Market Commentary




1Q20 Market Commentary

By Shoaib Vayej – Portfolio Manager


COVID-19 Pandemic infects markets

Vladimir Ilyich Lenin — 'There are decades where nothing happens; and there are weeks where decades happen.'

The new decade began with hope for a recovery in the global economy, after more than a year of trade wars, predominantly between the United States (‘US’) and China. Manufacturing, which had been hit particularly hard by increased tariffs and uncertainty, looked set for a cyclical upturn with the announcement of a Phase 1 trade deal between the US and China early in the new year.

A new health risk emerged at the same time in the city of Wuhan in central China, with scientists discovering a cluster of pneumonia cases leading to the identification of a new corona virus, named COVID-19. While there have been similar outbreaks historically, for example SARS in 2003 and MERS in 2012, COVID-19 is less deadly, countered by very high rates of transmission and a long period before infected people exhibit symptoms. It attacks the immune systems of infected people leading to a high rate of hospitalisation, especially for people with underlying risks and the aged. There is currently no vaccine for COVID-19 and development of a vaccine at a global scale would take at least 18 months which necessitates a dramatic change in lifestyles until a cure can be administered.

While the Chinese government imposed a strict and extended lockdown on Wuhan and other areas of Hubei province, the virus has been quickly transmitted across the world. As we write they are 2.6 million confirmed cases globally with more than 184,000 deaths resulting. Given that interconnectedness is synonymous with development, it is no surprise that the major economies of North America, Western Europe and Northern Asia lead in terms of confirmed cases. To slow the spread of the virus and enable health systems to adequately deal with the case load, governments have enforced strict restrictions on mobility and non-essential economic activities. Governments are sacrificing their economies in the interests of health outcomes. More than 80% of the world, weighted by economic contribution, is currently under some form of mobility restriction. Some of the Asian countries that are emerging from lockdown are seeing a 2nd wave of infections making them more cautious in their approach.

Oil markets were exhibiting some stress before the impact of COVID-19, with OPEC+ struggling to balance weak demand growth and strong US shale supply growth. The extent of COVID-19 lockdown measures has decimated oil demand. At the beginning of March, Saudi Arabia and Russia failed to agree on supply cuts. The Saudi response was unexpected as they announced increased supply and increased discounts for oil. This set off a rapid collapse in prices from $50/bbl to $30/bbl. A month later the US managed to bring the parties back to the table under the auspices of the G20 forum, however the quantum of pledged reductions is underwhelming relative to the level of demand destruction. The rates of oversupply imply that the world would run out of storage capacity during the second quarter of 2020 which would result in a collapse in spot prices and forced shut-in of existing capacity.

The COVID-19 crisis and the measures implemented to contain it are sure to drive the global economy into recession. Uniquely, the single cause in this instance is an exogenous natural phenomenon, impacting both the supply and demand side. The last precedent was the Spanish Flu, which resulted in 50 million deaths globally, approximately 3% of the global population at the time. While the recession is expected to be relatively short in duration it also expected to be very deep, greater than the 2% fall in global growth during the Global Financial Crisis (‘GFC’). It is also more diffuse, impacting every industry and geography. What is difficult to ascertain at this stage is to what extent second waves of infections will continue to depress activity as well as the magnitude of permanent demand loss in sectors such as travel & tourism.

The most vulnerable to this crisis appears to be small businesses, lower income workers, less developed countries and highly indebted individuals and companies. The International Labour Organisation estimates that 40% of the world’s 3.3 billion (‘bn) strong workforce are currently employed in sectors that are experiencing a drastic loss of demand. It is estimated that US unemployment will peak between 20 and 30%, two to three times the peak during the GFC and on par with the great depression almost one hundred years ago. Many mega trends that were already in play, including technological disruption, localisation of supply chains and the polarisation of politics will be accelerated by this crisis.

