Apr 28, 2020
Global stock markets fell in a heap in the first quarter as the global spread of the coronavirus (COVID-19) cast a shadow on the global growth outlook — the disruptive nature of the containment measures undertaken by the various countries is negatively impacting economic activity through a demand and supply shock. Against this backdrop, developed market (MSCI World Index -21.1%) and emerging market (MSCI Emerging Markets Index -23.6%) equities fell precipitously as markets factored in a challenging operating environment for most corporates. On the other hand, global bonds (Bloomberg Barclays Global Aggregate Bond Index -0.3%) were more resilient as investors flocked to safety (particularly US Treasuries) given the threat the pandemic poses to global growth. All returns are quoted in US dollars.
The domestic stock market (FTSE/JSE All Share Index -21.4%) took its cue from global equity markets as the indiscriminate selloff resulted in all sectors chartering in negative territory — industrials (-8.4%), financials (-39.5%) and resources (-26.7%). Listed property (FTSE/JSE All Property Index -48.1%) also pulled back sharply during the period due to the lockdown implications on rental income as buildings were placed under enforced shutdowns. Local bonds (FTSE/JSE All Bond Index -8.7%) were initially buoyed by a well-received budget statement, but the positive move was later retraced as emerging market debt fell out of favour amid the flight to global safe-haven assets. The sovereign credit rating downgrade by Moody’s Investors Service to one notch below investment grade also weighed heavily on sentiment, leading to significant selling by non-residents. Over the quarter, the rand weakened 20.3%, 16.2% and 21.5% against the euro, sterling and US dollar, respectively.
For the quarter, the portfolio outperformed the benchmark, although delivering a negative absolute return in what was an extremely challenging market environment.
Notwithstanding the drop in global equities, the offshore component of the portfolio was quite resilient and contributed positively to absolute performance, largely owing to a significantly weaker rand. Within the offshore assets, the material cash position (predominantly US dollar) was beneficial, while the exposure to Asian equities (mainly Chinese and unhedged Japanese stocks) cushioned the drawdown as these markets fell less than major global indices.
The small domestic cash holding also added to absolute returns, alongside the positions in the Africa African Palladium Debentures and NewGold exchange-traded funds (ETF) as well as holdings in British American Tobacco, Naspers and Prosus.
The investments in ‘SA Inc.’ companies, including Absa Group, FirstRand, The Foschini Group, Motus Holdings, Sanlam, Standard Bank Group and Truworths International, detracted from absolute performance.
The exposure to resources such as Anglo American, Anglo American Platinum, Impala Platinum, Sibanye-Stillwater and Sasol also dragged on absolute returns. Positions in MTN Group as well as the allocation to local bonds and listed property also weighed on performance.
During the quarter, we actioned some trades within the local equity component. We initiated an investment in Gold Fields as we believe its earnings will benefit from expected steady operational performance and a firmer gold price. We also purchased positions in Anglo American, BHP Group, Bidvest Group and Netcare. On the other hand, we reduced the allocation to luxury goods maker Richemont. The company’s earnings will likely disappoint due to falling economic growth, reduced tourism and waning consumer confidence, all of which should weigh on consumers’ propensity to spend on luxury goods. We also trimmed the exposure to Absa Group, Impala Platinum, Sasol, Sibanye-Stillwater and Woolworths. In terms of commodities, we sold the position in the African Palladium Debentures ETF and used some of the proceeds to purchase stakes in the NewGold and NewPlat ETFs.
Regarding asset allocation, we switched some local cash and partial proceeds from the Africa Palladium Debentures ETF sale into domestic bonds. We remained fully invested offshore, with market movements resulting in an increased overall allocation versus local assets. Within the offshore component of the portfolio, we reduced the exposure to equities in February amid the market volatility, before adding back to the asset class towards quarter-end.
