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JSE down 40% in dollar terms.
By Magnus Heystek*
Over the past 5 years Brenthurst Wealth has followed a deliberate investment strategy which was aimed at reducing local equity exposure in exchange for high income funds while at the same time increasing our offshore equity allocation, sometimes quite dramatically.
This strategy has been communicated over the years to our clients and the general investing public via seminars, newsletters and advertising campaigns.
This approach put us at odds with the asset management industry who viewed our underweight SA-stance as being “negative” and “short sighted”. Over the past few years we have often been approached by local equity managers with their offerings of “undervalued SA equites”, which we have consistently refused.
At end December 2019 we had a total exposure to SA equities across our investment portfolios of less than 10% of total assets under management, which was dramatically less than the average weightings of around 40-60% elsewhere in SA equity markets.
Our macro-research identified several deep-rooted structural issues within the SA economy and financial market which shaped our view that better returns in the equity space was to be found elsewhere in the world. At the same time SA’s very high yields offered very handsome returns, well in excess of the inflation rate.
But even the most successful investment approach could not withstand the brutal impact of not one, but two Black Swans, as these unforeseen and unpredictable events are called in financial markets.*
At the time of writing of this report (which runs the risk of being overtaken by events) global financial markets and economies are gripped by one of the most dramatic and spectacular collapses in modern history: the outbreak of the Covid-19 pandemic while at the same time the oil-price war which broke out between Saudi Arabia and Russia, two of the largest members of OPEC, which saw the oil price plummet to below $30 per barrel.
And even the unprecedented intervention by major central banks around the world in cutting interest rates to zero, could prevent one of the most dramatic sell-offs on stock markets all over the world.
This sell-off into bear market territory (a drop more than 20%) happened very briefly and without any technical warning. A month ago analysts were still confident that the 11-year bull market in global equities had some way to go.
All this changed in 7 trading days when Wall Street trading was halted on several days and on Monday 16th March, Wall Street recorded its largest point drop (over 3 000 in the Dow Jones Industrial Index) in history.
The safety of high-income funds
Brenthurst clients who invested in high income funds suffered no losses at all while investors in offshore equities were protected to a certain extend by the sharp drop in the rand from levels around R14/$ at the beginning of the year to R16,70/$ on the 16th March.
Pure equity offshore funds suffered dramatic drops in US dollar terms but the bond exposure within our Brenthurst Global Managed fund offered some kind of protection. It remains our single biggest offshore fund with more than R600m in assets.
The events over the past three weeks are equal to the collapses of stock markets in 2008, 1998 and even as far back as 1987. On the 19th October 1987 I was witness as a financial editor of a major newspaper when the DJ-Industrial index dropped 21% in ONE day.
Investors on the JSE have suffered a brutal loss. While down across the board, when expressed in US dollars, the JSE is down 40% so far this year. This is particularly painful to foreign investors who price their asset in global terms. This could lead to a further withdrawal from the local market which has seen foreign investors withdraw more than $500bn over the past 5 years.
Impact on SA economy
The sudden and unforeseen turmoil in investment markets and the economic upheaval all over the world also comes at a very inopportune time for the beleaguered SA economy.
Alan Pullinger, CEO of FirstRand, one of the country’s largest financial institutions, says SA’s economy has deteriorated so sharply that growth has “gone off a cliff” and a recovery could take as long as five years. “The economy is on its knees,” Pullinger said at the group’s interim results presentation on 10th March, where he presented a bleak outlook for the full year, saying it would trail behind its previous forecast of delivering earnings growth above inflation.”Our GDP outlook for the year anticipates 0% growth and will probably drift negative. We are pretty sure we will not deliver real earnings growth for the year, but should remain positive,” he said.
Real earnings growth implies earnings rising faster than inflation. With inflation at 4% and FirstRand delivering growth in headline earnings of 5% for the six months to end-December, Pullinger’s statement implies the results in the second half will be weaker than the first half.
Like its competitors, FirstRand, whose portfolio includes First National Bank, Rand Merchant Bank and WesBank, reported an increase in nonperforming loans, reflecting the stress that consumers are feeling within a stagnant economy and increased joblessness.
These are likely to get worse as companies and a state sector struggling with an unsustainable fiscal position seek to consolidate spending, especially on wages. An economy that slipped into its second recession in two years in the fourth quarter is facing fresh headwinds from the coronavirus spread, which has seen growth forecasts for economies across the world slashed.
Pullinger lamented the slow pace of implementing structural reforms, echoing comments made by his counterpart at Standard Bank Group, Sim Tshabalala, last week. He said that SA’s economic recovery could take three to five years and that a widely anticipated downgrade of the country’s debt by Moody’s Investors Service to junk is almost irrelevant because it is unlikely to be the only one with key reforms not forthcoming.
“The sense of urgency just doesn’t seem to be there, and as a country we are truly running out of choice and time. We never mentioned Moody’s in our presentation because to us it’s almost irrelevant. We are now anticipating a cut beyond the downgrade,” Pullinger said.
While he lauded the government’s determination to address the public sector wage bill, he said reaching an agreement with the unions is going to be extremely difficult.
In any event, if the reductions were agreed to, the medicine would make the situation worse over the short term, and that would mean everyone is going to feel the pain of lower wage increases for public servants, he said.
On the positive side, with consumer price inflation so well anchored in the middle of the targeted range, it gives the Reserve Bank the space to continue lowering interest rates.
