COVID-19 Economic & Market overview 23 March 2020
The COVID-19 pandemic continues to dominate conversations in every sphere of our lives. For most, the greatest challenge is navigating the uncertainty created by the coronavirus. This uncertainty is one of the key drivers behind the substantial market declines, despite stimulatory interventions by major central banks, including the South African Reserve Bank.
The longer-term effects of COVID-19 on markets and economies are also playing on market participants’ minds, with many investors pricing in the impact into perpetuity, instead of seeing the effects as temporary.
Our Listed Property, Fixed Income and Equity and Balanced teams provide an update (23 March 2020) on how they are managing current market uncertainty in their portfolios. Chief Economist Kevin Lings also provides a useful update on the virus with some views on the economic outlook.
Click on one of the links below to jump to that section of the article.
Equities and Balanced update
Written by Herman van Velze
At the start of 2020, the world economy was not vibrant, but did show promise of an improvement in global growth. The initial market expectations of the COVID-19 pandemic were that we would see a short and sharp recession with a deferred economic recovery. It was expected that the recovery would be enabled by stimulatory interventions from the major central banks, e.g. the Federal Reserve (Fed), European Central Bank (ECB) and the Chinese Central Bank (CCB).
However, in the last few weeks the economic impact from the virus has shifted significantly and global markets have experienced substantial declines. There are three key points to note as we steer through this pandemic:
- From a monetary policy perspective, central banks have maximised their support, which should technically buffer market impact. Markets have yet to react positively to this support.
- From a social perspective, governments have taken strong measures to protect people by encouraging physical distancing, and imposing travel bans and activity shutdowns that result in a decline in demand for non-essential products and services.
- These measures have affected the demand for goods and services severely, especially travel, tourism and general consumer services.
The resulting impact on the economy has created exceptional volatility, with markets selling down riskier assets. Liquidity challenges in the currency market are compounding the problem, which has exacerbated the pricing impact in the fixed income and equity markets – where there are many sellers and few buyers of assets.
Asset allocation: holding position until clarity emerges
Normally these selloffs are good opportunities to buy risk assets at low prices. However, while we know this pandemic and the effects on markets are temporary, the lack of visibility around both the duration and potential structural impact of are unknown. We therefore remain cautious. Furthermore, we are seeing daily changes in the environment making it difficult to establish a longer-term outcome.
We entered the year defensive with a substantial underweight in SA equities and an overweight exposure to global equity and SA fixed interest, given the risks to the South African economic environment. Our local equity underweight position has increased substantially as we have sold shares in companies that remain vulnerable to the unfolding pandemic.
Stock selection: impact on corporate SA
Companies are experiencing significant disruptions to their normal operations. The reduced ability to generate positive cashflow as a result of government’s measures to minimise physical interaction could result in balance sheet funding issues for many companies. Companies with higher gearing and those that rely on revenue from non-essential products and services will be particularly vulnerable. The knock-on effect for banks will be substantial, as many companies are unable to cover fixed costs with revenue and instead will draw down on debt which they cannot afford. We are awaiting news of a government support programme for companies that are unable to withstand a protracted revenue and cashflow loss.
Opportunities in the wake of the storm
While government’s protective measures have adversely impacted many companies through an outright cut in demand, they have also led to a shift in demand. This shift will see companies in categories such as essential foods and pharmaceuticals benefitting. Satellite TV providers like Multichoice, telecommunication companies and gaming companies such as Tencent, held by Naspers/Prosus, will gain in the current physical distancing environment.
A quality company like Bidcorp, whose share price has fallen significantly given its exposure to the most affected sectors, like hospitality. In many instances, and in the case of Bidcorp, the market is not valuing these companies for a temporary loss in earnings but rather for earnings loss into perpetuity. This suggests they are currently trading at significant discounts. From an equity selection perspective, this is an opportunity to add to our position. We have also added to our overweight position in MultiChoice, as they are well positioned to gain from the shift in demand for stay at home entertainment. We will continue to focus our attention on these types of companies, as well as companies that are well capitalised to withstand downturn and a temporary lack of business activity.
Our substantial holdings in defensive businesses such as Naspers and Dischem will benefit our funds regardless of the outcome. We remain cautious and will consider changes to portfolio positioning when buying opportunities arise.
Fixed Income update
Written by Victor Mphaphuli
As the current market uncertainty continues, central banks including the South African Reserve Bank (SARB) announce intervention to support markets, ensuring market liquidity and supporting businesses under pressure.
