It has been a roller coaster ride since we started following news reports from Asia that moved to Europe and North America before formally entering South African reality on 5 March. We understand there is a lot
of news out there, both real and fake. We also know there will be anxiety and panic. But we are committed to playing our role in keeping you informed and sharing the best information and data out there. This is a time for all of us to pull together and beat this virus.
Daily Maverick, 18 March 2020
The first six months of 2020 will be remembered for the rest of our lives. The facts as they stand are indicating that the coronavirus (COVID-19) is worse than the flu, more contagious and already widespread. The only thing we can try to control is how fast this virus spreads. We are still within the window of opportunity to slow it down and the next 10 weeks will be critical.
With the coronavirus outbreak having spread beyond China, global financial markets have seen a significant increase in volatility and related sell-off. At the time of writing, equity markets are down -25% to -40%, with our own FTSE/JSE All Share down -32% year to date. From commodities to credit to equity, there seems to be no end in sight regarding the freefall, with markets trading through a series of ‘circuit breakers’ (temporary trading halts). The reality is that a massive wave of stimulus has been unleashed globally but has done little to calm down fearful asset markets. The loss in asset values for investors in these markets is a tough and painful experience for us all.
Given the fluid nature of the situation, we are actively monitoring trusted information sources, including government authorities and the World Health Organisation, to ensure any threat to our business operation is quickly identified and responded to accordingly.
Our global operating model ensures that we are able to provide uninterrupted client service, while ensuring the health, safety and security of our employees. As a global organisation with multiple operational centres, key functions are transferable across locations; we have broad-based remote working capabilities across all teams in the business and a large part of our workforce is mobile as a function of their roles. We have to take the wellbeing of our people even more seriously than usual and we have put measures in place that will make sure we play our role to help with firebreaks. Most important, we have to do everything we possibly can to prevent community transmission.
From an investment standpoint, we have navigated client capital through many bouts of turbulence since our inception in 1991. As fundamental active managers, we are constantly reviewing what the coronavirus outbreak means for the global economy and the implications for client portfolios.
After several weeks of complacency, financial markets tipped into full-blown panic on 24 February 2020 as the coronavirus continued to spread. As a result, markets have been scrambling to price in the impact on the global economy of both a supply and demand shock. The supply shock is driven by the closure of a large portion of Chinese manufacturing capacity for several weeks in late January 2020. This has been followed by the implementation of travel bans by the US, Europe and South Africa – among others.
The data shows a big decline in manufacturing output in China in January and February. Exports were down 17.2% from a year earlier in February. The PMI fell from 51.9 in January 2020 into deep contractionary territory of 27.5 in February 2020. Though supply chains were carrying inventory into the Chinese lunar new year, these will likely be quickly be depleted. While factories in China have now reopened, the prospect of economic shutdowns across most of Western Europe and the US, over the near term, is increasingly becoming base case in order to contain the spread of the virus so that healthcare systems can cope with the resultant, mostly elderly, pneumonia victims.
The recent lockdowns in China, Italy and Spain, partial shutdowns in France and Germany and potential shutdowns in a range of other countries are generating a negative global demand shock as people have limited their trips to shopping malls, self-quarantined or cancelled travel plans.
The initial decline in oil prices was due to the demand shock as fuel demand plunged. For example, Lufthansa has cancelled 50% of all flights, Virgin has cancelled four out of five. The geopolitical battle between Russia and Saudi Arabia has exacerbated the problem greatly. These combined supply and demand shocks have created the conditions for a contraction in global growth in the first half of 2020. This will likely be aggravated by the possible halt to fixed investment in the coming months as companies are unable to make decisions amid the current chaos.
Going forward, markets will continue to grapple with the thought of how long such lockdowns and shutdowns may last. There are several forecasts of up to two months in parts of the US and Europe. The supply and demand effect of a prolonged halt to normal life will definitely be felt.
After the fall in equity prices, a global recession is increasingly being priced in – but this does not mean that markets have found a floor. Recent events have also begun to raise concerns about the sustainability of the corporate debt build-up, particularly in Emerging Markets and the US. The week of 9 March 2020 saw the biggest ever weekly outflows from investment grade and high yield credit markets as well as emerging market debt. Conversely this resulted in the biggest inflow ever into cash.
