what was the case two years ago. Barring more political economy schisms, not as obvious an outcome as we would like, the Euro Zone could emerge as a source of demand in the coming 12-18 months. However, there remains plenty of risk from a political economy perspective in the EU. The first of this is the threat of Brexit. While the UK is likely to remain in the EU, the rise of the voices arguing for exits and nationalist interest across various countries in Europe cannot be ignored. The refugee crisis has also brought the nationalist more airtime, and relations could be more fraught and the Europe more noisy in 2016. To the extent that such challenges on solidarity rise risk premium and reduce confidence, we could see some volatility in markets stemming from threats to EU stability.

4. Oil price – The collapse of the oil price remain a key theme of our times. When we thought oil prices could not fall further, announcement of increased production in Iran and OEPE’s decision to maintain if not increase production saw oil drop top prices last seen in the early 2000. The market is in the throes of a supply glut which looks set to continue for the next few months at the very least. In the meantime every leg down in oil prices ripples across risky assets as investors start seeing the ghost of low demand. We expect that at some point investors will start to look at the oil price and its impact on fundamentals more objectively. Lower oil prices are positive for some economies and negative for others. Once the dust settles the beneficiary countries will start to do well. Many experts believe that the supply/demand imbalance will correct later on in 2016, leading to recovery in oil prices at that time.

South Africa – Victim and protagonist

South Africa has struggled to find itself in the global context explained above. Lower commodity prices and global demand have rippled through the economy via all channels. GDP growth is lower, external imbalances persist and revenue pressures constrain fiscal consolidation. The country is now caught in a cycle of falling growth, widening current accounts, rinsing debt, rising inflation and credit ratings downgrades which started in 2012. The political economy has also deteriorated, as these things typically do, as the economic environment has become more difficult to navigate. The economic malaise has served to expose the country’s weaknesses and leadership is necessary to break out of this negative cycle.

We expect that the ongoing economic crisis could deepen into 2016, with this apparent on all fronts. Where typically investors can look at economic relationships for direction, the path we are on now requires policy makers to come to the party to change the trajectory. Predicting policy makers and political actors is notoriously difficult to do, and to the extent that they can still change the dynamic for the country, we believe that forecast has become more difficult for the years ahead.

GDP growth – Growth has been revised lower again by all comers. The most notable revision being that by the IMF. The institution slashed its projection for South Africa's growth to 0.7% in 2016 and 1.8% in 2017 from its October estimate of 1.3% and 2.1% respectively. Many economists have undertaken similar adjustments to their forecasts. The SARB will likely revise its forecasts for GDP and likely potential GDP growth by similar margins this week. We all hope that the very large revisions will put a floor to the growth outlook following three years of uninterrupted downward momentum in outlook revisions. However, even this is likely a tall ask, with risks to this outlook continuing to be biased lower.

Fiscal policy – The dimming growth outlook has created a bind for fiscal policy. Low growth has led to higher fiscal deficits and thus higher debt levels. National Treasury’s borrowing requirement remains high and the borrowing requirement of the public sector as a whole (including SOEs) have ballooned. Widening funding gaps at large state owned entities (notably Eskom and SANRAL) have increased government’s contingent liabilities and operational issues at smaller entities (notably SAA and SABC) have also pulled on the fiscus. The fiscal room created ahead of the crisis has largely been eroded, and the rating agencies have now become less forgiving. Fiscal policy is now being tightened in a pro-cyclical fashion. We expect that this trend will continue as Treasury tries to stave off ratings downgrades. However, this will further constrain GDP growth.

External accounts – South Africa’s current account deficit widened to 5.8% of GDP in 2013. This widening reflected the strength in import in 2011 and 2012 was exacerbated by the currency weakness from 2012 onwards. The current account deficit has since compressed slowly, as gains in competitiveness have been eroded by a fall in global commodity demand and in 2014, erosion in term of trade. We expect that compression will continue in the coming years. The terms of trade erosion is likely to have stopped as commodity prices have found a floor, and the recent depreciation in the rand will support competitiveness. Moreover, falling domestic demand is likely to further constrain import demand all factors that should see the trade balance move more decisively into surplus. However, the funding of the current account is difficult as the cost of funding has increased. A slow compression in the current account could yet maintain currency vulnerability.

Monetary policy – The stagflationary outlook painted above makes it particularly difficult for the SARB to behave and predict. The SARB had both feared and expected that the currency could come under pressure into Fed tightening, and chosen to raise rates in advance of this move. The rand did indeed depreciate but for different reasons. One was the decline in commodity prices on China fears and the other the decline in investor confidence following the change in finance minister in December. The SARB’s 125bp increase in the repo rate since Jan 2014 now looks inadequate, as the inflation outlook has deteriorated and the country’s cost of funding has increased. We expect that the SARB will again strive to get ahead of the policy curve by raising rates in early 2016, and have penciled in 100bp in the coming 12 months. Only when risk premium on domestic assets compresses can the SARB turn its focus away from inflation risks to growth risks. For now, we expect the Bank will focus overwhelmingly on inflation risks.

Credit ratings – South Africa now looks set to be downgraded to below investment grade by at least one of the two major rating agencies. The last time the country’s foreign currency rating was below BBB- was in early 2003. To the extent that the rating agencies have emphasised growth as a key determinant in the ratings path, and we see no escape from low growth at this time, we believe that the country can do little to avoid a downgrade unless the global environment improves dramatically in the next 12 months. Treasury will likely push to limit fiscal slippage if not reverse it, but in the absence of growth it will be increasingly difficult for authorities to show convincing projections.