Central bank intervention: addressing liquidity and market risk
Central banks have responded to the pandemic, which is causing major economic uncertainty, primarily through the easing of rates. Developed market governments have started to introduce other fiscal and monetary tools, such as funding for impacted business wages in the UK, to further support markets. These actions are expected to be positive for liquidity in general and positive for high-yielding assets, especially given that developed market bond yields are already close to zero or negative.
In South Africa, the SARB introduced a number of actions to alleviate the liquidity and credit concerns and stimulate the economy during this time, including:
- On Thursday, 19 March, the SARB cut interest rates by one full percentage point.
- The following day, on Friday 20 March, the SARB introduced a range of measures ensuring that liquidity is available in the market on a daily and weekly basis. On Friday R19 billion was made available and only R4 billion was taken up, which means the liquidity provided by the SARB is more than adequate at this time.
Our portfolios were positioned defensively with low duration and strong credit quality before the outbreak of the pandemic. The rate cuts by the SARB prior to the outbreak will assist bond holders. The additional liquidity provided by the SARB to the markets provides relief for banks. Banks will come under pressure as businesses start to default on bank loans. These actions support our portfolios which are already well positioned and allocated to predominantly AA high credit quality instruments.
Our portfolios should display low sensitivity to further negative shocks given our low duration, strong credit quality and the ongoing support provided by the SARB.
South African government bonds have now sold off significantly. Yields are now at least 2.5% higher than they were before the impact of COVID-19. Our SA 10-year bond fair value yield remains at 9% (even with a country credit downgrade that we believe was already priced in) and it is currently trading at over 11%. This means our bonds appear cheap.
Income funds have not been impacted by this movement, given the lower risk of income instruments.
As stated previously, while we remain defensive and cautious in these uncertain markets, the market sell-off presents opportunities, given some elevated yields and the shape of the yield curve. We are therefore looking to take the opportunity to slowly increase the duration of the funds and benefit from current cheap valuations. We are looking at increasing bond fund durations to at least in line with the benchmark by the time we get to the Moody’s announcement later this week. We expect Moody’s to downgrade South Africa at this time.
We will not however be considering longer-dated bonds in our income funds, as government finances remain under pressure in the short to medium term, particularly with the COVID-19 impact.
The market environment remains uncertain. Liquidity and solvency risks are investors main concerns, as money is withdrawn from riskier assets and geographies. Our defensive positioning places us in a strong position to weather the downturn and to take advantage of opportunities to benefit from a market recovery.
Listed property update
Written by Nesi Chetty
The local property sector has not been spared the significant stress on financial markets over the last two weeks with year-to-date declines of almost 45% for the listed property index. Large liquid companies like Growthpoint, Redefine and NEPI Rockcastle have seen their shares down to some of the lowest trading levels in their history.
During this uncertain time, it is usually better to stay invested and avoid crystallising losses driven by market sentiment, as this would mean missing the opportunity to participate in a subsequent market recovery.
Understanding the drivers of market performance: sentiment and fundamentals?
Listed property investors typically focus on the income generated by the funds and the underlying properties to determine the yield on their investment. Yields have been fairly stable, even as property companies have adjusted pay-out ratios and strengthened balance sheets through a shifting business cycle and low growth economy.
However, in the prevailing stressed environment, foreign investors into our property market have become concerned about liquidity and emerging market exposure, and exited the market quickly. This market sentiment and the resulting property sell-off are driving a significant reduction in valuation. Furthermore, investors are unable to assess the future impact on property companies, given the uncertainty around the duration of this pandemic and the outcome. History shows us that when the environment improves, foreigners will again return to our markets looking for yield.
While we are uncertain of duration of this pandemic, the impact over the short term will fundamentally place property companies under pressure. In the retail sector for example, footfall at shopping centres has declined due to social distancing being implemented, and we see disruptions due to trading bans on restaurants, pubs and other places of gathering. Rentals will therefore come under pressure as tenants opt to close shop. The travel restrictions will also result in weak performance of properties, like the V & A Waterfront, that are reliant on foreign tourists.
Government support for businesses occupying their space, is expected to alleviate the short term pressure for property companies. The level of support granted by government and private sector, e.g. banks, should also assist the longer-term outcome. We believe about half of the decline year-to-date is sentiment driven, while the rest is due to weakening short-term fundamentals in the sector.
Property Companies: Adjusting to a new operating reality
The COVID-19 impact to date on property sub-sectors is outlined below:
- Retail: Reduced footfall across shopping centres is expected to impact rentals earned over the short term, but food anchors will continue to trade well.
