The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.
Amid the chaos, the only bright spot is China
Authored by Archie Hart, Emerging Markets Equity
The events of Monday 9 March were the biggest ‘risk event’ in global markets since the Global Financial Crisis (GFC). There were two key contributors to the turmoil:
Firstly, the quarantining of 25% of Italy’s people (and 40% of its economy) crystallized fears around the spread of the coronavirus. Then, Italy placed the whole country under lockdown. Fears are directly over the life-threatening effects of the virus globally, and indirectly over the economy-threatening effects of the controls imposed to impede or stop the spread of the virus. Secondly, the fall out between Saudi Arabia and Russia has resulted in the collapse of the oil price as “OPEC+” effectively fell apart with Saudi Arabia vowing to regain lost market share in the oil market by discounting aggressively. As a result, equities across the energy sector experienced a widespread sell-off.
Contagion has spread to credit markets with spreads blowing out (11% of the US high yield market is related to energy) and signs of incipient stress, not least the collapse of US 10-year government yields to historically low yields of c.0.6%. Clearly, either the bond market or the equity market is correct, but not both. If the bond market is correct, then the equity market has significant downside. Or vice-versa.
Today, we are seeing some resilience in equity markets amid hopes for a large, globally co-ordinated, economic and financial stimulus. It is uncertain as to whether this will eventuate and even if does, whether it will be effective. There are two possible extremes to the outlook going forward. A ‘goldilocks’ scenario, where coronavirus comes under control without significant longer-term economic effects and economic growth resumes after a one or two-quarter. Or, a ‘multiple bear’ scenario, where an uncontrolled virus outbreak destroys social and economic confidence and leads to a major global recession. A third scenario is perhaps something in between.
It is very early to make a call on the outlook as the situation is developing rapidly on a daily basis. One complicating factor here is the role of psychology. A major difference between the SARS outbreak in 2003 and the coronavirus pandemic of 2020 is the ubiquity of social media (Facebook, WeChat, Twitter etc). This could magnify social concerns to such an extent that they wreak a significant economic impact as concern over the virus goes viral.
The second-order effects of the coronavirus and oil price decline are also likely to be significant. If this nationwide quarantine brings the Italian economy to its knees, could this trigger another crisis in the Eurozone, similar to 2011? Could US growth slow, making November’s presidential election too close to call? Could depressed oil prices trigger renewed (or in some respects, a continuation of) turbulence in the Middle East? There is much to ponder.
Amid this chaos, the only bright spot is China, whose people are quietly beginning to go back to work. Yesterday’s visit of President Xi Jinping to Wuhan is a strong indication that the Chinese government believes that it has brought the virus under control in a city which was the epicentre for the outbreak. Almost all of the new confirmed cases are currently being reported outside of China. Indications of the beginnings of recovery in China are many and varied. For example, at the height of the virus, 80% of Starbucks shops in China were closed, a figure that now stands at 10%. Congestion in Chinese cities is 85% of year-ago levels, however subway traffic is just 35% of year-ago levels, so many are clearly still concerned around the spread of the virus in public places.
First-quarter GDP growth for China will clearly be significantly impacted. The second quarter should see some continuing recovery – energy usage continues to rise as factories re-open – however it would appear that we will have to wait until the second half for China’s economy to be substantially normalised. Risks around this are whether there are renewed coronavirus outbreaks in China, whether Chinese consumer/investor behaviour has been significantly impacted and whether China sees significant contagion from its trade partners due to coronavirus impacting their economies. Notwithstanding the evident risks here, the nascent recovery of China will be an important underpinning to emerging markets equities as it represents more than 30% of the asset class
We continue to remain constructive on China, whilst being cognisant of these elevated short-term risks. We remain confident in the long-term prospects of the businesses we are invested in: importantly, we are yet to see significant stress in any of these companies. With regards to the outlook, we believe our style-agnostic process has – and will continue to – deliver attractive performance in the long-run, whatever the future trajectory of economies and markets. Dislocation in the markets is also likely to present us with compelling opportunities to identify stocks with the attributes we are so strongly focused on. We continue to focus on our process and our risk disciplines.
