Global Market Overview – 1st Quarter 2020
The first quarter of 2020 has been an unprecedented period in financial market history across numerous dimensions:
- The U.S. stock market fell into a 20% bear market in the shortest time ever—just 22 days—and continued further, dropping 30% in a record 30 days. The typical historical bear market peak-to-trough decline has taken around 12 to 18 months.
- Short-term expectations of stock market volatility, as measured by the VIX index—often referred to as the market’s “fear index”—closed at an all-time high in its 30-year history on March 16. And the market’s actual realized volatility has only been higher in October 1987 (Black Monday) and the late 1920s.
- The 10-year and 30-year Treasury bond yields fell to all-time lows of 0.54% and 0.99%, respectively, on March 9. This before shooting back out to over 1% during the same month , adding to overall market volatility.
- Oil prices had their biggest one-day drop since the 1991 Gulf War, plunging 25% on March 9, triggered by a price war between Saudi Arabia and Russia.
This quarter has not been an easy one for most investors. While it was already clear that we were in the later stages of the economic cycle, nobody could have predicted at the start of this year that large parts of the global economy would be brought to an abrupt halt by the COVID-19 pandemic.
Unfortunately, the debate has now moved on from whether or not there will be a recession this year, to how deep and long it will be. As markets have moved to reflect this new reality, equities have fallen sharply, with the worst returns coming in March. The S&P500 fell 20% over the quarter and the FTSE All Share declined by 25%.
Concerns about the effect of the shutdowns on profits have led to corporate bond prices declining, which will have detracted from the returns of some fixed income portfolios. As should be expected, riskier, junk-rated corporate bonds have fallen by more than investment grade rated companies, with high yield energy bonds the worst hit.
Commodity prices, other than gold, fell sharply over the quarter. As countries around the world halted activity to try to bring the spread of the virus under control, demand for most commodities declined, hitting prices. Oil was caught in a perfect storm with an agreement between OPEC and Russia to constrain supply breaking down just as the outlook for demand fell. This led the oil price to fall by more than 60%.
One doesn’t need to wait for the traditional economic data to be released to appreciate the scale of the hit to the economy, which is emanating from the virus containment measures currently in place across much of the world. A few select data points demonstrate the magnitude of the shock. For example, car sales in China fell about 80% in February. Data from the restaurant booking app Opentable show that bookings are down close to 100% in nearly every country that they operate in. In one week in March, over three million people signed up for jobless benefits, more than four times the previous record since 1967. Clearly, this is not just a normal recession, but a sudden shock to the economy that is unprecedented among developed economies in the post-war period.
An unprecedented shock requires an unprecedented policy response. And that is what we have seen. Most encouraging has been the policy response from the likes of the UK and Germany where governments have committed to pay a significant proportion of workers’ wages during the shutdown to enable companies not to lay off staff despite the dramatic hit to sales. This is precisely the right kind of policy to deal with this type of shock, to give those economies the best chance of rebounding sharply once the health situation is under control.
Government-backed loans should also help many companies to avoid otherwise inevitable cash- flow induced bankruptcies. However, loans may not be enough for the hardest hit companies, some of which are likely to require grants or bailouts to survive a substantial loss of sales, at least part of which is likely to prove permanent.
In the US, a very substantial fiscal stimulus package has been agreed, worth about 10% of GDP, which will include some grants to small businesses. The package also provides government backing for credit to be provided by the Federal Reserve (the Fed) to investment grade companies. This should ensure that large investment grade companies don’t fail in the near term because of a lack of cash-flow. However, again, some large companies may require grants or bailouts rather than just credit to survive this shock in the longer term.
In addition, while the US fiscal package significantly increases jobless benefits for the next few months, the policy appears less effective than the UK or German policy of encouraging companies to hold on to staff. Overall, fiscal policy has already delivered a significant stimulus globally but further measures are still likely to be needed to deal with the size of this shock.
