File Image: IOL
File Image: IOL

SA investors in better shape than the battered economy

By Izak Odendaal and Dave Mohr Time of article published Jul 7, 2020

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We’re halfway through 2020, and it would be tempting to think we’re also halfway through the greatest crisis to hit humanity in 80 years. But of course we have no way of knowing. Global Covid-related deaths have passed 500 000, and show no signs of slowing. The distribution of cases has only shifted from country to country and region to region. Worryingly, the US is showing a renewed spike in confirmed infection rates, particularly in the south.

The market is betting that this will not lead to renewed harsh lockdowns. This makes sense, since the purpose of the lockdowns in each country was to prevent health systems from being overwhelmed. Areas affected later by the pandemic theoretically had more time to prepare. There is also very little appetite among the broader population for a return to strict lockdowns. People are starting to learn to live with the reality of the coronavirus.

Six months ago, it didn’t even have a name, and the shock of its sudden spread was great. Now it’s a fact of life. We also know more about the virus than we did even three months ago. The evidence suggests that mask-wearing and avoiding prolonged exposure to crowded and poorly ventilated indoor spaces can make a big difference. This does mean that some sectors of the economy face a long uphill road to recovery – nightclubs,sports stadiums and some restaurants are likely to remain closed, while international travel is bound to remain restricted. This in turn means that some regions and countries – primarily those more dependent on tourism – will be slower to recover.

Central bank support

However, none of this is certain. What is much more certain is that the major central banks will not allow another major dislocation on markets while the economy is still so extremely fragile. This does not mean that equity values will necessarily go higher, nor does it mean that there cannot be a correction after an incredibly strong run in the second quarter. It just means that a repeat of March’s market madness is unlikely, irrespective of the course the pandemic takes.

It is also worth noting that the Federal Reserve in particular has only deployed a fraction of the funds it earmarked for each of the nine facilities it created to combat the US recession. The mere promise that it was acting has been enough to boost the equity market. For the rally to be sustained, however, we will need to see earnings growing again, which requires fiscal and monetary policies to be effective in reigniting economic activity. The market can divorce from the underlying earnings reality for a while, but not indefinitely.

Speaking of the second quarter, the bounce from the first quarter’s carnage was impressive. For the total global equity market – as measured by the MSCI All Country World Index - the 3.2% return in June lifted the second quarter return to 17%. While it has not completely recovered the pandemic-related losses, the index was marginally positive over one year at 2.6%.

The undoubted leader was the US. The S&P 500 returned 2% in June, pushing second quarter returns above 20%. While still in the red year-to-date, on a 12-month view, the S&P 500 is up 7.5%. With inflation over the same period only around 1%, the real return is pretty much in line with the long-term average. It’s as if the pandemic never happened, when in fact the US has been one of the hardest hit among rich countries, and continues to suffer due to a halting, incoherent and fragmented response. But this is the market reaction you get when your government issues the world’s most desirable currency, your technology companies are dominant and your central bank is innovative, pragmatic and determined.

Despite having none of these three attributes and despite also dealing with a still-raging outbreak, South African equities outperformed global markets in the second quarter. The FTSE/JSE All Share Index returned 7.7% in June, and 23% in the second quarter, the best quarterly return in almost 20 years. A 3% appreciation of the rand against the dollar pushed the dollar return to 26%.

Clearly, the longer-term picture is still disappointing. At the end of June, the three-year annualised return was 5% and five-year return only 4%. In retirement funds that are subject to regulatory asset class limits, local equities are the main growth asset and this performance has hurt local investors. Sadly, the JSE suffered a bear market in 2020 without having enjoyed a bull market in the preceding years.

This does not mean that SA equities can never recover. While you shouldn’t read too much into a single three-month period, what the second quarter clearly shows is that the local market ebbs and flows with the tide of global risk appetite. Sustained positive risk appetite that also reflects in firmer commodity prices and a weaker US dollar can see local equities do very well, despite weak domestic economic fundamentals. The latter determines our positioning within the emerging market universe. We were rated one of the better emerging markets, but that perception changed permanently following Nenegate and the revelation of deep governance concerns across the public sector, particularly in debt-laden Eskom. Governance failures in the private sector were also exposed (Steinhoff, African Bank, Tongaat), including the at-times questionable performance of major auditing firms.