To close I feel it would be remiss not to mention that we also have business continuity plans in place such that we can continue to manage your portfolios under any eventuality.
Assessing the oil decline’s wider impacts
Authored by Rhynhardt Roodt, Co-Head of 4Factor
It is important to place Monday’s sharp decline in the oil price in the context of recent events. The coronavirus (COVID-19) has severely dented oil demand, with the International Energy Agency (IEA) forecasting demand may contract compared to 2019, from its prior expectation of a 1.2 million barrel per day (bl/d) increase. In response, OPEC and allied producers, including Russia, had been considering further production cuts to support prices, in addition to the pact to cut output by 1.7 million bl/d until the end of this month.
With Russia refusing to make even deeper cuts to output following the coronavirus outbreak, Saudi Arabia’s response — to raise output and offer its crude at unprecedented price discounts – will ensure the mutual destruction of both economies unless there is some form of face-saving compromise. Saudi Arabia needs about US$60/bl to balance its budget, while 65% of exports and c.40% of its federal budget are dependent on oil and gas. Non-OPEC producers could attempt to mitigate some of the impact by taking production off the table when prices fall below the cost of production – this will primarily be onshore rather than offshore producers, as the former can take production offline more easily – but this is still a significant ask and we may see the oil price testing US$20-25/bl before there is a sustained reaction.
Much of the US exploration and production sector is already financially stressed, with memories of a raft of bankruptcies in 2014 still fresh in the memory. A mutually acceptable outcome for both Saudi Arabia and Russia could be another round of shale companies entering bankruptcy proceedings. This would allow both sides to claim they have beaten down the prospects for further shale production (although realistically not much will disappear as such companies will continue to trade in Chapter 11 bankruptcy).
The global oil sell-off adds another potential pressure on financials. It is worth pointing out that banks are in a much better position today than in the oil sell-off in late 2014 to 2015, as they have pared back exposure to the sector. Overall exposures are relatively contained and are typically investment grade; however, oil-price weakness will slow down fee income and could lead to higher impairments. Furthermore, the key question now is what knock-on effects potential defaults may have on high-yield, leveraged-loan and CLO markets, with CLOs seeing exponential growth in recent years and being where banks and insurance companies are most exposed.
Taking a step back, financials had started the year well, but the coronavirus outbreak resurrected fears of a global slowdown and potential recession, which the market believed had been laid to rest following a successful end to phase one of the US-China trade talks in late December. The shock 50 bps cut by the US Federal Reserve has done little to quell markets — and banks, being geared macro plays, have reacted extremely negatively, especially in the US and Europe. Further rate cuts are being priced in, and banks and insurers are facing further downgrades, with names selling off indiscriminately.
What does this mean for our 4Factor investment portfolios?
The 4Factor investment philosophy and process are focused on bottom-up, long-term drivers of share prices. Currently, our Global Core Equity and Global Dynamic Equity strategies are underweight energy. In Global Core Equity, we are also underweight materials and overweight gold.
Specifically, more than half of Global Core Equity’s exposure by revenues is to downstream that can benefit from lower input raw material prices, as opposed to upstream, which is more affected by selling on raw materials at lower cost.
In our Global Strategic portfolio, we are overweight energy, but this includes defensive exposure to the oil price, such as a tanker company that delivers refined products and a downstream refiner. These companies are beneficiaries of lower oil prices and so we believe they will be resilient in the current environment.
In terms of financials, all the Global Equity strategies have been underweight banks for some time, but in some of the portfolios we have taken overweight positions in capital-market-related names within exchanges and ratings agencies, which are typically much more defensive in a downturn.