Central bankers have thrown the kitchen sink at the problem, cutting rates to their lower bound and restarting and expanding asset purchase programmes. The Fed’s commitment to purchase as many government bonds as necessary is a substantial step, which should enable it to keep government borrowing costs low, despite the massive fiscal stimulus that is required to deal with the economic consequences of the virus. The Fed’s corporate credit programme should also prove a significant support for investment grade corporate bonds.
While the European Central Bank and the Bank of England have not been quite as explicit that their firepower is unlimited, we do not doubt their commitment to keep government borrowing costs low and provide liquidity for investment grade corporates. In short, the central banks are doing all that can reasonably be expected of them to fight this crisis.
The depth and duration of this recession will therefore depend on the extent to which governments fill in the gaps in their current fiscal responses, comforted by the support of the central banks, to ensure that unemployment is prevented from spiralling higher and bankruptcies of otherwise sound businesses are prevented.
By now, we have seen an extremely wide range of estimates for second quarter domestic and global GDP figures. For the US, Morgan Stanley expects a 30% drop associated with an almost 13% unemployment rate and the President of the St Louis Fed James Bullard recently said Q2 GDP could drop by 50% and unemployment reach 30%.
Whilst we believe the latter is at the extreme negative end of likely outcomes, the reality is that we are currently operating in an environment of extreme uncertainty and have to anticipate an unusually wide range of possible outcomes. These primarily depend on the ultimate duration of lockdowns in major economies with current base case assumptions that these will last until the end of April. Should the strict measures be extended materially beyond that date, we believe there is additional risk for markets on the downside as this would add to the economic cost as well as deepen and extend the current recession.
It is encouraging to see that the US government finally appears to acknowledge the seriousness of the situation when Donald Trump and Anthony Fauci came out with comments over the last few days indicating that they expect millions of cases in the US and many thousands of deaths. The current restrictions are also likely to stay in place at least until the end of April.
Given the significant uncertainties surrounding the outlook, we continue to believe that a neutral allocation to risk assets, such as equities and credit, makes sense. With central bank and government support, highly-rated large investment grade companies seem most likely to survive this shock whereas some junk-rated companies will likely not make it through this crisis. This suggests to us that a selective , up-in-quality approach continues to make sense within both credit and equities until there is greater clarity around the outlook.
Government bond yields are likely to remain low, despite significant government spending, supported by central bank purchases. However, with less room for government bond prices to rise now interest rates are at such low levels, investors may wish to consider alternative forms of portfolio diversification.
A month ago, China’s authorities were criticized for their “draconian” measures used to curb the spread of the COIVD-19 virus. Just over a month later and their economy is almost back at full capacity. With this in mind, Cyril Ramaphosa has been praised for his urgent intervention, which is quite similar in nature, putting SA into a national lockdown until the 16th of April. One week in and already the infection rate has slowed down to a more controllable level. Through private-public partnerships, the government is doing all it can to keep the virus away out of the most vulnerable communities. An outbreak in townships, where individuals live near one another, in appalling conditions, would be disastrous for the healthcare system which is already in a precarious situation.
All major local asset classes ended the month well in the red. Local equities fell 12%, bonds fell 10% and listed property fell 37%. The Rand weakened significantly to new multi-year lows against the US$ but proved to be more resilient than many of our oil exporting peers like Nigeria, Russia and even Mexico. At the end of March the Rand was trading 17.9 to the US$, 19.7 to the Euro and 22.2 to the Pound.
The South African economy has been in a fragile state for a prolonged period and it now appears that thanks to this global economic slump, we will face an economic recession in 2020. Considering how quickly things have escalated, the most reliable sources of data appear to be activity and sentiment surveys. The most recent readings show that the Manufacturing PMI fell to its lowest level since 2009, while the BER Business Confidence Index is now at its lowest level since 1999. Furthermore, total new vehicle sales plummeted 29.7% y/y in March.
One a more positive note, the collapse in the oil price will result in a significant cut in the petrol price in the coming month which, along with the recent cut in the repo rate, will provide some relief to households. The banking association of South Africa has also announced industry wide measures to allow a broad response by banks to provide relief to their customers. Examples of this are payment holidays and discounted rates without infringing on competition laws.
