Apr 28, 2020
The ‘downside risks’ cited by the US Federal Reserve (Fed) following the first emergency rate cut on 03 March 2020 have fully materialised into a humanitarian and economic crisis in a matter of weeks. Indeed, Fed Chair Jerome Powell remarked late in March that the US economy may well be in a recession. The manufacturing PMI slid into contractionary territory in March, coming in at 49.2 from 50.7 in February (the 50-mark separates contraction from expansion). The reading reflected the quickest deterioration in operations since the global financial crisis. US job claims shot up to 3.3 million (6.6 million) by end of March) on the back of the coronavirus (COVID-19) shutdown – the first real glimpse of damage to the US economy at the time. The Fed was quickest out the gates among the leading central banks, and by quarter-end had slashed rates by a cumulative 150 basis points (bps), committed to unlimited quantitative easing (QE) and an unprecedented venture into corporate bond purchases following congressional approval. On the fiscal side, the White House agreed a US$2 trillion stimulus package in order to shore up the defence against COVID-19.
Europe’s economic conditions have severely degenerated since the outbreak, with many member states bringing their economies to a halt in order to tackle the health crisis. The infection rate on the continent surpassed 100,000 with around 75% of the cases coming from the four major economies of the region. The manufacturing PMI fell to 44.8 in March, from 49.2 in the previous month, although ahead of consensus expectations of 39.0. This was the sharpest pace of contraction in operations since July 2012 as COVID-19 has led to widespread disruptions to business activity in the area. The European Central Bank (ECB) shocked global markets as it launched the audacious Pandemic Emergency Purchase Programme, which comprises an expansion of quantitative easing by €750 billion over the next nine months in addition to the €120 billion announced earlier in March. Policymakers are, however, mindful that monetary policy alone will need to be supported by a coordinated fiscal response by member states. Thus far, the lack of any conclusive outcomes from EU meetings highlights the existing deep divisions within the EU regarding the degree to which common resources ought to be deployed to alleviate the economic devastation brought on by the pandemic. Countries such as Germany and other northern states have rejected calls for the issuance of joint debt which has been dubbed ‘coronabonds’.
While China was initially the hardest hit economy from the deadly spread of COVID-19, the country now seems to be slowly returning to normalcy, following strict and intensive lockdown measures implemented by authorities. As such the rebound in the official purchasing managers’ index (52 in March) from record lows in February (35.7) was not surprising, although the magnitude of the recovery surprised ahead of consensus expectations. This is another example of how effective containment measures in a country can lead to a quicker resumption in economic activity. China’s recovery has also been supplemented by a ramp up in stimulus measures. That said the People’s Bank of China has refrained from pronouncing unlimited quantitative easing as evidenced by other central banks in developed markets.
In South Africa, the weakness in the local economy will no doubt be further intensified by the strict lockdown measures implemented by government on 27 March 2020, which has sent the entire economy into hibernation, barring essential services. The South African Reserve Bank (SARB) cut the benchmark interest rate by 1% to 5.25% at its 19 March Monetary Policy Committee (MPC) meeting. Following extensive engagement with market participants, the SARB increased and extended the tenor of their repo operations and took the historic step to support South African government bonds in the secondary market. The SARB, however, emphasised that this is a monetary policy reaction designed to facilitate the transmission of monetary policy – not QE or monetization of the deficit. In what felt more like a sideshow amid the coronavirus outbreak, ratings agency Moody’s unsurprisingly downgraded South Africa’s sovereign credit rating to one notch below investment grade at Ba1. The negative outlook was kept in place, foreshadowing the risk of a further downgrade within the next 18 months. The move meant that South Africa will no longer form part of the FTSE World Investment Grade Bond Index (WGBI) effective 1 May 2020.
For the quarter, the portfolio underperformed the benchmark.
After a pretty good start in January and a decent effort by National Treasury to deliver a credible budget in February, March saw a sharp deterioration in risk appetite for emerging market debt (EMD) and currencies as the coronavirus began to take its toll. The positioning adjustment in capital markets was brutal and South African assets were not spared in the carnage. The unprecedented sell off in government bonds saw the benchmark JSE ASSA All Bond Index drop 12.2% over the quarter. Our defensive duration positioning on the curve slightly helped relative performance. Our option strategies also helped protect some of the capital in the portfolio.
