The economic impact of actions taken to moderate the spread of COVID-19 remains uncertain. There is evidence that efforts to #FlattenTheCurve are helping reduce the incidence and impact of the virus. However, the economic and business effects are material, and there can be little doubt that the global economy is undergoing a sharp contraction. Many countries are in shutdown, or approaching a shutdown, to contain the spread of coronavirus. Economic numbers from China that were released earlier this week give an indication of the economic implications of shutdown.
In January and February, compared to a year ago, China’s industrial production, retail sales, and fixed-asset investment were down 13.5%, 20.5% and 24.5%, respectively. This deep contraction points to China’s growth in gross domestic product (GDP) slowing to 3.0%, versus S&P Global’s expectation at the start of the year of 4.8%. If we push this impact up to the world economy, it seems reasonable to expect global GDP to contract for two consecutive quarters, and for the full year to grow by just 1.3% compared to the 2.8% forecast at the start of 2020. Similar downgrades to growth are anticipated elsewhere, including South Africa.
Source: Cannon Asset Managers
The economic shock of COVID-19 has been amplified by the oil war being waged between Russia and Saudi Arabia. Having managed investments through the Asian and Russian crises of the late 1990s, Y2K, the Twin Towers and the global financial crisis, there is a temptation to point to similarities between the COVID-19 crisis and these other shocks. There is also a temptation to suggest “this time is different”. Our view is that there are many similarities and important differences.
The many similarities include market reactions of fear, extreme anxiety and “correlations going to one” by which is meant that all things sell off together and in such a circumstance there are few places to hide. The volatility index (VIX), which is also know as the “fear index” sits at 80 points, which is the highest it has been since it was introduced in 1990. The differences are that the economic impacts are happening at the same time as financial impacts, and that the shock to the system is broad based, all industries and all countries are impacted. What started as a somewhat distant event in February has translated into a dramatic series of market moves with real economic impacts.
Source: Cannon Asset Managers
Policy makers have been swift to react, including Sunday’s decision by the Fed (15 March) to move forward its rate decision and cut the Fed funds rate by 100 basis points (one percent) to 0.00%-0.25%. The Fed also announced an increase in its asset buy backs by at least an extra $500bn of US treasury stocks and $200bn of mortgage-backed securities. Then, on Wednesday the European Central Bank (18 March) announced a €750bn Pandemic Emergency Purchase Programme (PEPP), emphasising that the buyback figure is a minimum and that the ECB will “terminate” the PEPP only once the “COVID-19 crisis phase is over”.
In this environment, interest rates have fallen sharply as the global spread of the coronavirus increases the probability of more adverse scenarios for economic growth. Interest rates could continue to fall and are likely to remain low for some time given accommodative central bank policy. Notwithstanding the swift central bank action, there is considerable uncertainty around the effectiveness of interest rate cuts in an environment which depends on public behaviour amid health concerns. This uncertainty is being aggravated by the oil market which faces a twin shock with demand collapsing and supply being fed by the oil war between Russia and Saudi Arabia. The oil price has fallen from $53/barrel a month ago to $23/barrel. In this context, market prices are moving wildly. This has had impacts on energy-exporting countries that come on top of the effects of COVID-19.
Against this backdrop, South Africa’s 10-year government bond yield has risen to 11.56% compared to 8.89% a month ago. and the JSE All Share Index has been hit hard. Non-residents have been selling South African bonds (R40.3bn) and South African equities (R30.5bn). There is cold comfort in the fact that South Africa is not alone in the emerging market selloff. Since the unexpected COVID-19 outbreak in Italy and South Korea in February, emerging markets have seen capital outflows that are substantially higher than those during the taper tantrum of 2013 and the 2015 commodity collapse. Consequently, the rand has moved from R14.01/$ at the start of 2020 to R17.36/$.
What this means for our portfolios
We are closely monitoring market moves and the implications for our portfolios. In equity portfolios, at the beginning of last week we sold down commodity exposure and have held onto the cash since then. Where we have held excess cash, we have moved into the market with exceptional caution and care. This is not a place to be looking for fallen angels.
Richemont’s share price is down almost 30% from January’s high and, at R686, Capitec is more than 50% off its mid-February price of R1,440. We expect these businesses, and others, to come under substantial earnings pressure. In Richemont’s case, Swiss watch exports for the month of February declined 9.2% with year-on-year sales in China and Hong Kong down 51.1% and 40.2%, respectively. These are the biggest declines in 20 years. Capitec’s earnings are likely to be materially impacted by the South African economy, and this will have implications for the bank’s balance sheet.
This underlines our stance that buying in at substantially lower prices must first take account of the dramatically changed economic environment, and then consider businesses balance sheets and the strength of their cash flow before contemplating earnings and price recovery. We are of the view that companies that navigate this shocked environment will experience disproportionate earnings recovery. However, given the liquidity crunch brought about by the sudden economic slowdown, others will face darker outcomes. Managing risk must always sit at the front of any investment decision.
We are particularly sensitive to the implications for companies in some sectors, including the energy sector (we have no direct exposure to Sasol). Resource companies will also see a sharp markdown in earnings, and you will know from last week’s letter that we have reduced exposure to that sector in our equity portfolios. Also, travel and leisure companies are under extraordinary pressure. City Lodge’s share price is down 70% since January and Famous Brands’ share price is down 60%. Despite established records and the massive price falls, we are not buyers of these stocks until we can be confident of better earnings visibility and price discovery.
The COVID-19 pandemic has caused economic and market shocks. There is no poor pun intended, but the speed and extent of the selloff across markets and asset classes means that no one has immunity. We expect these stresses to remain for some time, affecting consumer confidence and business confidence.