Market Commentary

 

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3Q20 Market Commentary

By Zahira Osman – Portfolio Manager

Global Overview

A second wave threatens the economic recovery and political tensions increase

The unparalleled monetary and fiscal policy response by central banks, along with easing COVID-19 restrictions saw global Gross Domestic Product (‘GDP’) during the third quarter rebounding sharply from the second quarter collapse as the pandemic hit economies worldwide.  As countries reel post the unprecedented aftermath of COVID-19, the resurgence of economic activity and a possible V-shaped recovery are once again threatened as many countries now face a second wave of infections and the reinstatement of stricter virus containment measures including targeted lockdowns, restricted movement, social distancing and curfews.  The United States (‘US’), the United Kingdom (‘UK’) and Europe have seen rising infection rates, with some countries showing case levels above the first wave  peaks, although hospital admissions are lower thus far.  The US continues to maintain the number one position in total cases, with US President Donald Trump (‘Trump’) and his wife also recently having tested positive.  In contrast, China, the origin of the virus, has managed to contain infections remarkably well and as a result has rebounded earlier and faster than the rest of the world with its focus on infrastructure investment.  The imminent revelation of President Xi Jinping’s next 5 year plan is likely to continue spurring growth. 

The advent of a second wave, coupled with still elevated levels of unemployment, support schemes having run their course and the fear factor are likely to slow the path of economic normalisation to pre-COVID-19 levels.  With monetary policy rates zero-bound in developed economies and at record lows in emerging economies, central banks face challenges in sustaining the recovery with an increased need for additional fiscal stimulus, which in turn will place a further burden on public finances.  This quarter also saw a key development by the US Federal Reserve Bank (‘Fed’) through its stated shift towards a greater tolerance for inflation above its target rate, which should keep a lid on interest rates in the medium term.

Global equity markets, buoyed by the significant monetary stimulus intervention, have re-rated positively, leaving limited room for negative surprises.  Risks include a disputed and contested electoral outcome as Trump and Joe Biden (‘Biden’) go head to head in the next month.  Biden is currently (at the time of writing) ahead in the national polls in the race for the US Presidency.  A Biden win could potentially be positive for risk assets and emerging markets (EM) if trade war risks de-escalate.  On the other hand, increased taxation and regulation may be a dampener in the short-term.  If Trump wins, we could see an intensification of trade wars and the promulgation of further protectionist policies and inward industrialisation, which would be negative for global trade.

Ongoing US-China tensions, Brexit discussions and an unforeseen delay in an effective, reliable and widely available vaccine in the absence of extensive herd immunity are also likely to heighten volatility in markets as we head into the final quarter of the year. 

Commodities: Prices hold up despite market turbulence

In spite of the severe economic contraction and COVID-19 uncertainty, commodity prices have held up reasonably well, with returns on the whole positive in both the second and third quarter post the sell-off in the early part of the year.  Supply and demand dynamics remain supportive into 2021, further bolstered by negative real rates.  Miners have remained quite disciplined with capital expenditure and COVID-19 has disrupted production in major producer countries. Chinese stimulus has been particularly commodity intensive offsetting some of the negative impact of weak demand from advanced economies.

Iron ore prices continue to lead the pack this quarter (+20.4%), boosting year-to-date (‘YTD’) returns +35.5% due to surprising strength in Chinese steel production.  The property, infrastructure and automotive sectors continue to be key pillars of growth for China. Supply remains challenged as Vale has struggled to recover from the Brumadinho dam collapse at the start of 2019.

Despite a softer quarter (+5.9%), Gold prices in both real and nominal terms remain extended, having soared as a safe haven asset during the COVID-19 crisis, returning +24.3% YTD. Notwithstanding the elevated levels, investor appeal should remain given accommodative monetary conditions and increased political risks.