The simplest way to illustrate this relative deterioration is to compare our US dollar credit default swap (CDS) spreads relative to a basket of similar emerging markets. (There is no need to get into the specifics here. While a CDS is a fixed income instrument, it does offer valuable insights for equities too.)

Chart 2: 5-year US dollar credit default swap spreads for selected emerging markets

It is obvious how we went from rated less risky with a lower CDS spread (or at least in line) to more risky (higher). It is also clear that the whole emerging market universe rises and falls with global risk appetite. Irrespective of our position relative to our peers, when emerging markets rally, we will rally. And if that does happen, the rand is likely to appreciate too, which means the relative performance of local versus global equities can change substantially. This is an outcome that is managed through appropriate diversification.

Whether it is a likely outcome is more difficult to judge, but it is easy to sketch a scenario where it happens: as the pandemic eases, global growth accelerates but central banks keep rates extremely low. Investors are forced to search for yield, and emerging markets are an obvious source. Meanwhile, large fiscal and current account deficits in the US (relative to other rich countries) start putting downward pressure on the US dollar. As the dollar falls, returns from emerging markets rise, attracting yet more capital. This is clearly only one of an infinite range of unknowable future states of the world, but it could happen. Why would you explicitly bet against it?

At any rate, it is also not as if the equity market has completely ignored domestic conditions. The rebound in the JSE has been led by the mining and rand-hedge industrial shares.

Resources delivered the best return in the quarter (41%) with gold and platinum miners leading the way. With the gold price on a tear towards $1 800, gold mining shares have predictably been flying. Unlike days gone by however, they are no longer big enough to significantly move the headline JSE indices. The impact on the local economy from gold mining is also much smaller since the heyday of the industry in the early 1980s. Most of the gold has been mined out and the index of gold production has declined by more than 80% since then.

Industrials returned 17% in the second quarter. The sector is positive in 2020 with a 6.7% return, largely thanks to Naspers/Prosus and other rand hedges. Despite firming recently, the rand was still 24% lower against the dollar in the six months to end June. Industrial companies focused on the local economy, such as retailers and food producers, still have some way to go to recover the first quarter losses.

Of the big three traditional subsectors on the JSE, financials are more locally than globally orientated and it shows in their performance. While financials were positive in the second quarter with a 13% return, the sector was still 31% lower than at the start of the year. Financials have endured a deep and sustained bear market. Part of the reason is that listed property companies are counted as financials on the JSE. The SA listed property index was weak going into the Covid crisis and then tumbled in line with global property. Despite a recent recovery, the year-to-date loss was still substantial at 38% at quarter-end.

Looking back and looking ahead

Unlike a sports match, investors do not get a specific halfway break to stop, rest and reassess. Markets operate continuously and investment horizons of individuals are all different, though they do overlap. Still, it is common practice to treat the end of a calendar period (month, quarter, year) to take stock. What stands out yet again is that the experience of South African investors and the outlook for investment returns are much better than that of the economy in general.

Morningstar data show that the average retail balanced fund returned 0.5% in the 12 months to June. This is a very disappointing return in isolation, but in the context of the deepest local recession on record and a period of unprecedented global market volatility (exceeding even the 2008 episode).

Looking ahead, a South African balanced fund can deliver solid real returns. The most reliable indicator of future returns is current valuation, not current macro conditions. Local equity valuations are in line with long-term averages while property and bonds offer attractive yields in excess of inflation. Money market yields have declined considerably as the Reserve Bank has cut interest rates, but are still slightly ahead of inflation. Investors in developed countries cannot say the same, with long and short-term interest rates below inflation.

Izak Odendaal and Dave Mohr are strategists at Old Mutual Wealth Investment


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