Within banks, our US interest-rate exposure sits with global banks while we are underweight US regionals which are most exposed to both rates and oil and gas. Banks have arguably reduced exposure following the oil-market sell-off into 2015, which we believe puts them on a better footing today.
As a further means of dampening rate exposure, we are exposed to housing finance which typically benefits from lower rates, while we are underweight US life insurance.
Again, in Global Core Equity, we have a small exposure to European financials, spread across insurers and banks. As in the US, the uncertain rate environment continues to weigh on valuations. Our exposure here focuses on names with strong balance sheets that aim to deliver solid (and potentially rising) capital returns.
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Emerging Market Debt
Authored by Peter Eerdmans, Head of Fixed Income, & Victoria Harling, Head of Emerging Market Corporate Debt
Sovereign debt - keeping fundamentals in firm focus
Against the headwinds of collapsing demand, OPEC and its allies met to discuss further cuts to oil production. While Saudi Arabia led the push for additional cuts of 1.5 million barrels per day (bpd), Russia strongly resisted this, citing the need to undermine the US shale industry. The meetings ended in failure, not only to agree to further cuts but also to extend the current 2.1 million bpd cuts beyond the end of March – something the Russians were willing to agree to.
Over the weekend, Saudi Arabia – probably in an attempt to convince Russia to come back to the negotiating table – lowered prices on April loading and suggested it could dramatically increase production.
The result has been a collapse in oil prices, with Brent crude trading in the mid-30s at the time of writing – down from US$45 at Friday’s close and US$66 at the start of the year.
With coronavirus already weighing on market sentiment, the oil shock has compounded volatility, with a sell-off occurring across equity, currency and credit markets, and US Treasuries rallying even further into record low yields.
While the failure of OPEC-Russia co-operation was a not a complete surprise – tensions had been building for months, if not years, as Russia was perceived to be free-riding – the timing couldn’t have been worse, given the coronavirus-induced collapse in demand for oil.
This combined demand and supply shock is the worst we have seen for many years. We think that oil prices could fall below US$30, and – in the absence of further intervention – remain low; there is a significant excess supply of the commodity and demand for it could take some time to recover fully if the coronavirus outbreak persists into the early summer.
We cannot rule out a quick U-turn by OPEC and Russia. The outcome of the OPEC+ discussions was sub-optimal for both parties – both have an incentive to try and stabilise the oil market at a higher price.
However, the Russian finance minister saying the country can withstand oil prices in the region of US$25-30 for the next six to 10 years, does not bode well for a near-term rapprochement with Riyadh. Moreover, the demand outlook is looking increasingly challenging as coronavirus spreads through Europe and the US – the International Energy Agency just lowered its demand forecasts significantly, foreseeing the first full-year contraction since the global financial crisis. Therefore, we expect a significant excess supply of oil through the second quarter.
Outside of the oil market, the risks to the global economy from coronavirus remain significant. While it is still difficult to gain conviction on the exact future path of the outbreak, it is likely to get worse and the impact on the global economy will likely be more protracted than that associated with a sharp V-shape plot of economic activity.
The market reaction on Monday has been significant, with high-yield oil and currency markets the worst hit in our asset class.
Implications for our strategies
Hard currency sovereign debt
Sovereign debt of oil exporting nations with a high-yield rating has been badly impacted, with bond prices down 6-10 percentage points at the time of writing.
The most vulnerable name we own is Ecuador, which had already seen its bond market fall by around 35% from January highs, largely on idiosyncratic headlines. Oil revenues are important for Ecuador’s fiscal health. However, we expect it to be able to adjust and finance itself, supported by the IMF and a continuation of prudent macro policy.
Given its heavy reliance on oil exports for external and fiscal receipts, the Angolan economy will also be negatively impacted by much lower oil prices, but we expect to see a revised budget and increased multilateral support to reduce the burden on this economy in the short term. We retain our overweight positioning.
