Global Market Overview
The rebound in equity markets extended into May. A cross-sectional review of asset class returns shows that asset prices have moved on from pricing in reflation to pricing in the impact of re-opening and stimulus on growth. The USD (a highly countercyclical currency) was the worst-performing major asset while junk bonds and EM bonds topped the list.
Oil had its best month since Brent futures began trading and were the single best performing asset last month. Obviously, this performance reflects more than just the expected impact on demand of an economic recovery in the second half of the year. The rally was supercharged by supply-side adjustments, with OPEC and non-OPEC producers alike quickly curtailing production. Moreover, the dislocation in the crude market in late April resulted in an extreme contango in the oil curve, a development that is often a springboard for strong oil rallies.
The impact of the COVID-19 pandemic continued to dominate markets, with an increasing focus on how countries would begin to relax their lockdown measures and how this would affect the economy. Volatility declined and the more moderate market moves compared to April suggest that investors are being watchful of how the situation develops. Many states in the US began some level of reopening, though the daily infection rate has only fallen to around 65% of the peak infection rate from mid-April. The S&P 500 climbed, to end the month 4.8% higher and is now just 10% below the February peak. The infection rate across the major European economies has fallen significantly, though the infection rate in the UK still remains high relative to its European peers.
Investors appeared to have become somewhat more optimistic about the outlook after initial signs of success in human trials of a vaccine against COVID-19. Growth stocks outperformed value stocks while global government bond markets were broadly flat. European and Japanese stock markets, typically cyclical markets, also ended the month higher. Despite the first steps being taken to exit lockdown and some positive news on a potential vaccine, it’s still too early to say with confidence how the public health outlook will evolve.
The global manufacturing PMI has begun to pick up, rising to 42.4 in May from its April record lows of 39.6. This improvement is nothing major yet, but it will gather momentum. On this front, the experience of China is very instructive. PMI’s quickly rebounded to the 50 line once lockdowns measures were significantly relaxed. Considering the large amount of both monetary and fiscal stimulus injected in the global economy since March, this scenario is likely to repeat itself in the rest of the world over the course of the summer.
The experience of Italy confirms that a sharp rebound in the global PMI is likely. Italy suffered one of the worst outbreaks of COVID-19 in the world and imposed some of the most severe quarantine measures. Its economy collapsed. But in May, as soon as the measures began to be loosened, manufacturing PMI, jumped to 45.4 from 31.1, far in excess of the 37.1 forecasted by the consensus.
A continuation of the rebound in the global manufacturing PMI will put downward pressure on the USD. Moreover, a weaker dollar often leads to an increase in inflation breakeven rates. Thus, the continued pickup in global industrial activity should result in some upside for yields, even as the Fed stands pat for the foreseeable future.
Economic data in the US has been particularly weak. The US unemployment rate for April reached 14.7%, the highest level in post-war history. With around 10 million additional people claiming unemployment insurance over the last month, the expectation is that the unemployment rate will continue to worsen in the next jobs report on 5 June. The flash purchasing managers’ indices showed that activity continued to weaken in May across both manufacturing and services. With stay-at-home orders in the US having started around the end of March and activity still not back to full capacity, the expectation is for second quarter GDP to be considerably worse than in the first quarter.
US corporate earnings reports for the first quarter of 2020 drew to a close in May and confirmed that earnings contracted by around 14% compared to the first quarter of 2019. Defensive sectors such as consumer staples, utilities and health care were more resilient and had positive earnings growth. High demand for technology driven by increased remote interactions helped to keep earnings in the IT sector robust. Zoom Communications, is now worth more than the world’s seven biggest airlines – collectively. Financials, energy and consumer discretionary were the worst hit sectors. Earnings for the second quarter are expected to fall in excess of 40% year on year.
The surge in the US household savings rate is a natural consequence of the recession. It also highlights that for now, the large explosion in the US government deficit has not boosted demand, has not widened the current account deficit, and has not been inflationary. However, the government has injected that money into the economy. As the re-opening progressively expands, jobs will come back, the unemployment rate will ebb and consumer confidence will turn the corner more meaningfully. As a result, the money being saved today will make its way into consumption and result in a wider current account deficit.
