Investment Perspective: the quarter that followed 2019

David Crosoer, Executive: Research & Investments at PPS Investments

After registering strong gains in 2019, global equity markets sold off sharply in the first quarter of 2020, as the COVID-19 pandemic spread across the globe and authorities took extreme containment measures in an attempt to halt its spread. While economic growth has abruptly ground to a halt, authorities are intervening on a massive scale to support markets.

Equities, currencies, fixed interest, and commodities all impacted
For the quarter, most equity markets, including South African (SA) equities, fell at least 25% in local currency terms. Shares linked to the SA domestic economy (including banks and property companies) were down substantially more.

The rand depreciated close to 30% against the US dollar over the quarter as part of a broader emerging market sell-off, while both SA nominal bonds (down -9.0%) and SA inflation-linked bonds (down -6.6%) also fell sharply.

In contrast, rand weakness largely cushioned the fall of foreign equities, while substantially boosting the return from foreign bonds (which were largely flat in hard currency terms). Rand weakness was not sufficient to mitigate the collapse in key commodity prices including oil that traded below $20 a barrel during the quarter.

SA cash returned a positive 1.6% (in rand), but experienced a cumulative 1.25% in cuts over the quarter. SA inflation remained subdued near the mid-point of the target range.

What are the recovery scenarios?
Given this substantial economic cost, most forecasters expect the shutdown in its current form not to last much longer than three months, but such a sanguine view (the so-called V-shaped recovery) is based on the assumption that the existing lock-downs are effective in controlling the pandemic, and can be quickly removed, without causing additional flare-ups.

Clearly, a more protracted U-shaped recovery (where the lockdowns are in place for up to six months) will expose many more businesses to significant difficulties, while an even deeper L-shaped recession (i.e. where the global economy goes through protracted periods of shutdowns until a global vaccine is widely available) could expose all bar the most resilient of companies (and countries) to severe financial distress.

Why should I stay invested?
Regardless of the shape of the economic recovery, the SA economy has entered this global recession with far less firepower than in 2008. And haemorrhaging SOEs (Eskom and SAA required an additional R60 billion in February) and a ballooning public sector wage bill (where NT is looking to make R160 billion in savings) might give SA no option but to undergo painful structural reforms, possibly with the International Monetary Fund (IMF) assistance.

How were PPS funds positioned at the start of the year?
Investors in PPS multi-managed funds entered the recent market correction well-diversified, and benefitted from both an explicit allocation to certain multi-asset (MA) managers that were focused on capital protection, and a house-view allocation that was overweight in foreign equities and SA fixed interest assets.

We continue to maintain an overweight position in foreign equities in our houseview, and have increased our exposure to SA fixed interest assets too. While SA equities should perform spectacularly in a V-shaped recovery, they appear less resilient than (selected) foreign equities in other scenarios, and consequently we have down-weighted them in our funds.

SA inflation-linked bonds preference
SA inflation-linked government bonds now offer returns well in excess of inflation + 5% should they be held to maturity (depending on the bond, this could be for the next 30 years), and even more return should you be willing to take on some inflation risk by holding nominal bonds.

And perhaps SA will be able to implement some of its much-needed reforms. In fact, we now believe the real return from SA bonds more than compensates us for the risk that SA will be ineffective in terms of implementing necessary reforms.

But remain cautious on SA equities
Many domestic-orientated SA companies (including the banks) are now trading on low single-digit multiples, and offer compelling value for a longer-term investor, even if some don’t survive. SA resource companies are a geared play to a recovery in global growth should China succeed in re-opening its factories and leading the global economy out of the current recession.

Our concern though is should there not be a V-shaped recovery, many SA businesses will be severely stressed. So, we still prefer to hold global companies managed by global asset managers, although we retain a meaningful but underweight exposure to SA equities across our portfolios. If SA equities do well, our portfolios will benefit, but they’ll also protect better in a challenging environment.

Important take-aways
Our disciplined and diversified multi-managed investment process strives to appropriately take on the required risk to achieve our return objectives, while adequately protecting client capital.

In our funds you’ll find managers that are invested in companies they think will fundamentally change the way the world works, and managers that are invested in companies that mine rock from the ground. Here our task as a multi-manager is not to try to forecast the future, but instead find managers that think differently about the world, and thereby build portfolios that are robust to different scenarios materializing.
The next few months will be very challenging. Markets are likely to remain volatile as they try to price in the relative trade-off authorities will be forced to make in terms of reviving the global economy and saving lives. Recent market volatility has resulted in significant opportunities, and certain unloved asset classes are now trading on very appealing valuations.

While it is easy to flee to the apparent safety of SA cash in such circumstances; this is seldom to the long-term benefit of the investor. In all our portfolios we are mindful of the need to strike the appropriate balance between participating adequately should the world turn out better than expected, while remaining sensibly diversified should there be further periods of market weakness.

As a multi-manager, our purpose is to remain disciplined and diversified. We continue to stress the significant upside in asset class prices should things turn out better than feared, with the need to balance this by preparing for a potentially more difficult environment. The managers we have appointed in our portfolios, and our asset class positioning, strives to ensure our portfolios will continue to strike the appropriate balance between these two competing objectives.