Investment views in the midst of market turmoil
Portfolio management at these times requires staying true to our investment philosophy. This ensures we do not react to short term noise, but consider the longer-term impact of events and the potential opportunities they present.
STANLIB Absolute Returns cut risk significantly at the end of February, reducing exposure to offshore equity in favour of offshore cash and SA nominal bonds.
STANLIB Equity team indicates that unless company and macro fundamentals are no longer sound, they will remain invested based on their overall investment thesis. Where fundamentals change (positively or negatively), the positioning will be continually assessed to determine if any changes need to be made within the portfolio.
STANLIB Fixed Income continues to be positioned defensively across the income spectrum. Income Funds are very low duration the team continues to improve the average credit rating of the instruments in the portfolio.
STANLIB Listed property indicates that the current volatile market as a result of COVID-19 and sharply declining oil prices presents the opportunity to invest in defensive global property companies in the logistics, healthcare, data centre and towers sector.
STANLIB Index Investments who manage a multi-factor equity fund remains cautious about the future macro-environment and the continued impact of COVID-19 on future growth. During times of uncertainty and softening macro-economic data they favour defensive factors such as growth and quality.
The worldwide panic about coronavirus (COVID-19) gathered momentum in recent weeks, as contagion outside Chinese borders continued to grow and the World Health Organisation declared it to be a pandemic. Market volatility was compounded by a sharp drop in the oil price after Russia and Saudi Arabia failed to agree to cut output.
Portfolio management at these times requires a calm head and staying true to our investment philosophy. This ensures we do not react to short term noise, but consider the longer-term impact of events and the potential opportunities they present.
Absolute Returns views
Just when we thought it was time to “take risk”, following a phase one US-China trade deal and many factors leading to an increasingly favourable market environment, it became clear by February that COVID-19 was spreading exponentially through the Chinese mainland.
At the time we highlighted the likely impact of supply and demand shocks feeding through to the economic data and market dynamics over the next quarter. The extreme response from China to contain the virus meant we could expect a soft patch for markets, assuming that the virus would not cross borders.
We were not so fortunate. The virus has now spread to multiple countries with a significant impact on Italy. Markets took in the reality of worldwide contagion and the impact of limitations on human movement, supply chain disruption and the potential shock to what was, until then, a seemingly “bulletproof US consumer”. The market moved quickly to price in the negative feedback loop of declining growth, earnings and short-term cashflows, especially in an environment characterised by over-indebted capital structures that support rich equity prices. This price reaction stretches from the negative equity moves to an aggressive move across to “safe” sovereign bond curves and an adjustment in currency markets, most notably the yen. All of these point to significant fear and to some degree, rightly so.
In our minds the “draconian” virus containment in China, followed by the closing down of Italy, is too late, and the spread will continue. The reaction from various governments, and more importantly society, may well dictate how extreme the economic impact is.
As was the case in late 2018, the US Federal Reserve has cut rates by 50 bps in an emergency meeting (despite continued strong economic data) in an effort to shore up market confidence. The futures market is pricing in further cuts by the Fed this month. Central Bank commentaries around the world are unanimous in their statements around “standing ready to act”. We believe they have taken and will continue to take action. The virus has stirred credit markets because of the potential cashflow impacts of supply chain disruption, and stocks have begun pricing in some really poor earnings results.
Oil has sprung a leak, adding to market fragility
The announcement about the breakdown of OPEC agreements, more specifically Russia declining to join OPEC in curbing oil production, and subsequently Saudi Arabia slashing oil prices, has effectively ushered in a short- term price war between the two largest exporters of oil. Oil, which is a highly leveraged sector in US junk and high yield markets, has sprung a leak.
The market adjustment to an oil price drop has impacted global equities dramatically again, at a time where fear is already elevated. It remains to be seen if this is something that is resolved quickly or if it is a longer- term play against US shale markets. Clearly, leverage (or capital structure) is a concern when looking at a company like Sasol, whose equity was down approximately 80% between 9 and 12 March. BHP, a diversified resources company with around 25% of its EBIT coming from energy, was down approximately 20% for the same period. Both highlight the risk to equities in highly leveraged corporates. To be clear, BHP is not excessively leveraged, but it is leveraged to the cycle, despite being a so-called rand hedge!
In 2015/2016, we saw similar issues in credit markets among material companies. This time, the system and corporates are more leveraged, and we are at peak margins and elevated equity multiples. As a result, the speed of the move lower in equity and yields and, more widely, in credit spreads was eye-watering. In our minds, the combination of these two events has materially increased the risk to the constructive outlook we provided only a few weeks ago.
We believe markets move economies and right now the market is screaming for “support”. A co-ordinated fiscal response from superpowers is probably looming. Will it come quickly enough? Will it be enough? We have learnt not to “fight the Fed”, but a fear-induced demand and supply shock is creating a potential economic air-pocket. The impact on growth is hard to quantify but it will be poorer than current consensus. While the economic impact of COVID-19 is clearly negative, the extent is unknown. While we hope this does not usher in a recessionary world, the oil spat adds even further to the downside probability.