Almost all states have relaxed their lockdown orders to some degree despite the fact that several states are still experiencing an acceleration in new daily infections. As US states begin to increasingly relax their stay-at-home orders we will need to monitor the infection rate. As the US economy shut down, consumer spending fell dramatically, despite the increased spend on groceries.
After the US Federal Reserve (Fed) reacted quickly last month by increasing its balance sheet purchases, it made no meaningful adjustments to policy at its May meeting. The Fed Chair did signal a hesitance to using negative rates, particularly given some of the downside effects on the banking sector.
First quarter GDP in the UK fell by 2.0% quarter on quarter – the worst reading since 2008. The UK government’s Job Retention Scheme, introduced to limit job losses, was extended to the end of October, though some of the government’s contribution will shift to businesses from September. The scheme provides workers put on furlough with 80% of their salary (currently up to GBP 2,500 per month). The uptake of this Job Retention Scheme (JRS) has been sizeable with a recent Office of National Statistics (ONS) survey showing that around 77% of businesses have applied for the scheme. Despite this support, the claimant count rate, which looks at the number of people claiming benefits largely due to unemployment, increased from 3.5% to 5.8%.
The UK government announced further plans to continue to gradually reopen more sectors of the economy. There has been no material increase in daily infections but this will need to be monitored closely over the next couple of weeks. The FTSE All-Share rose by 3.4% over the month. The 10-year gilt yield fell slightly over the month and sits just below 0.2%.
The spread of the virus appeared to calm across the eurozone. The daily infection rate is now roughly 90% lower than its peak at the start of April. Austria and Denmark appeared to lead the way in reopening their economies.
Much of the attention in Europe has been over a European Union (EU) wide recovery plan. The plan would allow the European Commission to borrow EUR 750 billion in financial markets – equivalent to around 5.4% of EU GDP – to be funded by EU budgetary resources (contributions are based on a country’s Gross National Income). The proposal is for EUR 500 billion of spending to be made available, mostly as grants, and to make EUR 250 billion of loans available to any EU country but focused on those most in need. This should help countries with already high debt levels, such as Italy, to access funding without having to issue more of their own debt. The spread of the 10-year Italian government bond yield over Germany fell by 43 basis points in May and so Italian government bonds returned 1.7%.
The European Central Bank (ECB), under the terms of its purchase programmes bought over EUR 125 billion in government and corporate bonds over the past month. With the outline of a recovery fund announced by the European Commission, expectations are for an increase in the ECB’s pandemic purchase programme at its next meeting on 4 June. European high yield gained 3.0% on the month.
Locally, South Africans are growing despondent of the slow, communist approach to the re-opening of the economy after its 9-week lockdown, but a slightly more upbeat global backdrop gave investors reason to cheer. The FTSE/JSE All Share Index gained 0.3% in the month, while the rand strengthened by 4% (against the US$), and commodities were broadly stronger. The property sector remained on the backfoot, albeit with a wide variance in returns from the individual counters.
Like we have seen in other parts of the world, the recovery on the local bourse off the March lows has really been driven by a small segment of the market. The lack of earnings visibility in the banks, consumer cyclical stocks, and domestic REITS has kept investors on the sideline for now, despite trading on record low historical price multiples. Most market commentators admit there is significant upside in “SA Inc” basket but how long it may take to play out is anyone’s guess. For example, year to date the big four banks are still down between 30% and 50%, despite a small rebound in May. On the other hand, resource companies have delivered eye-watering returns in recent months, in particular the gold and platinum producers who have benefitted from higher PGM prices and a weaker Rand. Sasol has also been on the front foot of late, as global oil prices have stabilized which should put a highly anticipated rights issue on hold for now.
The lack of appetite for domestic facing business shouldn’t come as a surprise, after all the February GDP figures (released in May) showed that the economy was firmly in a recession before the COVID-19 pandemic spread to this part of the world. Conversations with our managers indicate that in many respects, guidance provided by management teams suggests a significant slowdown in growth. Further to that, the forecast risk is very high.