We are also overweight Ghana. Although it’s an oil exporter, Ghana has a much more diversified export base compared to its peers and oil makes up only a small part of government revenues. Growth dynamics are also positive for the country’s bonds and so we retain our positive long-term outlook for this market.
By contrast, we are running a sizeable underweight to Middle East oil names and other high-yield African markets, such as Nigeria and Gabon. We have no exposure to the high-yielding markets of Oman, Bahrain and Iraq, which are among the most sensitive markets to oil. We continue to prefer investment-grade exposure in Saudi Arabia and Qatar, and we have zero weights in the United Arab Emirates and Kuwait. Saudi Arabia is the most oil-sensitive of these and has sold off significantly in Monday’s trading. However, given the size of Saudi Arabia’s gross foreign exchange assets, we believe it can withstand lower oil prices for some time.
Local currency sovereign debt
In local markets, the main oil-linked currencies are down around 7 to 8% on the day at the time of writing. Local rates in oil markets, in particular, have also backed up in the sell off. Our main oil-exposed positioning is as follows:
We have an overweight in the ruble and are also overweight Russia rates. As we have highlighted in the past, Russian economic fundamentals remain very solid, even with oil prices at current levels. Since the 2015 oil collapse, Russia has taken painful steps to: reduce its non-oil fiscal deficit (from -15% to approximately -5%); run an overall budget surplus; build its FX reserves (from a low of US$360 billion in 2015 to current levels of US$570 billion); and bring down inflation to below 3%. Therefore, it’s not surprising that the Russian ministry of finance stated on Monday that the country could withstand oil prices of US$20 to US$30 for the next six to 10 years – a positive for Russia, but perhaps not for oil markets in aggregate, if Russia chooses not to re-engage with OPEC. Based on these strong fundamentals, we are confident to keep this risk in our strategies and we generally prefer to manage our oil exposure through other, structurally weaker, countries.
Our Russian exposure is offset by an underweight in the Colombia peso, given its recent outperformance and its exposure to oil prices. We are neutral Colombia’s local bond market, although we do see value in the long end of the curve.
We are neutral the Mexican peso, having cut our overweight a couple of weeks ago. Although we are also neutral the local bond market overall, we are slightly underweight nominal bonds while holding a small position in inflation-linked bonds.
We are short the Nigerian naira where we see a poor risk-reward ratio and rising devaluation risks. Elsewhere in Africa, we continue to like unhedged Ghanaian bonds, with yields over 20% and positive debt sustainability dynamics.
Emerging Market Multi-Asset
In the equity portion of our Emerging Market Multi-Asset Strategy, we are long Chinese equities and underweight broader emerging market equities, as we expect China to recover from the coronavirus before the rest of the world and believe a lower oil price will be supportive for Chinese companies.
As always, we are actively managing risk in our strategies, seeking to take advantage of market mispricing within the wider sell-off.
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Authored by Jeff Boswell, Head of Developed Market Credit
Dynamically seeking pockets of opportunity
On an absolute basis, the Multi-Asset Credit (MAC) and Global Total Return Credit (GTRC) strategies have generated a negative return year to date. However, they have fared significantly better than many equity and high-yield credit markets.
Given the wider market sell-off, our exposure to European high-yield and US high-yield bonds has weighed heaviest on returns. From a rating perspective, BBB and BB rated bonds were the key underperformers, while investment-grade AAA rated bonds have given a small positive return, and our exposure to European Loans (in MAC only) and AAA and AA collateralised loan obligations (both strategies) cushioned against more significant drawdowns elsewhere in the credit market. Most sectors came under pressure, led by the more cyclical areas, with automotive and energy our biggest detractors.
More broadly, the most affected areas of the credit market are largely those that had become too tight (i.e. valuations too expensive) earlier in the year, or those that are inherently more cyclical and are likely to suffer a direct impact from the virus fallout. This includes some parts of the high-yield market, in particular ETF-style high-yield bonds (the most liquid part of the high-yield market) and ‘BB’ rated bonds that are perceived as low risk. These are market segments that we have not targeted for some time.