Inflation-linked bonds (ILBs) got caught in the same cross currents and they too ended up dragging on performance.
Listed property as a sector halved in value in the first three months of the year and as such, was a significant detractor (despite our strategically underweight position).
The yield-enhancing corporate bond allocation continued to enhance gains over the quarter, while returns from listed property added value.
Our portfolio construction tries to avoid quarterly drawdowns and eliminate 6-monthly drawdowns completely. We discuss our views going forward in more detail below, but with market valuations where they are and the income on offer going forward, we anticipate returns improving over the remainder of the year.
The global economy remains in critical condition, pummelled by an unrelenting, highly virulent virus which has forced economies into lockdown, and the global economy sliding toward recession, with only the data now left to confirm what for everyone is by now a foregone conclusion. The humanitarian cost has been devastating as the total number of infections topped a million infections globally, with more than 190 countries with confirmed cases, and more than 100,000 deaths at the time of writing. The disruption to labour, business operations and supply chains is unprecedented, and the intensity of this shock to the system will ultimately be a function of containment measures, policy responses by central banks and governments, as well as corporate and consumer behaviour as the pandemic plays out across geographies. At the moment, the implications for world economies remains uncertain given that the depth and duration of the virus remains a moving target. The ‘sudden stop’ in the world economy (which is loosely described as the immediate halt of any economic activity resulting in supply and demand shocks) could see an avalanche of bankruptcies and job cuts which could well undermine the recovery in growth once the curve begins to flatten. Thus far, the negative impact on regions has been staggered, starting with China in February, then moving to neighbouring Asian countries in March, and spreading to Europe, the US and the rest of the world. Central banks and government officials have moved aggressively to provide liquidity, while government officials have thus far operated within their means to provide fiscal stimulus and support to healthcare operations.
The US stimulus measures rolled out in March have been the largest in the post-war era. Fiscal spending and loans are on track to be in the range of 15% – 20% of GDP (at the time of writing) this year and most governments around the world are likely to experience similar surges in their government debt-to-GDP ratios. The Fed’s balance sheet could also rise by between US$2 – 3US$ trillion this year alone.
Across the Atlantic, Europe became the epicentre of the virus, with the euro economy in freefall as borders, factories and households are forced to padlock. While we expect the ECB to remain true to its commitment to do whatever is necessary, Christine Lagarde will have to navigate scepticism within her own ranks to expand monetary policy further as the crisis deepens. The concern for the euro area remains the deep divisions among EU member states, with countries only focused on their own domestic policy responses to the pandemic. We believe sooner, rather than later, EU member states will have to put their differences aside, and devise a coordinated policy response alongside monetary policy, if they intend to piece the economy back together after this calamity.
In emerging markets, China was the first economy forced into lockdown during the outbreak, and now appears on track to be the first to stage a recovery. The measured reopening of factories and production is currently underway and metrics such as real estate sales, coal used in power stations and traffic congestion appears to be picking up, signalling a modest pickup in domestic demand while the rest of the world is in hibernation. Beijing has rolled out an extensive range of measures to counter the massive drag on economic activity since the outbreak. Thus far, these measures have proved effective, but we do not expect a quick V-shaped recovery given the rest of the world is yet to flatten the curve. We also do not expect China to launch a bazooka of stimulus as it did back in 2012, given the amount of debt it has ramped up since, and the priority by Beijing to rein in credit growth. While select emerging markets in Asia will have room to support their economies, other emerging regions such as Latin America and Africa have very little in their arsenal to mount a decent defence.
South Africa’s economic situation has severely deteriorated. The exogenous shock to demand from the coronavirus was already having a negative impact in the real economy and this will unfortunately be exacerbated by the lockdown and declaration of a ‘state of disaster’. For the lockdown has already had severe impacts for agricultural exports, the tourism industry, hospitality, and sectors reliant on imports. Although the rating downgrade to sub-investment grade by Moody’s was not overly surprising, it could not have come at a worse time. While structural reforms are needed to boost long-term sustainable growth, the advent of the coronavirus now calls for both fiscal and monetary stimulus in the short term. South Africa already has very limited room to manoeuvre here, so fiscal stimulus needs to be targeted to vulnerable households and firms in order to accelerate and strengthen the recovery in 2021. Unlike most developed countries, South Africa does not have the luxury of issuing bonds at 0%, so the country might need to rely on institutions such as the IMF and World Bank or the BRICS Development Bank to assemble a relief package that will support labour, households and small and medium enterprises. On the monetary front, we believe the SARB still has space to cut interest rates further. This follows the disinflationary impulse from the collapse in the oil price. The only scenario where we forecast inflation threatening the top end of the SARB’s 3% – 6% target band is where oil virtually triples and the rand goes to R21 against the US dollar. Most plausible scenarios show inflation below the mid-point of the band, and negative growth of between -6% to -7% for the year, depending on how quickly we get systems back up and running. This leaves the SARB with room to cut rates materially from the current level of 5.25%, possibly to below 4%, most likely at the May scheduled meeting, but even possibly sooner.