- Office: Flexible working will see more people work from home as opposed to offices. We don’t, however, expect office rentals to be impacted in the medium term.
- Offshore: Reduced trading in some centres in Romania and Poland, as a result of these governments’ banning of non-essential retailers from operating and only allowing food anchors and pharmaceutical to continue to trade.
- Logistics and warehouse: We expect this sub-sector to hold up well in this environment, as supply chains are critical during this pandemic.
Overall, our investment thesis suggests that some property companies have been oversold and therefore unfairly devalued in the short term. We expect distributions per share to be revised downwards in the short term (3 – 6 months), taking into account the impacts of the slowdown. On the positive side, the recent rate cut of 1% by the South African Reserve Bank will improve liquidity for the markets and support local and global property refinancing and valuations. Expect, as a temporary measure, some property companies to suspend or defer dividend payments to conserve cash.
Where to from here?
At the start of the year we were cautious in our outlook for listed property. In our engagement with management teams, we urged them to bring down high loan-to-values (debt) and retain sufficient cash for a tougher local market. We actively positioned the portfolio towards more quality, defensive counters, pre COVID-19.
COVID-19 and the recent soft lockdown measures in South Africa have and will continue to impact sentiment, trading and overall economic activity. We continue to be defensively positioned in property sectors that show value, such as logistics, storage, low LSM retail and offshore inward-listed companies. We remain cautious and continue to manage the developing market risks. The next few weeks and months will be testing, but we believe markets and economies will eventually emerge from the current stress, and long-term investors should not panic.
Property is a long-term investment, and for the patient and discerning investor the current listed property valuations offer many opportunities.
COVID-19: pandemic update
Written by Kevin Lings
Globally, the number of COVID-19 infections has, once again, risen substantially during the past week. As at 23 March a total of 339 645 people are estimated to have been infected with COVID-19, which is up a staggering 157 155 infections in just one week.
The focus, in terms of new infections remains on Italy (which recorded an increase of 29 598 cases over the past week), Spain (a rise of 17 173 infections in the week), Germany (a jump of 12 598 infections during the week), and the United States (up 22 973 in the week). These four countries represent 56% of the weekly increase in COVID-19, although a total of 169 countries are reporting infections.
Unfortunately, despite an extensive lock-down in most of Europe, there is still no clear evidence that the rate of new infections is abating. Instead the number of deaths worldwide is now up at 14 717, but more positively at least 98 840 people have recovered from the virus, which means the number of active cases in the world is currently around 226 088. It is critical that the world will quickly get to a situation where the number of people recovering from the virus each day exceeds the number of new infections. Yesterday, this ratio stood at 9.3 to 1.0. In other words, nine more people are testing positive for the virus for every one person that is recovering. Two weeks ago, this ratio was down at 1.6 to 1.0.
In contrast, the rate of new infections in mainland China, where the virus originated, as well as South Korea (which has the most comprehensive testing programme in the world) continue to moderate meaningfully. In China, the number of new infections has slowed to an average of 26 per day over the past week – all from people flying into China, while in South Korea it is down to an average of 101 per day.
It is also extremely encouraging that out of the 81 454 people infected in China, only 6 188 still need to be treated. In fact, the city of Wuhan in China, the epicentre of the virus reported no new infections on Thursday last week and is slowly returning to business, including the opening of the railway station, the removal of car checkpoints, the return of some workers and even the re-opening of Starbucks. That does not mean things are back to normal. The streets are still relatively empty, food supplies remain difficult to obtain and prices are 300% to 400% higher than normal.
In South Africa, the number of infections has risen to 272, mostly in Gauteng, Western Cape and KwaZulu Natal. The government is trying to evaluate the success of the “lock-down” measures the President introduced just over a week ago and need to decide if more stringent restrictions are required. It appears highly likely that more restrictions will be introduced this week.
Economic impact update
South African Reserve Bank announced support
- Interest rate cut of 100bps
Encouragingly, the South African Reserve Bank (SARB) decided to cut the repurchase rate (repo rate) by 100bps to 5.25% at its Monetary Policy Committee meeting last week. The decision was unanimous. The SARB last adjusted interest rates on 16 January 2020, when they cut rates by 25bps. Prior to that they cut rates by 25bps in July 2019.
The SARB also highlighted that despite substantial currency weakness in recent weeks, they do not expect that this will result in any significant upward pressure on inflation. In other words, the pass-through impact of currency weakness on inflation is now assumed to be extremely low and should not prohibit the SARB from cutting rates further. Especially given the expectation that the petrol price will decline by around R2.00/l at the beginning of April, due to the sharp fall-off in the international oil price, pulling inflation significantly lower.