What does this mean for our strategies?
Our strategies’ return profile has been consistent with our expectations, reflecting our philosophy and process.
Our team structure (aligned by sector, asset-class agnostic) allows us to be dynamic and shift our strategies to areas of the market that we believe offer the best value. Equally, it means we can shift away from parts of the market that become over-valued, such as the segments mentioned above. This approach distinguishes us from other market participants who are tied to more structural allocations to asset classes.
With many credit markets trading at exceedingly tight spreads at the start of the year – valuations either approaching or exceeding their post-financial crisis levels – we moved away from the more expensive parts of the market and towards better-value credit market subsets. This has helped cushion some of the downside in the recent sell-off, and we believe it means our strategies are well positioned for further market stress. The current positioning will also provide the opportunity to dynamically shift the portfolio into areas where the recent market correction has been exaggerated, as we look to capitalise on the significant widening in credit spreads.
Through the recent volatility we have already started this process, selectively adding risk in BB rated opportunities, where a significant repricing has led to attractive spread levels – valuations that belie the quality of the issuers’ underlying fundamentals.
Overall, our portfolio allocation has evolved in a manner that reflects our philosophical approach. As yields/spreads get tighter, rather than reach out to the higher risk areas of the market (i.e. lower credit quality) for more yield, we get comparatively defensive (i.e. allocate more to higher-quality and less-cyclical credit). It is following a significant risk-off widening, like the one taking place currently, that we would typically shift to a more risk-on stance (as we did in 2016). Ultimately, regardless of the environment, we believe our bottom-up, benchmark agnostic approach allows us to find pockets of opportunity for investors in any market.
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Authored by Clyde Rossouw, Co-Head of Quality
Global Franchise’s defensive qualities provide support
Equity markets have again fallen significantly as fears of a further spreading of the coronavirus, and likely stricter containment measures (particularly in the US), have been compounded by the emergence of a price war in the oil market, after Russia refused to agree to production cuts proposed by Saudi Arabia. Market volatility has spiked to levels not seen since the eurozone debt crisis in 2011. Amid this turmoil, however, we would urge long-term investors to note the underlying strength of the businesses we invest in, the inherent growth these businesses should deliver, and to strive to overcome any short-term negative sentiment that may result from the current market environment.
While not immune to the market sell-off, the Global Franchise portfolio has again shown its relative resilience, with smaller drawdowns than the market in the short term. Strong and reliable cash generation; healthy balance sheets (with aggregate net debt across the portfolio of around zero); lower cyclicality than the market; zero exposure to energy companies; and zero exposure to banks (whose net interest margins have been impacted by falling longer-term Treasury yields), have all contributed positively to relative performance in the short term. This has more than offset the negative impact from stocks held that have detracted from performance in the very short term (for example other financials such as Moody’s and Charles Schwab).
What is our outlook and how are we positioned?
It is difficult to draw meaningful conclusions over such short time periods, particularly given the rapidly changing situation. With regards to coronavirus, while medical professionals continue to model increased incidences of infections and mortalities worldwide, the reality is still that nobody knows how this will evolve, and extreme predictions will likely carry on receiving more airtime in the short term. We continue to believe that there won’t be a classic ‘V’ shaped recovery. However, with a significant global monetary and fiscal policy response, and signs that the growth of infections is now slowing in China, we still believe that the outlook should improve later in the year.
The cash position in our global portfolios had built up to around 10% at the beginning of this year. This has not only provided an additional buffer in these turbulent markets, but has also given us the ability to take advantage of recent short-term volatility. We have already begun to put some of this cash to work as valuation opportunities emerge on a longer-term view. We continue to monitor developments closely and remain front-footed in terms of portfolio positioning.
