Investment Perspectives: Events that shaped the second quarter

Reza Hendrickse, Portfolio Manager at PPS Investments

Reza Hendrickse, Portfolio Manager at PPS Investments, provides some insights (for editorial consideration) about the economic events that occurred in the second quarter.

In a nutshell, how would you describe the quarter?

Global equity markets regained composure this quarter, rebounding sharply despite continued economic fragility. The sustained bounce following last quarter’s steep selloff is surprising given that we are in the midst of the deepest economic recession in decades, coupled with the fact that there is very little visibility going forward. It seems that markets are taking comfort from the swift, synchronised and large-scale fiscal and monetary support from across the globe, anticipating it will provide an effective counterbalance to the economic fallout from the widespread COVID-19 lockdowns.

What are conditions like in South Africa at the moment?

South Africa entered the crisis on a weak footing, hampered by poor fundamentals including low growth prospects, high unemployment, and elevated sovereign debt levels. The South African Reserve Bank (SARB) was able to respond by lowering rates which fed through immediately into consumers’ pockets, and also provided liquidity to keep bond markets functioning smoothly.

Further assistance from the government’s heroic R500 billion fiscal package stood poised to offer additional support, but invariably must make its way through the transmission mechanisms’ “leaky plumbing” that contributed to the pre-COVID budget deficit. Having now added to the debt burden however, a credible plan for overhauling the National Budget is needed now more than ever in order to keep debt levels in check.

What are the global growth expectations?

Before COVID-19 transpired, the global economy had been emerging from a soft patch and was poised to reaccelerate this year. The International Monetary Fund (IMF) now expects global growth to contract 4.9% this year, recovering to 5.4% next year; however, given the fluidity of conditions, these forecasts are of course subject to change for the better or worse.

Have global policymakers reacted appropriately?

With 2008 still fresh in the minds of policymakers, their response has been swift and drastic, with the quantum of planned stimulus exceeding that employed during the Global Financial Crisis (GFC). It appears that authorities are determined to do whatever it takes to support their economies, and in some cases, are arguably even overstimulating at this point.

What tools are being used to stabilise economies?

With interest rates at virtually zero in major developed markets, monetary authorities have relied on other tools such as ramping up asset purchases in addition to forward guidance, while governments have also eased fiscal policy and embarked on large-scale deficit spending.

What is needed in order to move SA forward on the front foot?

Aside from political buy-in and the courage to endure near-term pain for longer-term gain, the other way to ease the burden on the state and broaden the opportunity set would be to rekindle domestic growth. The bar for a positive surprise is low, but unfortunately due to factors largely out of our control, domestic growth will be sharply lower this year.

How the equity markets participate?

The South African (SA) equity market rallied 21.6%, in its strongest quarter since 2001. This was a dramatic turnaround from last quarter. Cumulatively, share price moves are reflecting the likelihood of lower corporate profits in the short to medium term.

Global equities, which have far outpaced domestic equity for a number of years, bounced 16.0% for the quarter, held back by the rand which strengthened. Returns continue to be dominated by the US, which comprises more than half of the global index. Outperformance has relied increasingly on a narrow group of US mega-cap technology businesses, which have propelled the Nasdaq to fresh record highs recently. Despite the downturn this year, the MSCI All Country World Index is still up 16.5% in 2020, with the bulk of the move having come from the rand which has lost a quarter of its value this year.

Which segments of the market showed the greatest strength?

Resources shares led the rally this quarter, with gold and platinum counters performing particularly well on the back of buoyant gold and PGM prices. Industrials were driven mainly by the large cap rand-hedge multinationals, while financials which are more vulnerable to the domestic outlook lagged. Listed property, which had been deeply oversold, bounced in line with overall equity market, but the sector remains fraught with challenges. Although risk assets were the biggest beneficiaries of the revival in risk appetite, the All Bond Index also rallied close to 10% this quarter.

How are portfolios positioned to navigate the current environment?

Portfolios are currently overweight in foreign equities and underweight in domestic equities. While valuations favour domestic shares at the moment, their cheapness highlights the challenging local outlook. Foreign equities on the other hand are less constrained by structurally low growth, and the opportunity set for managers to find attractive opportunities is far wider.

Having said that, the distinction between SA and foreign equity is not entirely clear cut. The SA equity market is not a pure SA proxy, with large multinationals comprising a sizeable portion of the index. These companies earn the bulk of their revenues abroad and are therefore largely unaffected by local conditions. Without these companies, SA equity would have fared significantly worse, and their diversified income streams are what keep us from becoming too pessimistic on SA equity overall.

Having upweighted domestic government bonds during the selloff earlier in the year, we still view the asset class as offering reasonable compensation for their risk. We added exposure when bonds were offering the prospect of equity-like returns and have maintained the overweight. We expect the asset class (both nominal and inflation-linkers) to deliver good prospective returns, but should yields rise in the interim, we would anticipate the currency effect of our portfolios’ offshore exposure to neutralise some of this.

Looking ahead

Although we expect the environment to remain challenging for the time being, the approach is not to avoid risk, but rather to take on risk provided that one is being sufficiently compensated for it.