Coronavirus investment note: uncertainty deepens

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Dave Mohr | Chief Investment Strategist | Old Mutual Wealth | mail me |


 

 

 

 

 

 

 


Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me 


There is a distinct lack of good news at the moment, and certainty is in short supply. The coronavirus is spreading rapidly in Europe, the Middle East and North America, and we have to assume it will continue spreading at a rapid rate.

Seven cases have now also been confirmed in South Africa. Furthermore, but hardly a surprise, we learned that the South African economy was in recession in the second half of last year. Since we can do nothing about the past and little about the present, we need to focus on the future.

The economic cost of the corona virus

There is still tremendous uncertainty at this stage. The Organisation for Economic Cooperation and Development (OECD) is one of the first large forecasting bodies to put a potential number to the economic cost of the outbreak.

Its baseline scenario is that most of the economic pain is concentrated in China, where economic growth is taking a short-term hit before recovering in the second half of the year. Full-year real global economic growth would then be 2.4%, instead of 2.9% as was forecast a few months ago.

The OECD also has a downside scenario, where several other major countries experience a China-like decline and the hit to consumer and business confidence means recovery is delayed.

Under such conditions, global growth would be only 1.5% in 2020. One of the factors that can lead to such a domino scenario is that weak or highly indebted companies cannot stay afloat for the three or four months that sales decline due to the virus. (New coronavirus cases in China are peaking, about three months after the outbreak really began to take hold.)

It is worth repeating that the economic damage is not from the virus itself, but from the steps taken to halt its spread: cities quarantined, borders shut, flights cancelled, schools closed, workers staying at home etc.

If such measures are implemented full-scale across the world, the economic shock could get a lot worse before it gets better. If governments choose the alternative route of letting the virus run its course, the health costs might be higher but the economic costs lower. It remains to be seen.

Which scenario plays out is of course not knowable at this stage, and in the past two weeks markets have been swinging wildly between optimism and pessimism.


Chart 1: Global equity markets in 2020

Source: Refinitiv Datastream


Policy response

A major determinant of which scenario we end up in is how global policymakers respond to cushion the economic blow of the coronavirus outbreak.

The world’s most important central bank, the US Federal Reserve (the Fed), cut its policy rate by 0.5% (instead of the usual 0.25%) at a non-scheduled meeting. Of the major global central banks, it still has the most room to ease and markets are pricing in further rate cuts.

The Fed’s reaction shows how seriously they view the situation; the last emergency rate cut was at the height of the Global Financial Crisis. The Bank of Canada and Reserve Bank of Australia also cut rates, the latter to a record low.

Australia’s economy is very closely linked to China, and therefore greatly exposed if the Chinese economic recovery is delayed. Finance ministers of the G7 nations also met last week and, reminiscent of the coordinated response in 2008, promised to ‘use all appropriate policy tools’ to maintain economic health. Unfortunately, no specific actions have been forthcoming.

The risks to global travel and tourism industries are obvious, and the impact of supply chain disruptions – firms unable to secure supplies from China and elsewhere – is well understood. These issues should eventually resolve themselves as the viral outbreak will be temporary, no matter how severe.

As noted, the deeper hidden risks lie in companies that cannot sustain themselves for an extended period where sales fall while fixed costs and debt service need to be covered. Here the actions of central banks in keeping credit flowing freely are crucial.

Central banks can do nothing about cancelled conferences and factory backlogs, but they can prevent money markets from gumming up as in 2008. Nonetheless, targeted government support measures will probably be needed to help specific vulnerable sectors, regions or firms.

Italy has for instance announced a stimulus package that includes tax credits to companies reporting a 25% loss in revenues. The collapse in global interest rates (the benchmark US 10-year Treasury yield fell well below 1% for the first time ever) means it is affordable for developed countries to borrow to fund such plans.


Chart 2: Central bank policy interest rates

Source: Refinitiv Datastream


Little room locally

Locally, however, the room for a policy response is limited. As we saw in the recent budget, government does not have money to stimulate the economy.

On the contrary, its focus is rightly on containing spending, to prevent the interest cost of accumulated debt eventually overwhelming it, irrespective of ratings. Unlike in the developed world, where interest rates are below nominal economic growth rates, we cannot grow out our debt as long as growth is well below interest rates.

New economic growth numbers from Stats SA confirmed this. Real economic growth was negative for a second consecutive quarter (-0.8% in the third quarter and -1.4% in the fourth) and the economy is therefore in a technical recession.

In fact, five of the past eight quarters have been negative. We will only have official first quarter data in May, but the indicators so far are not encouraging. For the 2019 calendar year, real economic growth was only 0.2% down from 0.8% in 2018.

Nominal economic growth, adding back inflation, was only 4.2%. This is the broad growth rate of money incomes in the economy, and is clearly well below prevailing long-term borrowing costs of 8% to 10%.

The causes of economic stagnation are widely known already. Load-shedding played a big role, as did South Africans’ understandable unwillingness to buy cars.