The South African Government bond market, much like most markets globally, unravelled during the month of March. Part of the repricing is a legitimate fundamental deterioration due to the worsening growth outlook and its negative impact on an already strained fiscus, but by far the most significant part of the repricing has been a liquidity shortage emanating from foreign bond holders. This has now been rectified with swift action from the SARB. From a duration perspective, we came into the year with the duration position flat to the ALBI, and most of it in the front end and belly of the yield curve (this is 10-year maturity or less that is most exposed to SARB rate decisions). Following the February budget announcement by the National Treasury (which we viewed positively), we started to reduce risk due to the deteriorating external environment on the back of COVID-19 and excessive market volatility. We began to reduce our exposure to the long and ultra-dated bonds and shifted more into the belly as these will benefit from SARB action in coming months. We have slightly increased duration into the current weakness. Going forward, given the significant value on offer, we will be looking to increase the duration of the portfolio – again focusing on buying shorter-dated bonds most tethered to the SARB. R186 bonds (5.5-year maturity) yielding 11% with a repo rate of 5.25% (and soon to be in the 4% region) and the SARB supporting the secondary market seem like good value to us. But volatility and risk management are paramount, and we will only be doing this gradually, erring on the side of being a tad too late than too early. Our focus as always is more than just on returns, but also carefully looking at the risks and preserving capital.
We came into the year not anticipating material rand weakness as we believed the global environment would remain supportive through stabilising growth and accommodative central banks. We were also of the view that the high real interest rates the SARB had been maintaining would remain an anchor for the rand. However, two things have changed materially this year. Clearly COVID-19 developments have made the growth environment exceptionally hostile, and the rand as a cyclical asset has duly depreciated. Secondly, the SARB began cutting rates in January (25bps) and has since cut by another 100bps to get the repo rate at 5.25% (and we anticipate another 50-100bps before the next scheduled meeting in May). We began to gradually increase our ILB position on the back of the SARB cut in January – which we interpreted as a softening in the stance of the SARB around inflation, which would at the margin soften the rand high real rate anchor and possibly increase inflation risks. Despite the fall in oil prices coming off the Saudi-Russia dispute and the resultant demand shock, we are maintaining short-dated ILB’s as they offer some protection against a weaker rand.
We have maintained a strategically underweight position in listed property over the past few years – only increasing it tactically around valuation-driven events. Our allocation has almost halved since the middle of the quarter owing partly to sales and market moves. We believe value is starting to emerge in the higher-quality names, but given the direct impact that social distancing and lockdowns will have on the property sector, we remain very cautious in increasing the position materially.
The portfolio has maintained a defensive investment grade credit positioning in light of the weak local growth outlook in recent years. We therefore have minimal exposure to the cyclical sectors of the economy, while increasing the allocation to defensives; namely banks, insurers, government- guaranteed state-owned enterprises and large blue-chip corporates with strong balance sheets. A key risk associated with negative rating action is that of credit spreads widening as investors demand a higher return for taking on credit risk. The macro effects of the sovereign downgrade (weaker currency capital outflows, higher sovereign cost of funding) coupled with continuing uncertainty associated with the possible effects of COVID-19, will have a dampening impact on the country’s economic growth outlook with adverse implications for credit quality in general. Given the fact that credit spreads have tightened appreciably over past two and a half years, we believe that credit spreads will begin to reflect a widening bias in response to weaker economic fundamentals.
First-quarter index returns and indicators
|Cash (STeFI Composite Index)||+1.69%|
|Bonds (All Bond Index)||-8.72%|
|Listed property (JSE All Property Index)||-48.07%|
|CPI (inflation)||4.6% (Feb)|