The primary source of the problem is the multiplying new cases of coronavirus infections. We would expect new countries to follow the path we have seen in Wuhan as the numbers accelerate for two to three weeks and then the growth rate starts to slow before the eventual numbers plateau. So long as the number of confirmed cases in a number of northern hemisphere countries continues to rise exponentially, there will be uncertainty on the shape of the recession or how long it will be until economies start to recover. Until that changes, we believe it will be very difficult for markets to rally. Medical experts indicate that a vaccine is at least a year away, though antivirals (which alleviate the symptoms of the virus) could be available in 2020 and are likely to have a big impact on the mortality and severity of coronavirus cases.
The conclusion is that when the coronavirus infection data stabilises, markets are likely to rally strongly. However, there is no clarity on how long that will take. It therefore seems prudent to be cautious for now.
From a portfolio management perspective, we are cognisant of the potential implications of this outbreak on some of our positions. That said, we believe it is paramount for us not to deviate from our disciplined investment process even in the face of such event risks — our process allows us to cut through inefficiencies, enabling us to avoid behavioural biases and to deliver repeatable and dependable returns over the long term.
Macro variables and event risk all have a significant impact on stock returns. It is thus tempting to forecast these and position the portfolio accordingly. Our experience, however, is that these variables and risks are extremely difficult to forecast. Further, there is insufficient breadth in this type of risk taking — the outcome is typically binary. We prefer the breadth of asset selection and stock-picking where we are able to diversify risk across a wide range of assets. We believe markets are efficient over the long-term. However, inefficiencies occur due to behavioural biases (particularly in periods of increased market volatility) which can be exploited to the benefit of our clients. Generally, we believe risk assets deliver a return premium over time. To achieve the desired returns for the Balanced Strategy over time, our assets are skewed towards risk assets and are generally equity centric. In this respect, a long-term horizon is necessary in our view to weather the inherent short-term volatility of equity markets and to capture both the equity risk premium as well as the benefit of reduced volatility that comes from time diversification in markets. At appropriate times, emphasis will shift from capital growth to capital preservation and, in such instances, cash holdings will be tactically increased.
While the portfolio will always reflect our highest conviction investment ideas, we are cognisant of risk when constructing the portfolio. We believe that diversification is the best tool to manage risk and is an integral part of our decision-making process. We consider how a particular investment fits into the broader opportunity set which is reviewed regularly to create a consistent framework to assess new positions. Overall, we believe our investment process and philosophy should ensure consistency in our portfolio construction and help us navigate the challenging terrain.
The moderation in global economic activity was a prevalent theme for most of 2019, albeit signs of stabilisation surfaced in the final quarter of the year. However, the backdrop has swiftly changed given the coronavirus outbreak and its potential impact on growth — the risk of a global recession has risen quite sharply.
Policy remains supportive as most central banks have exhibited a dovish bias - although the efficacy of policy on growth and markets is increasingly being questioned. At the time of writing, stimulus measures had reached $1.9 trillion, with everything from lower interest rates, bond buying and quantitative easing (QE) being thrown at the virus. Against this backdrop, we believe it is prudent to remain cautious given the downside risk to global growth as well as other issues such as the oil price shock.
Our offshore allocation remains favourably disposed to equities, wherein the exposure continues to be skewed towards European and Asian investments as well as corporates and markets that we believe are most likely to provide returns. Beyond the return potential, these two markets offer significant diversification benefits given their low correlation with the domestic equity market. We continue to prefer cash over global bonds. A third of the offshore component is held in cash. It acts as an attractive shock absorber in times of heightened market volatility and material market drawdowns.
The local growth outlook remains under severe pressure. Business and consumer confidence remain subdued, Eskom continues to be an albatross around the country’s neck given its financial and operational concerns, while policy uncertainty and rising unemployment (and low real wage growth) compound the problem. South African businesses and consumers are also very quickly getting to grips with the short and medium-term implications of the virus — on how we live, work and play.