In a surprise announcement, the SARB cut the repo rate by 100bps in March and implemented several open-market measures to provide liquidity to the bond market. While these measures are stimulatory in nature, they shouldn’t be described as quantitative easing which typically occurs when policy rates are near zero. The SARB’s efforts provided some calm following the initial wave of foreigners who dumped approximately 6.5% of their holding of local bonds, in favour of safe-haven assets. SA’s 10 year bond peaked at 13.2% mid-month after starting the year at about 8.3%. Thanks to the SARB policy measures, bonds rallied into the end of the month despite having been dealt a much anticipated downgrade by Moody’s.
No one doubt’s Fitch and S&P who justifiably downgrade SA’s sovereign rating to sub-investment grade in 2017, both of whom sighted a deterioration in the fiscal outlook, waning economic growth, and lack of policy action. But it was rather disappointing that Moodys did not delay its decision considering the implications of the COVID 19 pandemic, which is placing major stress on the global economy. Were it not for the deterioration in global growth expectations, they would almost certainly kicked the can down the road. Afterall, Treasury seemed to finally have their affairs in order as seen by the relatively pro-growth budget earlier in the quarter. The market has been pricing the potential downgrade in for quite some time now, but now that it’s out the way, the bond market will shift it’s attention to the next rebalancing of the World Government Bond Index (WGBI) which is due to take place in April. How the market responds at this juncture will depend greatly on the appetite for risk globally.
Very few local equities were spared in the March sell-off, with only a handful ending the month in positive territory. The most obvious of course were the defensive retailers who benefitted from the mad rush by consumers who stocked up ahead of the shutdown. Shoprite and Pick n Pay gained 13% and 10% respectively. Despite the order by the competition commission to reduce data prices, the demand for data from households in the national lock is expected to provide a tailwind for the likes of Vodacom and the recent share price reflects that (+7%). Similarly, mobile gaming, entertainment and online services reported an increase in activity and was supportive for the likes of Naspers and Prosus.
Industrial commodities and the PGM space both took strain as non-essential industries around the world reduced their operating capacity, or shut down entirely. Auto makers such as BMW, Honda and Toyota halted production amid a lack of parts and falling sales. Gold producers were buoyed by the rise in the rand gold price, but the only major company to end the month in the black was AngloGold Ashanti.
Year to date, the big four banks have fallen between 35% and 60%, most of which occurred in March. Major concerns rest in the deterioration in the balance sheets of borrowers (households and businesses) and the uncertainty of whether many small to medium enterprises will survive the national lockdown. The knock-on effect from a business level, right down to poorest of households has the potential for significant revisions to provision for bad debt. But for now, it’s hard to predict just how bad things might get.
The local listed property had its worst month on record following its previous worst month in February. The historic dividend yield for the sector is at an eyewatering 20%, but the ever-increasing loan to value ratios and the heightened and probability of rent “standstill” by large tenant suggests that the forward yield is likely to be materially lower. To date, some REITS such as Redefine have already announced the suspension of their dividends and distribution guidance which suggests that yields in the sector should be approached cautiously.
We are all now living through a period in history none of us will ever forget. The impact on our families, communities, and country has been profound. And it continues. There remains great uncertainty, worry, and fear about the coronavirus and its impact: how widely it will spread, how fatal it may be, how long it will last. When will we see signs of stabilization in its spread and a decline in daily new cases? When will we “flatten the curve”?
As investors, it is so important to maintain our focus on our long-term financial goals and objectives. As hard as it may be, from an investment perspective we need to try to look through the current environment of fear and concern—emotions which, given the circumstances, are totally justified and felt by all of us—to the almost certain outcome of the virus crisis receding and economic recovery occurring.
Throughout history, the world has faced numerous severe challenges and economic downturns and has always come out the other side. While not minimizing the unique risks and unknowns from the current crisis, we will bet on that being the case again. There is a good chance the recovery may start happening before the end of the year.