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Authored by Philip Saunders, Co-Head of Multi-Asset Growth
Will markets ultimately prove resilient to the 'three shocks'?
The material weakness of oil prices, resulting from the recent inability of Saudi Arabia and Russia to agree on production cuts in response to the sharp weakening of demand, has amounted to a second shock to markets following the spread of the coronavirus (COVID-19). This has compounded the sense of uncertainty, which in turn has resulted in disorderly price action across asset classes.
Market weakness itself has the potential to become a third shock, through the mechanism of tighter liquidity conditions and a negative impact on wealth. At this point, markets are heavily oversold in the case of ‘growth’ assets such as equities and credit and overbought in the case of ‘defensive’ assets, such as government bonds. Poor market liquidity, more positive investor positioning coming into the new year and financial leverage have combined to produce the extreme price action that has been witnessed recently. Now we are anticipating a further period of uncertainty and volatility as market participants seek to get a clearer understanding of the scope of the impact of the coronavirus outside China, especially in the US, and what measures governments and central banks may take to underpin growth and offset the shock to liquidity. Although the two other ‘shocks’ have emerged, the impact of the coronavirus is likely to remain the pre-eminent source of market uncertainty.
So far, constructive efforts by China to contain the virus, including in the Wuhan district where it first appeared, have been overshadowed by the acceleration in the number of cases recorded elsewhere in the world. For the moment, the impact of fear may be disproportionate to the actual risk represented by the virus itself. At the time of writing, over 100,000 cases have been reported globally. Even if many cases have gone unreported and the true figure is closer to 200,000, this is still a relatively modest number. Furthermore, 80% of reported cases have not required hospitalisation; 17% have required hospitalisation but haven’t resulted in fatalities; and 3% of cases have resulted in death. These statistics compare favourably with both the SARS (2003-4) and MERS (2012) viral outbreaks. For uncertainty to subside, investors need to see the trajectory of the spread of the disease to be firmly on a downward path in Europe and the United States. The longer that takes, the greater the economic disruption and the higher the risks are for a more negative outcome.
The key judgement to be made by investors is whether this combination of shocks is sufficient to cause the world economy to slip into a material recession, or whether global economic momentum (before the outbreak) combined with further policy response will prove sufficient to allow it to withstand the shorter-term impact of the prevailing uncertainty on economic activity. Notwithstanding the continued negative price action in markets, the response by policymakers is now ramping up. This is particularly true of the United States where a further official rate cut to underwrite dollar liquidity could be the step that tips the balance. Should this be the case we should arguably be looking to 1987 as the closest parallel to the current market environment. (Updated on 13 March 2020)
Central scenario – growth recovers after a period of disruption and weakness
We believe that the balance of probabilities strongly suggests that the impact will be more modest than is currently feared. The US economy has continued to display robust growth, led by solid consumer demand and construction. Elsewhere, the downturn in manufacturing, which had characterised 2018 -9, had been showing signs of ebbing from the last quarter of 2019 as companies started to rebuild inventories. Developments in China appear to be constructive. The spread of the virus has been contained by the draconian response by the authorities, and the probability is that the interruption to global supply chains – to which China remains critical – will be limited to the first half of the year. President Xi has visited Wuhan, the epicentre of the coronavirus outbreak. If the pattern is similar in the West, the actual disruption could prove to be much more limited than markets currently fear. While lower oil prices – if sustained – can be disruptive in the short term, they are the equivalent of a tax cut for consumers worldwide. Notwithstanding, the shock to investor confidence will have to be worked out in the form of a period of volatile consolidation.
Risk case – the ‘three shocks’ trigger a recession and deeper bear market
For a more negative outcome to play out, the interaction of the ‘three shocks’ on economic activity would have to be more material and lasting, resulting in a deeper and – in all probability – more drawn out bear market in growth assets. Market prices have already moved materially to reflect such an outcome as investors have de-risked. Significant relief rallies are likely to occur even under this scenario, potentially offering opportunities to rebalance if the environment shows signs of longer-term damage to final demand.