- Measures to improve liquidity in SA money market
Last week the SARB also announced a range of measures to improve liquidity in the South African money market. This follows concerns by many market participants that the lack of liquidity in the markets was pushing the cost of funding unnecessarily higher and that the bond market looked like it was “freezing”.
Overall, the recent 100bps cut in interest rates, the improved money market liquidity and the pending large reduction in the petrol price will certainly help to ease the current downward pressure on households and business sector. However, these measures cannot stop South Africa’s economic recession deepening significantly over the coming months or halt the further substantial increase in the number of people unemployed.
Global economic outlook
In terms of the outlook for the world economy, most global growth estimates continue to be revised substantially lower. The COVID-19 shock is now expected to produce a global recession, with all of the world’s major economies experiencing a sharp contraction in activity over the next three months. This means that for the US, the longest global expansion on record will end in Q1 2020. It also means that the global and local economic outlook debate should start to focus on gauging the depth and the duration of the 2020 recession, not whether or not there will be a recession.
For example, we have already adjusted the Q1 2020 growth outlook for China to a massive decline of 34% quarter-on-quarter, largely in response to the sharp-fall-off in retail sales and industrial production in February 2020. Economies closely tied to the China supply-chain (such as Korea and Taiwan) will directionally follow China’s growth path in Q1 2020, consequently, growth forecasts for these countries have also been substantially reduced. The economic debate is therefore focused on understanding when these economies are expected to return to growth?
For the United States and Western Europe, the COVID-19 shock will likely straddle the first two quarters of 2020. The decline in activity during March will likely be sufficient to tip both economies into contraction in Q1 2020, but the real economic impact is expected to be concentrated in Q2 2020, where both regions are expected to contract at a double-digit annualised pace. These outcomes are worse than were recorded during the global financial crisis or the European sovereign crisis.
While the COVID-19 shock is moving more slowly through emerging markets outside Asia, their vulnerability is increasing in a number of areas. In addition to their heightened sensitivity to falling global demand for manufactured goods and commodities, they are experiencing a significant tightening in financial conditions – including South Africa in the past week. Oil producers are experiencing concentrated terms-of-trade losses, while relatively weak public health systems in many emerging markets suggest that the spread of the virus may prove wider and take longer to contain.
Looking beyond the first half of 2020: scenario building
Given the apparent containment of COVID-19 in China and South Korea, it can be argued that the process of normalising China’s economic activity could start to emerge in H2 2020, boosted by monetary and fiscal stimulus. Under these circumstances, the depth of the current downturn could become a springboard for a strong snapback in growth towards the end of 2020 – the so-called V-shaped recovery. The speed and strength of the recovery in China is important not just in shaping global business confidence on its own but also because it is likely to be treated as a template for how other economies could rebound once the virus is under control.
This argument can be taken further to suggest that the aggressive containment measures in most of the other major economies will cause the number of active infections to peak at around 10 weeks after the surge in infections were first recorded. Under these circumstances, the fading of the virus threat should result in some resumption of economic activity in key parts of the world, that systematically gains momentum towards the end of 2020.
Unfortunately, the above scenario relies on at least two critical assumptions.
- Aggressive containment measures are effective
Firstly, that the aggressive containment measures introduced in many countries will actually be effective in controlling the spread of the virus – so far there is still no indication that this will occur. If the virus cannot be contained, the virus outbreak will persist for longer than many people envisage, and consequently economic activity will remain restricted for a longer time, resulted in the emergence of more serious economic consequences including a credit crisis as household and corporate defaults surge, as well as a social crisis as unemployment rates surge. The widespread closure of many businesses would negatively impact world economic growth over the coming years.
- Containment of re-infection in China and South Korea
The second key assumption is that the risk of re-infection, especially in China and South Korea, can be contained. A too rapid relaxation of the containment restrictions could result in a renewed surge in the virus. The policymakers in China face a critical dilemma: if their containment measures are removed too quickly, the virus could again start spreading, but if the restrictions are maintained then the recovery will be much slower. Ultimately, if the recovery in China falters or the virus outbreak remerges as the restrictions are removed, investor and business sentiment is likely to ratchet down again on fears that the economic destruction could be much larger than currently believed with the pandemic lasting much longer.
On balance, it is fair to assume that the various authorities around the world are likely to take a cautious approach such that the containment restrictions will remain effective for longer. This, along with the slowdown in global demand, will temper the pace of any potential economic recovery.