Portfolio decisions – adapting quickly
We cut risk aggressively towards the end of February and went into March very conservatively positioned, although still holding emerging market debt. We indicated in February that COVID-19 spreading outside China would be a game-changer. We therefore cut equity risk aggressively towards the end of February after our momentum, volatility and market liquidity signals began flashing negatively across multiple markets. We have no advantage in our COVID-19 information and understanding but are simply following our process and philosophy. Our first job is to protect capital and, as you would expect, we have continued to act with that objective at front of mind.
Market fear is currently feeding on itself, and given the small clustering of virus cases reported in the US, the slow widening of credit spreads and “stickiness” in volatility curves, as well as anecdotal evidence of business stoppages, we have not yet added capital into equities or SA fixed income. Our view of the rand relative to SA bonds has been borne out (with fixed income holding steady and the rand seeing significant pressure) but the call becomes much tougher from here. Staying very liquid is important and allows us – should we see opportunities – to deploy and manage risk in more volatile markets. Our broad positioning at the end of February relative to the end of January (when COVID-19 was still largely contained) shows a significantly reduced exposure to offshore equity in favour of offshore cash and SA nominal bonds. Despite our previously articulated views (pre-COVID-19), we adapt to events and manage risks as they develop. We believe we are well placed to take advantage of the opportunities that are thrown up when market volatility erupts.
Equity and Balanced Views
Market volatility over the last few weeks has been abnormally high. The uncertainty that COVID-19 has introduced into financial markets, as evidenced by recent price movements, shows that financial markets can extrapolate and potentially over-react to available information, even when the data is unclear. This in itself can provide opportunity for the patient investor to earn above-average market returns from attractive valuation levels.
Portfolio positioning: staying the course
As with every market cycle and short-term market movement, it is important for us to stay true to our investment philosophy and process. Unless company and macro fundamentals are no longer sound, we will remain invested based on our overall investment thesis. Where fundamentals change (positively or negatively), we will continually reassess our positioning and determine if any changes need to be made within the portfolio. We believe that the pace and quantum of the sell-off indicates that the market is reacting on sentiment, and not necessarily to longer-term fundamental changes. Therefore, within our balanced funds, we are maintaining a broadly neutral allocation to equities. Our equity positioning remains aligned to companies with higher-quality growth business models, supported by funding capacity that can steer them through these troubled times.
We need to be mindful that further spread of the virus could constrain economic activity and may potentially trigger a credit spillover, impacting company inventory levels and sources, debt levels and access to credit.
Looking forward: volatility remains elevated
We anticipate economic data slowdown and earnings contraction during 2020. However, with China and other countries actively stimulating their economies by way of monetary and fiscal policy, we expect data to improve dramatically from these very depressed levels, which will ultimately support risk assets. The worst-case scenario is that COVID-19 could see the global economy dip into a recession.
We expect volatility to remain elevated as new information becomes available and we will closely evaluate the valuation levels of the respective asset classes and align portfolios accordingly to the medium- to long-term opportunities.
We will continue to closely monitor the developments around the COVID-19 virus and its potential impact on economic growth and earnings.
Fixed Income Views
The South African fixed income market was not spared from the week’s market turmoil. This adds to SA’s prevailing headwinds, which include the effects of load shedding, recession fears, the possibility of a Moody’s rating downgrade and a National Budget that may be difficult to achieve.
Portfolio positioning: defensive
Our portfolios continue to be positioned defensively across the income spectrum.
Bond Funds are short duration biased with an underweight position in the long end of the curve. On the credit front, we have for some time been deliberately opting for quality and avoiding lower-rated credit options, which could suffer more in difficult environments such as we are experiencing now. For the past three years, we have also been reducing our allocation to credit, as the spreads have reached overstretched levels and do not adequately compensate us for the risks assumed.
Our Income Funds are very low duration (now operating very similarly to Money Market funds) and we continue to improve the average credit rating of the instruments in the portfolio. We are also keeping a close eye on fund liquidity. We are continuously stress testing the funds for liquidity and any possible valuation losses after a likely Moody’s downgrade.
Looking forward: liquidity brings opportunities
While we remain defensive in uncertain markets, the market sell-off presents opportunities, given some elevated yields and the shape of the yield curve. Major central banks are easing rates to manage the economic impact and will probably introduce other tools to further support markets. These liquidity injections are expected to be positive for high-yielding assets across all markets, given developed market bond yields are already close to zero or negative.
The next big development could be a resumption of the carry trade, depending on the announcements from major central banks. The South African Reserve Bank is now also expected to cut rates by at least 50 basis points this year, since the already benign inflation profile is likely to tick lower as demand wanes and oil prices linger at lower levels.