The Platinum Group Metals (‘PGM’) basket has continued to climb this quarter, with Rhodium’s contribution now in excess of 40% post a phenomenal performance.  Tightness in the Rhodium market is expected to continue to support Palladium (+18.8% YTD and +18.9% for the quarter).  Any marginal substitution into Palladium and Platinum is likely to result in tension in these markets, tipping them into deficit as we move into 2021.  Platinum prices have been steady during the quarter (+7.7%) due to investment demand, correlated with the gold price rally.  As activity levels normalise, a recovery in auto sales and a substitution from Palladium could easily rebalance the Platinum market and provide further support to the PGM basket.

Brent crude remains the laggard, declining -0.5% over the quarter and -38.0% YTD following the record demand shock as a result of COVID-19, the related travel and movement restrictions globally and uncertainty around OPEC+’s ability to curtail production.  Geopolitical risks could see further volatility in oil prices and supply dynamics.

Emerging Markets (‘EM’):  Staging a recovery this quarter

EM’s outperformed their developed market (‘DM’) counterparts this quarter.  In US dollar (‘USD’) terms, the MSCI EM was up +8.7%, ahead of the MSCI Developed World (+7.5%).  MSCI India and MSCI China were the standout performers this quarter, up +14.9% and 11.7% in USD respectively.  Many EM currencies also saw a strengthening relative to the USD this quarter. 

Within EM, South Africa (‘SA’) continued to underperform in US dollars (-3.4%) due to investor concerns around much needed sustainable structural reforms, lacklustre growth and the unmanageable debt burden which continues to crowd out private sector investment.  SA equities and bonds have registered foreign outflows of USD6.3 billion and USD3.6 billion YTD. Whilst the Rand strengthened 3.6% this quarter on stronger trade surpluses and terms of trade, investors are likely to remain cautious as we head into the Medium Term Budget Policy Statement (‘MTBPS’) which has been rescheduled to 28 October. 

EM’s remain under-owned by investors.  Diminishing trade uncertainties and sustained global growth in a post COVID-19 world would be required to see a rotation back into EM risk assets.

Value vs. Growth:  The dislocation continues

Global value stocks have continued to languish relative to growth, having underperformed by 50% YTD.  Relative price levels and valuations are now at extreme levels relative to history.  Growth and long duration assets have benefitted significantly from loose monetary policy, whilst value stocks have perished in a persistently low growth and interest rate environment.  Growth stocks remain overbought and priced for perfection.  Given the extended dislocation in valuation, we believe that value stocks are looking exceptionally attractive and could prove defensive should earnings falter in growth counters.

 

SA Overview

SA growth structurally impaired despite improving infection rates and easing restrictions

This quarter saw the peak in SA infections, with cumulative infections of circa 680 000 (at the time of writing) placing the country in the top 10 globally, despite SA moving to a strict set of lockdown rules in March 2020 which brought all non-essential economic activity to a grinding halt. The government’s Risk Adjusted Strategy meant that we witnessed a gradual opening up of the economy with each level of easing.  Infection rates have dropped off meaningfully over the last few weeks and recovery rates are now at 90%.  As a result, we moved to Level 2 in August and finally Level 1 during September, allowing for a large portion of the economy to restart.

Given the above containment measures, it is unsurprising that second quarter GDP fell to record lows, with growth contracting -51% and -17% on a quarter-on-quarter annualised (‘qoq’) and year-on-year (‘yoy’) basis respectively.  There were also 2.2 million job losses, with the employment ratio at 36%. Domestic relief measures have only had partial success with many businesses folding due to the tardiness in rolling out the Temporary Employer/Employee Relief Scheme (‘TERS’).  The largest respite has been from the 275 basis points (‘bps’) reduction in interest rates, which falls short of the what is required to heal the economic scarring as a result of COVID-19.  SA has managed to secure approximately USD5.6 billion from the New Development Bank, the African Development Bank and the International Monetary Fund (‘IMF’).  Whilst the IMF’s USD4.3 billion emergency funding is positive, it has certain conditions attached, particularly in relation to fiscal consolidation and a sustainable growth trajectory.  Active tightening measures are necessary to achieve the R230 billion spending cut target to prevent a continued deterioration in the debt path.