As a long-term investor, trying to time market tops and bottoms is a fool’s errand. The evidence is overwhelming that most investors diminish their long-term returns trying to do so. They are more likely to chase the market up and down, and get whipsawed, buying high and selling low. But incrementally adjusting portfolio allocations in a patient and disciplined fashion in response to changing asset class expected returns and risks makes a lot of sense for long-term investors.
The time to be adding to stocks and other long-term growth assets is when prices are low and markets—and most of us personally—are gripped by fear and uncertainty rather than complacency, optimism, or greed. Investing at such times will feel very uncomfortable. It may seem like the market could just keep dropping with no bottom in sight. But that is exactly where research, analysis, patience, experience, and having a disciplined investment process come most into play.
Otherwise, if we invest based on our feelings and emotions, we are very likely to cash out of the market after it has already dropped a lot, locking in those losses. Then, waiting to reinvest after our discomfort and worry are gone, the market will already be much higher. That is not a recipe for long-term investment success, yet it plays out in each market cycle.
Facing the current medical and economic crisis, the situation is probably likely to get worse before it gets better. But, with some necessary and shared sacrifices from all of us—and clearly those on the medical front lines much more than most—it will get better.
Fund and Portfolios Overview
The IZA portfolios held up extremely well during the turmoil of the last quarter. During the worst Q1 ever for the Dow Jones Industrial average and the worst quarter for the broader market since 1987 the flagship Iza Global Balanced Fund lost only 6.38% and the Iza Growth portfolio 6.51% in GBP terms. In March , the worst month of the quarter, all three of the selected equity managers were in the top 10% for the ASISA Global Equity category , each one besting the MSCI AC World index by more than 5% and proving the benefits of active manager selection . The Iza Global Balanced Fund was in the top 3 best performing funds for the ASISA Global Multi Asset Flexible Funds category with the average fund being down 8.5% in GBP.
As highlighted in our mid-month commentary, capital preservation is always front of mind when it comes to portfolio construction and this means when adding equity risk we select managers who’s core underlying belief is to invest into high quality businesses that can sustain a high return on operating capital employed; businesses whose advantages are difficult to replicate; businesses which do not require significant leverage to generate returns; businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return; businesses that are resilient to change, particularly technological innovation; businesses whose valuation is considered by the investment manager to be attractive. Even with these similar tenants shared across our equity manager selection there is minimal stock overlap and therefore very little concentration risk due to nuances in investment strategies across investment houses.
Diversifiers such as gold added to performance during the sell off by rallying over 12% in the last week of the quarter , having come under pressure earlier in March as investors suffered margin calls and were forced to sell down all their liquid assets. This was witnessed across most safe haven assets with low risk investment grade credit also coming under pressure . This has created some opportunities in funds like Rubrics Global credit as spreads rose for positions that would be maturing in less than 12 -18 months ,some are even trading below par and should see this gap close as bonds approach maturity over the next couple months.
Late February we took the decision to sell out of our Pimco Real return holding as the fund had generated over 11 % in the preceding 12 months and we were concerned that rates were already low and the risk of inflation dropping further had increased as oil started to waiver. This was very timeous as the fund went on to lose 12% at the peak of the sell-off in March and end down some 5% come the close of March. We are watching the fund closely and may take up a position once again given the historically low inflation rates that could surprise on the upside but would like the nominal yields to move out a bit more first.
To take advantage of the turmoil we will be deploying capital into China via a very talented manager that we have been tracking for some time and completed a thorough due diligence process on. He has continued to demonstrate his ability to outperform his benchmark and navigate the very retail driven nature of a market that we believe is poised to outperform developed markets over the next 10 years. With China having passed the worst of the pandemic, already back to work and continuing to stimulate, the jurisdiction is well placed to garner attractive annualised returns going forward. Cognisant of the volatile nature of the market, sizing will be important, so we will be keeping the allocation in the 5-7.5% range and staging our entry. Additionally, we will be topping up the auto call structured note exposure given double digit rates on offer and attractive downside barriers to provide much needed protection.
On the operational side the Iza Global Balanced South African Feeder Fund just launched in March and investors can now access the Offshore Iza Global Balanced fund via this South Africa feeder fund without having to use up any of their offshore allowance.