The central bank could cut the repo rate 25 basis points three or four times, though this “has to be weighed against foreign creditors demanding a higher yield to lend to an economy that is stagnant”, he said.
Bulls and bears fighting it out
The Covid-19 outbreak, it appears, is on the verge of becoming a global pandemic and its impact on the global economy will likely be much larger than was initially thought. Markets are in turmoil because of the threat to global growth and the related uncertainty that this brings. It is just too early to predict what the ultimate impact will be. This lack of visibility has manifested in abnormally volatile share prices since the end of January 2020. The Bulls and the Bears are engaged in a tug of war where both appear reasonably equally matched for now.
The bullish case
The Bulls believe that the economic impact on China and the world will be severe but short-lived. Gross Domestic Product (GDP) in the first quarter (Q1) of 2020 should experience a deceleration (and possibly even a mild recession) induced by a sharp contraction in Chinese manufacturing. As the virus subsides naturally into the northern hemisphere summer, Chinese manufacturing and global economic activity will rebound sharply resulting in a V-shaped recovery. Annual GDP growth should therefore only experience a small negative impact. Bulls draw from the SARS experience in 2003 where Chinese growth fell to just 3% in Q1 2003 but by the end of that year the impact on annual GDP was less than 1%. They also argue that central banks around the world are injecting massive monetary stimulus into the system, which will also be complemented by fiscal stimulus in the most affected economies. Historically these policy interventions have been hugely positive for equity markets even though their effectiveness, in relation to economic growth, is questionable at best. The Bulls therefore advocate “buying the dip” which has been a very profitable strategy over the past decade.
The bearish case
The Bears believe that China has underreported the severity of the virus and that the economic impact will be much worse than currently forecast. In the short-term, large downgrades to global GDP growth mean that earnings expectations will be sharply downgraded. Given that global markets were already significantly overvalued before novel coronavirus, the de-rating could be far more severe than many expect. Warnings from large corporates are increasing by the day. Industries such as airlines, luxury cruises, shipping and tourism have reported drastic drops in current and projected volumes. These industries have high fixed operating costs and will likely experience financial distress which could have knock-on effects in banks and the financial system in coming months.
Longer-term market implications are more concerning. Multi-nationals have concentrated the bulk of their supply chains in China. Global pharmaceutical, telephony, technology hardware, automotive and mineral processing are but a few which will be forced to reassess the diversification of their business models. This reshaping will have a medium term economic impact which could lead to inflation, supply disruption and margin contraction. Earnings growth could remain below trend for some time which will ultimately lead the market lower.
The Bears are also more sanguine about the likely success of stimulus i.e. the US Federal Reserve’s (Fed) recent surprise cut. They argue that this is predominantly a supply shock and that demand is merely pent up due to containment measures and fear. Cheaper money is therefore largely ineffective in its ability to stimulate additional demand. Instead, a comprehensive package of policies that support troubled businesses is needed. This falls within the domain of fiscal stimulus, which thus far has been absent. Fiscal measures will also take far longer to effect. The size of the response requires greater visibility of the size of the problem. This will only become clearer as the pandemic peaks, which is still some time away.
Conclusion
Markets were expensive and on shaky ground even before Coronavirus emerged. Global growth had already been slowing and 2020 earnings growth projections were in the low single digits; hardly a recipe for rampant equity market rallies. Yet, that is exactly what happened over the past six months. Global equities rallied to record highs in January 2020. Driving factors included the Sino-US “Phase I” trade deal, three US Fed cuts and $500bn of quantitative easing, Chinese monetary stimulus and avoidance of a hard Brexit. The world is flush with cheap money which has underpinned expensive valuations. Despite the recent sell-off, global markets are only 10% or so lower than historic highs – hardly a panic.
Until valuations more adequately reflect fundamentals, our funds will remain conservatively positioned in risk assets. We continue to advocate exposure to cheap, high yielding equities with strong balance sheets and sound fundamentals. These companies will likely be affected but will have the financial strength to weather the effects of a potential downturn. Our funds also hold above average levels of cash, which will provide optionality when markets re-price downward.
At this stage, the South African Reserve Bank (SARB) will probably not want to be seen to panic and will highlight risk-premia to keep foreigners invested. As such, while cuts in 25 basis point increments over the next few meetings are anticipated, a deep cut with more possibly to come by the US, could mean we have room for 50-100 basis point cuts if the picture deteriorates.
That said, Coronavirus has merely accelerated the return to normality. We have no doubt that this, like most other epidemics, will pass. At this stage, however, it is too early to predict the impact on global economic activity and earnings. Until a clearer picture emerges, a cautious approach is warranted.
Different bear markets
Important differences between different types of bear markets While all bear markets are painful, the different categories have very different profiles. Importantly: Structural bear markets on average see falls of 57%, last 42 months and take 111 months to get back to starting point in nominal terms (134 months in real terms). Cyclical bear markets on average see falls of 31%, last 27 months and take 50 months to get back to starting point in nominal terms (73 months in real terms). Event-driven bear markets on average see falls of 29%, last 9 months and recover within 15 months in nominal terms (71 months in real terms).
We remain underweight SA equities and have in fact increased our offshore exposure on the view that the rand can come under substantial pressure as studies by Goldman Sachs have shown.
- Magnus Heystek, Investment Strategist, Brenthurst Wealth.
