As we write this, we are in the midst of a 21-day lockdown to help stem the spread of the coronavirus (COVID-19) in South Africa. The US-China trade spat of the previous year is a distant memory of a less volatile time. It has been replaced by fears of a global pandemic and its unforecastable economic consequences. As a result, the first quarter of 2020 has been abysmal for markets; the worst we have experienced since the Global Financial Crisis (GFC). To add to the gloom, ratings agency Moody’s Investors Service finally downgraded South Africa’s sovereign credit to sub-investment grade.
Policy responses from governments across the world have been swift. Entire countries are on lockdown or have severely limited movement, while both monetary and fiscal stimulus are being utilised to prop up economies, prevent businesses and individuals going bankrupt, and to provide much needed liquidity to fragile financial markets. However, we are first and foremost dealing with a health crisis that has completely suppressed consumption (other than staples). Stimulus may prevent the collapse of institutions and individuals, but we expect growth will be severely impacted by the complete cessation of global economic activity.
In financial markets, risk assets endured one of the worst quarters on record. Global equities (MSCI ACWI) plunged -21.4%, lows last seen during the GFC. Developed market equities (MSCI Developed Market Index) closed 21.1% lower, while emerging market equities (MSCI Emerging Market Index) came worst off, down 23.6%. Yield-oriented assets fared relatively better, helped by the US Federal Reserve’s (Fed) rollout of unlimited quantitative easing (QE) and pledge to snap up as many government bonds and corporate bonds as necessary. The Bloomberg Barclays Global Aggregate Bond Index ended the quarter flat at -0.3%. In South Africa, the JSE All Share Index was down 21.4%, with the All Bond Index down a disappointing 8.7%. While the rand was initially resilient, it weakened 21.7% over the period.
In this extreme environment, your portfolio delivered a slightly negative absolute return, lagging its inflation-plus benchmark. However, more importantly, it maintained a positive absolute return over the 18 months to the end of March 2020, the period over which we target capital preservation.
Performance over the quarter was largely driven by positive contributions the offshore equity component, notably, high-quality names such as Microsoft, Nestlé and Verisign. Locally, British American Tobacco and the NewGold exchange-traded funds (ETF) added value. Diversified miner Assore was the standout contributor following the announcement that the Sacco family intend to take the business private. The share rallied 82% on the news.
These gains were partially offset by negative contributions from our small property component (Capital & Counties and Growthpoint Properties), as well as exposure PSG Group, Standard Bank Group and Distell.
The portfolio’s local bond component was the biggest detractor from absolute performance. Interestingly, yields rose before the Moody’s rating downgrade as investors sought capital amid a liquidity freeze. The downgrade itself seemed to have little impact on the local bond market.
We are not short-term traders. Instead, we prefer to buy what we perceive to be high-quality companies that offer good value, and we hold these positions over the medium to long term. As such, activity over the quarter was muted.
We added slightly to the South African government bond allocation on the back of more attractive valuations. In equities, we made small reductions to holdings in luxury goods maker Richemont and food service operator Bid Corp.
The question on most investors’ minds seems to be: Is it time to buy depressed assets? Our concern is that it is almost impossible to determine if asset prices are depressed if there is uncertainty around the future cash flows of companies. At the best of times, forecasts are difficult; in the current environment, they’re almost impossible. Ultimately, growth and profits will depend on the extent of the pandemic and the length of time that economies remain under lockdown. The spread and impact of COVID-19 has been far worse than most anticipated. But the slowdown in economic activity is self-imposed as governments have curtailed movement, and therefore only we as a global collective can determine when the infection rate has been reduced and contained to the extent that it is safe enough to return to our normal, productive lives. In the short term, we are therefore preserving cash in the portfolio and will only deploy it if we find attractive opportunities.
Looking beyond the medium-term uncertainty, there are further risks that we will need to navigate. The pandemic may accelerate deglobalisation as nations become increasingly inwardly focused. Supply chains may need to be diversified away from China. Comparative advantage may have to suffer to ensure the security of supply. Some industries may be permanently impacted by changed patterns of consumption. And a steady diet of increasing leverage among corporates in a low interest rate world may have to be reassessed in light of plummeting revenues.
This medium -to-longer-term uncertainty highlights the importance of focusing on Quality, especially in a low-risk portfolio. At its core, Quality investing means buying businesses with low leverage that produce goods and services that are fundamental to society. When balanced with appropriate income-generating assets, this creates a safe harbour portfolio that is able to weather extreme movements in markets, while generating inflation-beating returns over the medium to long term. On this basis, the best driver of growth in the portfolio remains what we perceive as high-quality global businesses with limited sensitivity to the economic cycle. We favour those businesses that generate high and sustainable returns on invested capital in excess of their costs of capital. These businesses have not suffered to the same extent as the rest of the market and have provided South African investors with positive returns once the depreciating rand is accounted for.
On the income front, the best opportunity remains South African government bonds generating real returns just north of 6% over 10 years. A lack of global liquidity has pushed local bonds to these levels, with some relief now on offer in the form of QE from the South African Reserve Bank. It is easy to be pessimistic about local bonds given the fiscal and growth outlooks and resultant rising debt- to-GDP ratio. However, at current levels, yields are more-than pricing in this risk and provide far greater certainty than businesses that are only exposed to the local economy. Given that interest rates in South Africa have been cut by 1% (and there are expectations of more cuts to come) and inflation expectations continue to fall (especially given the fall in oil prices), bonds remain a core holding.
Considering property’s high correlation to bonds and the non-existent prospects for rental growth in the near term, exposure in the portfolio remains low. We continue to maintain a small holding in the highest quality stock in South Africa, Growthpoint, as well as exposure to the undervalued Capital & Counties.
We maintain a balance of exposures in the portfolio that offer protection in different investment environments. In light of prevailing risks in this fluid environment, we do not believe it is appropriate to position the portfolio for a particular outcome. As always, we remain unwavering in our commitment to growing your capital in a judicious and discriminate manner.