The promising improvement in fixed investment over the prior two quarters came to a halt. It is clearly visible how the fiscal consolidation efforts alluded to above are constraining fixed investment spending by government.


Chart 3: Real and nominal local economic growth

Source: Stats SA 


Local coronavirus outbreak

Unfortunately, the global coronavirus outbreak comes at a time when the local economy is already fragile.

The impact could play out as follows:

  • Firstly, on the export side, it should be noted that China is the biggest buyer of our resource exports, and commodity prices have already declined. Non-resources exports could also be impacted in terms of lower demand, as well as logistical delays.
  • Secondly, foreign visitor numbers could decline substantially in the coming months. This impact could be offset somewhat by South Africans cancelling overseas trips and spending locally.
  • Thirdly, if the virus does spread widely inside our borders, it could cause both a demand and supply shock. If workers stay at home, they are neither producing nor buying. Some local firms are already struggling to secure inputs from China and elsewhere. On the plus side, lower commercial electricity demand means less chance of load-shedding (as long as the coal mines still operate). Finally, given our dependence on foreign capital inflows, financial market sentiment is crucial. Global risk aversion tends to result in capital outflows, a weaker rand and upward pressure on market interest rates. We’ve already seen some of this happening.

With no money to spend, the South African government will have to look at other ways of stimulating the economy. It urgently needs to unlock investment opportunities in electricity and other network industries that are currently monopolised by state-owned enterprises.

It also needs to urgently address outstanding sources of policy uncertainty that discourage the private sector from making long-term commitments. Deregulation should also be high on the agenda. A crisis is a terrible thing to waste, as the saying goes.

Can’t count on rate cuts

If there is no fiscal stimulus to be had, can we expect help from the SA Reserve Bank (SARB)? Its response is unlikely to be nearly as strong as in the case of the Fed.

In a speech at the University of the Free State, SARB Governor Lesetja Kganyago highlighted three reasons why he didn’t think deep rate cuts were called for:

  • Firstly, a fair portion of the weakness in the economy is due to supply constraints, notably electricity shortages. He noted that the supply-side of this economy ‘is in deep trouble’ and that such issues cannot be addressed by rate cuts.
  • Secondly, he noted that although consumer inflation declined to around 4.5%, it was not at risk of undershooting the inflation target, as is the case in other countries.
  • Finally, the SARB has also long argued that it needs to guard against disruptive capital outflows that could lead to a weaker rand, in turn putting upward pressure on inflation. In the Governor’s words, the impact of ‘country risk’ would need to be reduced before he is willing to cut rates much further.

There is some merit in all these arguments, but that doesn’t mean the SARB should sit on its hands. It has persistently overestimated the impact of currency weakness on domestic inflation.

Meanwhile, the pressure on the global economy is disinflationary, particularly now that the oil price has collapsed. Faced with a weaker demand outlook, there was an expectation that the major oil producers, Russia and the OPEC countries, would agree to cut output to support the oil price. But they could not reach agreement over the weekend.

Instead Saudi Arabia has warned it will increase output and even offer discounts. The price of Brent crude oil was trading around $33 per barrel on Monday morning, sending shock-waves through global financial markets. Though the rand has also weakened substantially, it has fallen by less than the oil price, which should lead to petrol price cuts and lower inflation.

Reported local inflation remains low. While the SARB targets the headline consumer price index (CPI), there are other inflation measures worth looking at, such as the household expenditure deflator, a broader measure than CPI.

It rose by only 3.3% in the four quarters to December. Broad inflation trends, as well as the medium term outlook, are comfortably in line with the SARB de facto 4.5% target.

Further rate cuts will help squeezed consumers at the margin, and potentially also reduce pressure on indebted companies that are already struggling due to the stagnant economy.

Now what?

This is an extremely challenging investment environment, and now that the virus has hit our shores, the threat feels much closer and more personal.

Telling investors to keep calm at this stage is trite. Humans do panic, as seen by reports of local hardware stores selling out of dust masks even though they are an ineffective defence against infection.

All we can argue for at this stage is that investors think carefully about how much risk they can handle now, and to balance that with how much risk (i.e. equity exposure) they need to meet longer-term financial needs.

Disregard anyone who pretends to have all the answers. Rather than try to predict the future, investors should ensure that they are appropriately diversified.

Consider a few scenarios

If equity markets fall further, fixed income should be defensive. If the rand weakens further, it should help offset some potential losses from global market declines. But there is also a possibility that more deep rate cuts in the US sends the dollar lower and the rand stronger. Local bonds, retail and bank shares would then benefit.

Finally, if investors flood into the perceived safety of precious metals, JSE-listed miners could rally even as consumer-facing stocks fall. It is also likely that continued market volatility will create attractive buying opportunities for long-term investors. Fear of the unknown has led to indiscriminate selling, which presents a golden opportunity for astute equity managers to exploit mispricing. Therefore, the key thing is to have eggs in many different baskets, but also to not think only of the worst-case outcome.


 



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