During September, a recovery plan, centred on infrastructure-led growth was finally agreed by The National Economic Development and Labour Council (‘NEDLAC’).  Despite ambitious growth plans and austerity measures, SA still faces long-term structural impediments to growth.  Untenable public debt levels, inefficient and financially unstable State-Owned Enterprises, the inability to root out corruption and rigid labour laws remain barriers to a sustained economic recovery.  Recent load-shedding due to unplanned maintenance has once again highlighted the operational and financial challenges at Eskom and places a cap on economic recovery.

Local Market Review: Resources continue to outperform

Risk aversion was seen during the quarter with SA Bonds (+1.5%) outperforming SA Cash (+1.2%) and SA Equities (All Share Index +0.7%).  SA Property was the worst performing asset class, returning a dismal -15.4%. 

Equity performance this quarter was once again led by Resources, which advanced +6.1%.  With the exception of Specialty Chemicals (Mainly Sasol (‘SOL’)), all sub-sectors were positive, with PGM miners the star performers +21.6%, after surging +62.0% last quarter.  The sector continues to be driven by momentum in the price basket which is well supported by fundamentals.  Royal Bafokeng Platinum (‘RBP’) played catch up, rising +100.3% this quarter, followed by Northam Platinum (‘NHM’) +46.6%, Impala Platinum (‘IMP’) +30.3% and Sibanye Stillwater (‘SSW’) +24.1%.

Financials were down -1.7% during the quarter.  Only Banks bucked the trend (+6.2%) as the sector recovered from depressed levels, which were pricing in overly pessimistic earnings expectations.  The quality plays Capitec Bank (‘CPI’) and FirstRand (‘FSR’) recovered +20.8% and +8.3% respectively.  CPI should see an improved second half performance on lower impairments and incremental top-line growth as the economy recovers.  Whilst FSR saw a substantial increase in the credit loss ratio, it still has sector-leading returns on capital and is conservatively provisioned.  The Insurance sub-sectors underperformed due to uncertainty around COVID-19 related provisions and the impact of market returns on earnings.

Industrials regressed -2.3% this quarter, with divergent intra-sector performances.  Industrial Transportation increased +22.5%, driven by a stellar +41.4% from Motus Holdings (‘MTH’).  In its most recent set up results, MTH showed strong cash generation despite the challenging backdrop.  The aftermarket parts and financials services division provided a cushion to the poorer performances from retail and rental.  General Retail climbed +8.7%, with strong performances from The Foschini Group (‘TFG’) and Massmart Holdings (‘MSM’) respectively.  TFG saw a massive re-rating on the announcement and successful implementation of a capital raise, which largely allayed balance sheet concerns.  Notwithstanding severe COVID-19 impacts, MSM saw a strong rebound as it began showing early signs of a recovery in the ailing Massdiscounters business with its turnaround plan under the new leadership team.

On the downside, Pharmaceuticals retraced -17.0%.  Whilst balance sheet risk has largely been alleviated, Aspen (APN) fell as the market worries about transparency and acquisitive growth ambitions. The travel and leisure sector continues to be hard hit, down -11.8% for the quarter and -60.3% YTD.  Concerns around a protracted recovery and balance sheet strain are top of mind as business and leisure travel remain constrained despite the allowance for international travel from 1 October.  City Lodge (‘CLH’) and Sun International (‘SUI’) moved to raise equity during the quarter to address cash flow and balance sheet risk.

Whilst earnings visibility across the universe has somewhat improved, the timing and extent of the recovery is opaque.  With the potential of a double hit from the pandemic and the knock-on effect of further lockdown measures, we continue to manage the fund in line with our investment process, but with a preference for companies offering sufficient margins of safety and lower balance sheet risk.

Sources: Bloomberg, Refinitiv Datastream, Citi, Sarasin, HSBC, Avior, Noah, Nedsec, SBG, MRB