Thus, it is no surprise that earnings revisions remain under pressure across locally-oriented businesses (particularly food and general retailers as well as food producers) given the tough economic backdrop and operating environment, but we continue to focus on companies that are exhibiting improving earnings revisions profiles due to operationally-driven improvements or self-help measures. 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, Bid Corp, British American Tobacco and Reinet Investments. We also have exposure to select ‘SA Inc.’ plays with decent relative earnings revisions profiles and trading at reasonable valuations, including FirstRand and Sanlam.
We continue to hold a sizeable allocation to local bonds. In the domestic fixed income spectrum, it remains an attractive asset class given how high the yield over cash is. That said, worsening local fiscal dynamics are concerning from a rating action perspective. But the recent budget statement was received positively by the market due to the planned cuts in public sector wage growth. However, we believe the execution risk is material and failure to implement the cuts as outlined could result in further negative rating action. We believe investors are largely compensated for these risks as domestic bond yields continue to trade at a material premium to their emerging market peers, but we continue to monitor the situation. Inflation looks set to remain range-bound with the 3-6% target band, while the global monetary policy backdrop is quite accommodative, potentially allowing the central bank room to manoeuvre given the backdrop of tepid growth.
From a portfolio perspective, we are cognisant of the potential implications of this outbreak on some of our portfolio positions. That said, we believe it is paramount for us not to deviate from our disciplined investment process (picking stocks with positive earnings revisions at a reasonable valuation) even in the face of such event risks — the combination of objective factor-based screening and bottom-up fundamental research allows us to cut through inefficiencies, enabling us to avoid behavioural biases and to deliver repeatable and dependable returns.
We believe thorough bottom-up fundamental analysis is required to understand the source of earnings revisions. It is important to establish whether changes to earnings estimates are due to permanent or temporary factors.
When building and managing our portfolios, we believe the best approach to mitigate company specific risk is through:
Macro variables and event risk all have a significant impact on stock returns. It is thus tempting to forecast these and position the portfolio accordingly. Our experience, however, is that these variables and risks are extremely difficult to forecast. Further, there is insufficient breadth in this type of risk taking — the outcome is typically binary. We prefer the breadth of a stock-picking strategy where we are able to diversify risk across a wide range of individual stock positions.
Our aim is to maximise the benefits of our individual stock insights; hence we are aware of and closely monitor any unintended macro risks which may unintentionally be embedded in the portfolio as a result of the aggregate individual stock selections. Where necessary we take action to manage macro risk.
From a bottom-up perspective, there are pockets of the market where we are picking up ideas based on our philosophy and process. Earnings revisions remain under pressure across locally-oriented businesses (particularly food and general retailers as well as food producers) given the tough economic backdrop and operating environment, but we continue to focus on companies that are exhibiting improving earnings revisions profiles due to operationally-driven improvements or self-help measures.
As a team we are also performing in-depth stress test scenario analyses for a worst case (three to six-month disruption period). We are looking at potential changes in earnings revisions profiles, but also the free cashflow impact on companies and the effect on their balance sheets. For the companies that we have under coverage, we are flexing our assumptions for the key COVID-19 uncertainties: duration of trade disruptions and severity of impact in different regions.
The General Equity Strategy’s 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, Bid Corp, British American Tobacco and Reinet Investments. We also have exposure to select ‘SA Inc.’ plays with decent relative earnings revisions profiles and trading at reasonable valuations, including Bidvest Group, FirstRand and Sanlam.
The phrase “black swan” is derived from a Latin expression. The black swan theory (or theory of black swan events) is a metaphor which describes an event that comes as a surprise, has a major effect and is often inappropriately rationalised after the fact with the benefit of hindsight.
In our view, the cause of this sudden growth shock had very little to do with conventional economics or any of the previously widely held views on excess leverage or artificially low interest rates. Instead, it came out of the left field after it had started in the city of Wuhan, China.
Managing and navigating through a financial crisis is no fun at all for anyone. No one should have to choose between medicine and other necessities. No one should have to use the emergency room with fear of contracting a virus every time a child or elderly person gets sick. And no one should have to live in constant fear that a medical problem will become a global crisis. To quote from a speech by Abraham Lincoln before he became the 16th president of the United States “And this, too, shall pass”.