The first quarter of 2020 was characterised by significant market volatility and pullbacks across most asset classes. Meanwhile, the economic prospects that drive long-term asset returns remain highly uncertain. The immediate and direct impact of COVID-19, largely due to the appropriate but drastic curtailment of economic activity both here and globally, is likely to wane when evidence of a reduced rate of infection becomes apparent. This is already the case in some regions globally, but other countries are continuing to grapple with the rising spread of the virus and concomitant slowdown in demand and supply as their respective economies are largely shut down. That said, some form of economic activity normalisation will occur eventually.
In recent quarters, we had raised concerns around the fragility of global growth, high levels of indebtedness and a generally weak starting point for policymakers to enact meaningful policy changes to ensure sustainable growth. COVID-19 has not addressed these concerns, but rather added to them. Stimulus packages and policy measures to stave off a deep recession have been widespread and large in size, along with the loosening of regulations to enable counter-cyclical responses from governments and financial institutions. In our view, these will likely have the desired effect in the short term. Increased liquidity, lower borrowing costs and favourable funding arrangements may well prevent a worst-case scenario in the near term. But we do not believe these measures will come without any costs. In our view, there will likely be serious question marks around what ‘normal’ is when we see some normalisation in economic and market activity.
Our offshore allocation remains favourably disposed to equities, wherein the exposure is skewed towards Asian and European investments as well as corporates we believe are most likely to provide returns commensurate with the prevalent level of risk over the medium term. Chinese and Japanese markets continue to trade at significant discounts to the rest of the world, while concerted policy efforts in the respective countries should provide a fillip. Beyond the return potential, these two markets offer significant diversification benefits given their low correlation with the domestic equity market. In Europe, policy is strongly focused on asset price reflation and valuations remain well below historical averages. Regarding the balance of the offshore allocation, we continue to prefer cash over global bonds. The asset class acts as an attractive shock absorber in times of heightened market volatility and material market drawdowns.
In the current environment where local economic activity is grinding to a halt in a number of sectors, there are significant questions around which companies will have the ability to withstand a period of no or very little revenue. As a team, we are performing in-depth stress tests for worst case scenarios (three to six-month disruption period). We are looking at potential changes in earnings revisions profiles, but also the free cash flow impact on companies and the effect on their balance sheets. For the companies we cover, we are flexing our assumptions for the key COVID-19 uncertainties: duration of trade disruptions and severity of impact in different regions. There is no doubt corporate earnings forecasts will be revised lower internationally as well as locally. In an environment of broad-based negative earnings revisions, the ability to find corporates receiving overly bearish/bullish expectations presents an investment opportunity set to take advantage of. The bearish investment environment in which we find ourselves tends to lead to behavioural market errors and poorly assessed earnings forecasts that in turn lead to mispriced equities.
The local equity composition is diversified, with some capital invested in global cyclical companies geared to the global economic cycle and exhibiting favourable earnings revisions profiles such as Naspers (and Prosus) as well as platinum group metals (PGM) investments, alongside more defensive positions like AngloGold Ashanti, British American Tobacco, Gold Fields and Reinet Investments. We also have exposure to select ‘SA Inc.’ plays with decent relative earnings revisions profiles, trading at reasonable valuations and where we also have high conviction in terms of balance sheet quality, including FirstRand and Sanlam. We also have an allocation to commodities, namely the NewGold and NewPlat ETFs.
We have maintained the material allocation to local government bonds. The events (including rating downgrades by both Moody’s and Fitch Ratings) of the last few months have had a meaningful negative impact on the local market. The impact that a weak structural backdrop (illustrated by budget and current account deficits), high reliance on foreign funders to support the domestic market and the devastating impact of falling global economic activity (and subsequently the local lockdown) can have on domestic growth was painfully exposed over the last few months. The elevated local yields and large premium over peers with a similar risk profile were wholly insufficient to compensate investors faced with a collapse in market liquidity and the sharp deterioration in local credit quality. The selloff seen across the asset class has left us with materially higher yields and even larger potential compensation for the prevalent credit and inflationary risks. We expect outsized absolute returns from this asset class, without understating the fact that our assessment of fair value (the appropriate yield to compensate lenders for risk) is now substantially higher. Going forward, we view the returns from local debt as a potentially attractive contributor to overall returns.