The disease is successfully contained, economic activity rebounds and abundant liquidity fuels a ‘V’ shaped market recovery
Investors are currently placing a very low probability on a strong rebound in activity in the second half of the year, but such an outcome should not be dismissed. Briefer-than-anticipated disruptions to economic activity combined with solid underlying US and Chinese economic momentum, weaker oil prices and even looser monetary conditions could eventually combine to produce a positive shock.
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Tom Nelson, Head of Natural resources, James Webb, Analyst
Oil's double trouble
February provided an early warning that the spread of the coronavirus (COVID-19) in China was impacting oil and fuel demand in the country, which accounts for more than 10% of global demand. First came a wave of ‘force majeure’ pleas relating to supply contracts, predominantly for liquified natural gas (LNG). Then listed oil & gas majors, such as Total and BP, warned of a hit to global demand in the order of 500,000 barrels per day (bl/d). Finally, the OPEC+ countries announced the conclusions of their Joint Technical Committee (JTC) meeting, which advised the group to make a further 600,000 bl/d cut in March to keep markets balanced.
That advice has seemingly been thrown aside and replaced with geopolitical posturing and a race for market share. Having failed to reach a new accord on Friday, the OPEC+ countries ripped up the current agreement, which expires in April. Saudi Arabia, OPEC’s biggest producer, immediately discounted its crude and talked of increasing production. Brent crude prices dropped from about US$50/bl to US$35/bl, falling with a severity that eclipsed the declines at any point of the 2008/9 Global Financial Crisis or the 2014 oil-price drop. As a reminder, Brent was trading at US$68/bl in early January this year.
The concern for oil is now two-fold, with both a supply and demand dimension. This is highly unusual. Oil shocks are usually supply or demand driven — rarely, if ever, have they been both. On the demand side, demand has been very weak in the first quarter due to the coronavirus, sufficient for the International Energy Agency to predict average year-on-year demand will slightly contract in 2020. Now that the virus has spread beyond China’s borders, the consensus view that this will be a 3-6 month issue could be far too optimistic. On the supply side, the OPEC+ rift could return between 1-2 million barrels of crude supply to the market in the coming months. This oil wouldn’t have a use in today’s market, only finding a home in storage, and so could extend the depression of prices.
However, oil prices are the great enabler of market equilibrium and we have been here before. In 2014, the oil price started a descent from US$115/bl to US$46/bl. In 2016, it sunk to US$27/bl, having recovered to US$68/bl after the prior collapse. On both occasions, the lows were very temporary.
Given this recent history, there is a temptation to assume that the market has overreacted and that prices cannot stay down for long. At US$35/bl, the oil price is unsustainably low for a large cross-section of oil & gas producers. However, demand data could yet deteriorate from here, and we will be watching the second-quarter forecasts very carefully. Furthermore, the market’s confidence in OPEC’s ability to manage the supply/demand equilibrium — which was already fragile — is unlikely to recover fully. That said, if the political strongmen of Saudi Arabia and Russia can agree a constructive way forward, oil could recover very quickly. On the other hand, those relying on demand recovering or US shale production capitulating may have a longer and more arduous wait.
One other point needs to be emphasised. We do not believe that this collapse in oil prices threatens the energy transition or slows the shift to a low-carbon economy. Oil is not generally used to generate electricity, and electric vehicle sales are driven more by regulation and technology advances than by operating-cost arbitrage. While the impact to gas prices for power may be more nuanced, renewable-energy technologies are highly cost competitive and their costs continue to decline. It will be interesting to see how the oil majors allocate capital to ‘old’ and ‘new’ energies in the light of this commodity price move. It could be that lower but stable returns from renewable energy projects look more attractive than ever.