Listed Property Views
Market uncertainty resulting from COVID-19 and the recent dramatic fall in the oil price have increased global and local listed property price volatility. Listed property is a long-term investment, and, during periods of economic expansion or decline, global property lags the general economy. This is because commercial real estate (REITS included) have slower-moving income profiles as the leasing and rental fundamentals do not change rapidly.
Impact on the global property sector
COVID-19 is expected to impact global retail, hotels, lodging and even certain diversified asset sectors the most. This is particularly the case in Asia where we have already seen some retailers offer rent reductions and reduce operating hours at shopping centres. Admittedly, these are all short-term measures, but they are indicators that are likely to impact the industry fundamentals.
Initial Impact of COVID-19 on global property sub-sectors
Impact on SA property
Key factors impacting our local sector align to the worldwide impact including, declining shopping centre trading densities, a decline in foreign tourism to our shores and the impact on office staff that are required to self-quarantine. From a leasing perspective, COVID-19 will possibly have a negative impact on retail lease negotiations, but is less likely to impact office and industrial rentals. Building activity is also likely to slow, as investors are uncertain on the impact of COVID 19.
Portfolio positioning: Defensive
STANLIB’s global property fund is significantly underweight retail properties. We also continue to be overweight logistics companies, for example Prologis. The fund is underweight hotels in total and we sold out of our hotel exposure in Japan at the start of the year. From a country perspective, currently China is not represented in the top 15 countries in the EPRA NAREIT property benchmark we use, with 61% of the index being US-based. Global property cash weightings were as high as 3% at the beginning of the year. We will look to deploy this cash in better quality and growth property shares when opportunities arise.
COVID-19 will continue to present direct and future risks to global and local property. With our active approach to fund management, we intend to favour shares that can weather short-term volatility.
STANLIB’s local property fund has been underweight large retail shopping centres over the last year, this represents our concerns around the weaker fundamentals of this sector. We have offshore biases in the portfolios, with a preference to companies exposed to strong underpinning GDP growth fundamentals, healthcare systems and where proactive COVID-19 measures have been put into place. COVID-19 will continue to present direct and future risks to local property. As fund managers, we consider COVID-19 as a factor in our investment decision making process, with a focus on positioning our funds to property shares that can weather such volatility.
Looking forward: uncertainty prevails but opportunities can arise.
At this stage, it is premature to draw strong conclusions in respect of the impact of COVID-19 on global property markets. The 2002 SARS epidemic provides the closest model for predicting the impact of COVID-19 and it had a muted impact on real estate markets. SARS did not derail the long-term rental performance of property markets. If the spread of COVID-19 is contained swiftly worldwide, the financial impact on real estate markets is expected to be short-lived.
The low global rates are supportive for global REITS, however performance is expected to vary across different property sub-sectors. We expect retail, and hotels/lodging resorts to be most affected by COVID-19 in Asia.
Global rate easing should support an expansion in REIT multiples. We are concerned that the US, which is a significant market for global property, may be under threat if the spread of the virus is not contained in this region. We would expect healthcare and logistics sub-sectors to be the defensive plays in that market.
Market volatility may be difficult to navigate but it does often present investment opportunities. Through our thorough in-depth fundamental bottom-up analysis, we are able to identify and invest in attractively-valued property shares with conviction. The current volatile market as a result of COVID-19 and sharply declining oil prices give us the opportunity to invest in defensive global property companies in the logistics, healthcare, data centre and towers sector. The potential for greater remote working, increased healthcare for the elderly, and increased focus on cold chain logistics will improve demand for these sectors.
Index Investments: Multi-Factor Equity Views
Since COVID-19 started in China at the end of December 2019, there has been significant asset class volatility. Within equities a tremendous dislocation has taken place. This can be seen in the outperformance of US growth stocks over value stocks. US growth stocks have accelerated significantly since the start of COVID-19.
Value vs. Growth in United States
Coronavirus period: 31 December to date
From a South African perspective, we see a similar situation, however the dislocation is even more pronounced.
Value vs. Growth in South Africa
Coronavirus period: 31 December to date
Portfolio positioning: defensive factors in favour (Multi-Factor Equity)
We remain cautious about the future macro-environment and the continued impact of COVID-19 on future growth. During times of uncertainty and softening macro-economic data we favour defensive factors such as growth and quality. In line with this view, our Multi-Factor Equity Fund has 35% exposure to growth, 30% to quality, 15% to momentum stocks and the remaining allocation to sentiment and value. The table below shows our current top five overweight positions in the fund.
Source: STANLIB Index investments
Within the fund, there are stocks that have been negatively impacted by COVID-19 as a result of their exposure to the Chinese market. These stocks are Richemont (CFR), Glencore (GLN), Kumba (KIO) and Sappi (SAP).
Source: STANLIB Index investments
Encouragingly, our positioning on these stocks is fairly contained and is consistent with our systematic and disciplined decision-making process.
During times of volatility and uncertainty, it is critical that we stay true to our philosophy and continue to do so throughout the COVID-19-induced market turmoil.