Given the unprecedented nature of this crisis and its economic effects, policymakers are using all their powers to counter it. The International Monetary Fund (‘IMF’) announced that global fiscal stimulus amounts to $8 trillion, or 9% of global Gross Domestic Product (‘GDP’). Monetary policy makers have been as decisive with the US Fed cutting its funds rate to 0% and announcing unlimited monetary stimulus. The European Central Bank, which had already set interest rates in negative territory before this crisis, announced €750 billion in additional stimulus. Balance sheets of these major central banks had hardly retraced since their post GFC expansions, and on current trajectories will grow another 20% relative to size of their economies.

In financial markets, equities and high yield credit have shown the most stress. The MSCI world index fell 21% in the quarter, after being more than one third down during the quarter. Markets rallied strongly during the last few weeks on announced monetary and fiscal stimulus. Equity volatility reached unprecedented levels, surpassing that seen during the GFC, mimicking daily moves last seen during the great depression. Globally healthcare, consumer staple and information technology sectors have been defensive, although still falling over the quarter. Energy and materials were weakest during the quarter. Emerging markets lagged developed markets, with South Africa particularly weak down 40% in the quarter.

This crisis could not have come at a worse time for South Africa. Real economic growth was anaemic even with decent global growth, constrained by a fragile electricity system and poor economic policy. Government spending has been sticky to adjust with the result that fiscal deficits have increased leading to a debt spiral over the medium term. South Africa also has vulnerabilities that make it susceptible to a COVID-19 crisis; extreme levels on inequality, poor living conditions and sanitation, a failing public health system and a general disregard for the rule of law. South Africa announced a stringent three-week lockdown at the end of the quarter, which was then extended by another two weeks, extending it to end of April. The result is that nominal GDP is likely to be negative and the fiscal deficit will blow out to double digits. Of all countries analysed, the South African (‘SA’) government has amongst the least fiscal space to react to the crisis, with the burden largely falling on the private sector and the population. The South African Reserve Bank’s (‘SARB’) reaction has closed the gap on global peers, cutting interest rates by 2% in 3 weeks but also announcing some extraordinary measures to provide liquidity and including its own participation in the secondary bond market.

At the end of the quarter Moody’s ratings agency downgraded the SA Government’s debt rating to sub-investment grade, the last of the 3 major ratings agencies to have done so. The factors cited are a deterioration in fiscal strength and structurally weak economic growth which are unlikely to be addressed by current policies. This downgrade will automatically exclude SA from the World Government Bond Index (‘WGBI’), which will result in the forced selling of up to $7bn in SA government bonds. Fitch ratings agency followed soon after with another notch downgrade deeper into sub-investment grade. This action accelerated a sell-off in the SA Rand (‘Rand’) which remains one of the weakest performing emerging market currencies this year.

Gold prices are a safe haven in times of uncertainty and Rand gold prices kept making record highs through the quarter, leading to an outperformance by gold miners, gaining 5%. Companies that can transact virtually, like technology, media and telecommunications also performed well. The Naspers/Prosus stable was a standout performer during the quarter, up 12% and 17% respectively. Consumer staple companies, that are deemed essential and allowed to operate during lockdown, are also defensive. British American Tobacco (Tobacco +2%) and the Food & Drug retail sector held up relatively well (-13%).

The weakest performer on the JSE was Sasol (‘SOL’), down 88% for the quarter. SOL is normally highly geared to oil prices given its high operating leverage. The company has entered the current downcycle in oil and chemical markets with high financial leverage given the quantum spent on its Lake Charles Chemical Project in the US and runs the risk of breaching covenants. Travel and Tourism companies were obvious losers due to travel restrictions and that sector lost almost two thirds of its value. Lockdowns globally have affected the real estate sector, especially retail, as most stores are not allowed to trade. The Real Estate Investment Trust (‘REIT’) index lost half its value in the quarter.

Afena’s investment approach is to focus on bottom-up fundamentals, evaluating the value, prospects and quality of every investment opportunity. Given the drastic and wide-ranging impact of COVID-19 we are less confident in our ability to measure the prospects over the next year. Our focus for now is very much on tilting client portfolios to mispriced quality opportunities.