In May, the MPC committee unanimously cut the repo rate by a further 50bps (although two members would have preferred a 25bps cut) as lower inflation and growth forecast guided their Quarterly Projection Model down from their previous meeting in April. Local bonds experienced their best monthly return of 8% since the 2008 Global Financial Crisis. In fact, at the end of May bonds had erased their March losses and are now once again in positive territory for the year. The belly of the curve moved down significantly more than the short and long ends, as investors remain cautious of the deteriorating fiscus. Lower economic growth and a significant drop in excise taxes is expected to weigh in on tax revenue, while on the other hand the fiscal stimulus rolled out by the government will exacerbate the growing budget deficit.
Inflation is expected to remain at the lower end of the MPC’s target (if not marginally below) for the foreseeable future as pricing power has all but disappeared. However, the disinflation pressures from the collapse in the oil price since March appears to be behind us for now, and in early June petrol will increase by R1.18p/l. Right now, demand pull inflation is highly unlikely, and any surprises to the upside will likely be short lived. The high real yields still on offer by local government bonds underpins a strong case for the asset class, despite the strong run we have seen in the last two months.
With geopolitical tension abroad on the rise, and a local economy in the depths of a recession, the strength of the Rand may come as a surprise to some. In fact, from the beginning of May to the time of writing this, the currency has pushed below R17/$ from R18.5. There are a couple of factors driving this move, the most obvious being that the local currency was stretched well below fair value to begin with. Secondly, the US dollar was broadly weaker in May, characterized by a shift in relative strength away from the US, something not seen for quite some time. Thirdly, the monetary stimulus provided by major central banks since the start of this crisis has also re-ignited the carry trade and has lured foreign investors from the developed world into SA bonds (the recent rally in SA bonds is evidence of that). Lastly, the forthcoming stimulatory infrastructure spend in China, which is expected to kickstart that economy has been supportive for the commodity complex and has also contributed to an improvement in our terms of trade.
While negative news flow continues to dominate sentiment, there is a glimmer of hope. The government appears to have realized that the economy cannot survive on this trajectory, and they are facing mass legal action by opposition parties, affected industries and activist groups, which so far has gone against them. Mounting pressure from all fronts could steer their actions for the better in the coming months. With many investors sitting on the fence and equity valuations at highly attractive levels, there is a chance that domestics could lead the charge if the stars continue to line up.
Investors have found some cause for optimism as global containment measures have seen infection rates come down in many countries. The focus over the last month has shifted towards how successful countries will be with their lockdown exit strategies. There are tentative signs that countries are seeing increased activity, but countries which have been successful in preventing a second wave of infections have so far been opening very gradually.
Economic activity over the past month suggests that the second quarter will be worse than the first but investors are looking ahead to a possible recovery. However, significant uncertainty remains over when economies can fully and sustainably reopen and how quickly they will rebound. The longer infection rates remain high and social distancing is required, the more likely there will be more lasting impacts on the economy. Central banks and governments have so far helped cushion the blow to the global economy and markets but success will be measured by the extent to which companies avoid solvency problems and workers return to employment. Given the inherent uncertainty, investors might want to remain neutral on the outlook.
The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment.
Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. We have maintained below-benchmark levels of duration in fixed income portfolios and favor inflation-linked securities over nominal bonds.
While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate.
Fund and Portfolios Overview
The portfolios continued their impressive run in 2020 with the equity box once again leading the way. Two of the three equity managers ended the month in the top quartile, outperforming their peers and MSCI ACW Index. Scottish Mortgage delivered more than double the market while Fundsmith continued its winning ways to end in the top 15% for the ASISA Global Equity category. This was supported by positive returns from Gold, investment grade credit and global Property. The latter started the month negative but showed a strong about turn as cyclical stocks caught a bid toward the end of the month and higher yielding property gained traction in a low yield word. As is typical for all Iza portfolios, our manager of choice for this asset class Catalyst has significantly outperformed its associated benchmark and passive ETF peers on a year to date basis. In fact in just the last 5 months this alpha(outperformance) has now extended to over 7% . Should the world recovery from Covid continue and gain momentum we believe property has plenty of upside to offer however one needs to be allocated to the correct sectors and is why active management is so important. As mentioned earlier the USD lost value during the month and was the biggest detractor in GBP terms. The Iza Global Balanced Fund is the 2nd best performing fund in the ASISA Global Multi Asset Flex category year to date.