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Authored by Alastair Mundy, Head of Value
How close are we to the introduction of ‘shock and awe’ policies?
The impact of the coronavirus is being felt throughout the world, with global growth expectations being revised down sharply and many suggesting a global recession is now inevitable. The decision by Saudi Arabia over the weekend to slash the price of oil, following a failed attempt to get Russia to agree to supply restrictions in response to falling global demand was the tipping point for financial markets.
The performance of our Value equity funds has been disappointing YTD after a very strong 2019. Our view for some time has been that equity markets (especially in the US) were expensive and that within the market there were some stocks that were very expensive – their valuations driven higher by falls in bond yields. Whilst we recognized the risk of a recession, we felt to position for this by holding equities with low volatility was potentially dangerous. This view was driven by our belief that policymakers would be in no mood to see a recession develop and would therefore introduce ‘shock and awe’ policies. We believed investors would regard these policies as inflationary and pro-growth. Consequently, our portfolios hold stocks sensitive to economic growth (for example banks and industrials) that we believed were cheap on a through the cycle basis.
Unfortunately, many of these cyclical stocks have performed poorly recently (whilst other more highly valued stocks which we feel are also very sensitive to economic growth have held up better). Still, we think it is important for us to maintain an eye on the normalised profitability of these businesses, and we think we are paying very attractive prices on their long-term earnings prospects.
The Investec Cautious Managed Fund has not been immune to the pain felt on our equity-only portfolios. Whilst the Fund’s short position on the S&P500, alongside our exposure to gold and silver has offered some protection, this has been offset by the cyclical nature of the stocks we hold. The portfolio is positioned for the environment detailed above so the Fund’s bond portfolio is low duration. If this view is correct, then we fear we will move into an environment in which bonds no longer work as an offset to equity weakness and bonds and equities become more correlated. Therefore, our low allocation bonds should help relative to others.
We think those ‘shock and awe policies’ which we highlighted above will come earlier than expected. We have already seen the Federal Reserve make an emergency rate cut (at a time when US equities were very high and several indicators suggested the US economy was reasonably healthy), and now the Bank of England has followed suit. This suggests the Fed and other Central Banks are unlikely to sit on their hands if the prospects for economic growth deteriorate further. Policies could include further interest rate cuts, more Quantitative Easing and even the introduction of Modern Monetary Theory (which would see the printing of money to finance government programmes).
Even before we see Modern Monetary Theory, governments could simply increase spending with this financed by increased borrowing in the bond market. Indeed, with the US budget deficit increasing significantly, the UK budget very clearly signalling a loosening in the fiscal purse strings and even talk of a government financed Green Deal in Europe this move to increased government debt already appears to be well underway. What’s more, the Central Bankers and academics are increasingly vociferous in their views that Governments should be taking on more responsibility for economic growth. The mood music implies a change of policy from inflation targeting (i.e. keeping prices under control) to targeting nominal GDP (i.e. any combination of inflation and real economic growth). This would be a very significant change.
The outlook for equities under this scenario would be dependent on whether the economic growth or the higher bond yields have the greater effect on valuations. While not sure in what direction this would send equity markets, we think it would be a much better environment for value than it has been for many years.
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The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.
All investments carry the risk of capital loss.
General risks: The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
This communication is not for general public distribution and is intended for institutional investors and financial advisors only. It is not an invitation to make an investment nor does it constitute an offer for sale.
In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001).
All the information contained in this communication is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This is not a buy, sell or hold recommendation for any particular security. Portfolio holdings may change significantly over a short period of time.
Any decision to invest in strategies described herein should be made after reviewing the offering document and conducting such investigation as an investor deems necessary and consulting its own legal, accounting and tax advisors in order to make an independent determination of suitability and consequences of such an investment. This material does not purport to be a complete summary of all the risks associated with this Strategy. A description of risks associated with this Strategy can be found in the offering or other disclosure document for the Strategy. Investec does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.