Sickly Rand also a COVID-19 patient

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


 

 

 

 

 

 


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


The number of confirmed COVID-19 cases worldwide surpassed one million last week. This number probably still understates the true spread of the coronavirus given the lack of testing in many places, and the fact that some infected persons don’t show symptoms.

In China, where the virus first appeared late last year, the total number of cases is 83,000 and the daily increase has slowed to virtually zero. The bulk of the confirmed cases as well as related deaths are now in Europe and the US. Almost no country is spared, however. It is a truly global pandemic.

As far as financial markets are concerned, it appears that the first, acute phase of the crisis is over. It involved a rapid decline in the prices of equities, commodities, emerging market and corporate bonds to reflect the fact that the old paradigm of steady but unspectacular global growth was no longer in place.

A full-blown financial crisis prevented 

The forceful actions of central banks appear to have prevented a full-blown financial crisis where markets seize up and lending evaporates.

Investors engaged in a frenzied scramble for cash, but the major central banks have made sure to provide as much liquidity as needed. The trillions of dollars in fiscal injections will cushion the blow for many households and businesses in developed countries, but the money might not arrive soon enough for some. Still, most risk assets rallied off their lows in the last 10 days.

Investors will now confront the second, ‘chronic’ phase. To switch metaphors, the fire has largely been put out, and investors need to shift through the smouldering ashes to assess what can be salvaged, what must be thrown out and how quickly can the structure be rebuilt.

How long do economies remain shut down and how quickly do they rebound? What are company profit expectations? Which borrowers will default? Which companies and sectors are the winners and who are the losers? Which investments are priced for complete oblivion, and offer value? Which investments are still too expensive?

These are difficult questions to answer because it largely depends on when the coronavirus outbreak sufficiently subsides for life to return to normal. This is still an unknown. Only time will tell whether the V-shaped recovery seemingly priced in by equity markets materialises, and whether things turn out to be better or worse than expected.

Terrible toll

In the meantime, the economic toll is great. The US government produces data on weekly unemployment insurance filings, which is about as up-to-date an official indicator on the state of the economy you can hope for.

The claim numbers for the last four weeks read as follows: 217,000, 282,000, 3.3 million and 6.6 million. In the space of four weeks, it went from a level which was close to a 50-year low to one that no economist in their wildest dreams would ever have believed possible.

As Nobel prize-winning economist Paul Krugman pointed out, these job losses are inevitable and necessary as a result of social distancing to limit the spread of the coronavirus. He calls it the economic equivalent of a ‘medically induced coma, in which some brain functions are temporarily shut down to give the patient a chance to heal‘.

We have no similar timely indicator in South Africa, but what we have as a reasonably up-to-date indicator is new vehicle sales: they declined in March by 30% from a year ago.

It is surely a sign of things to come. Thousands of jobs are probably being shed by smaller businesses that are not earning any income during lockdown. That in turn puts pressure on other businesses in a vicious cycle.

With such tremendous uncertainty, the best course of action for investors is to remain appropriately diversified.

It is true that local equities and bonds have moved up and down simultaneously in the past four weeks (were highly correlated in other words), robbing local investors of an important source of diversification.


Chart 1: Global equity and local equity and bond returns in rand

Source: Refinitiv Datastream


However, where diversification has worked very well is in global exposure. The depreciation of the rand to a new record low of R19 to the US dollar has offset most of the losses of global equities.

Record lows for the rand

Fitch’s announcement of a further cut to its rating of South African government bonds – from BB+ to BB – piled further pressure on the rand on Friday.

Fitch cited the lack of a clear path towards stabilising government debt levels and the expected impact of the coronavirus shock on the economy and public finances. It maintained a negative outlook.

Like the Moody’s downgrade a week earlier, Fitch added to the negative sentiment around South Africa, but it is important to remember that ratings agencies tell us what we already know and this changes little.

Unlike the Moody’s decision, there are no implications for index exclusion since Fitch already had a sub-investment grade rating on government bonds.

The rand has largely depreciated in line with other emerging markets this year as global risk aversion intensified, though it did so somewhat faster than its peers.

Other emerging markets with currencies at or close to record lows against the US dollar include Brazil, Turkey, Russia, Chile, India and Argentina. According to the Institute of International Finance, capital outflows from emerging markets since January amount to $95 billion, four times as much as during the 2008 Global Financial Crisis.

This massive flood of money out of emerging markets has resulted in sharp falls in currencies, bonds and equities. South Africa’s experience has not been unique.


Chart 2: Emerging market currencies vs the US dollar in 2020, rebased to 100

Source: Refinitiv Datastream


Since the exchange rate was allowed to float freely in the early 1980s, the rand has weakened over time as the chart below shows. There is no reason to expect this long-term trend to change.

However, history shows that the rand tends to bounce back from blow-out episodes such is this one. It happened after 1986, 1998, 2001, 2008 and 2015. Therefore, it would be dangerous to assume that it can only get weaker from here.


Chart 3: Many big blow-outs: rand-dollar exchange rate

Source: Refinitiv Datastream


Implications of a weaker rand

A weaker rand normally results in upward pressure on local inflation as imported items become more expensive, but these are not normal times. For one thing, the oil price has fallen much more than the rand this year.

The oil price rallied last week on hopes of a US-brokered truce in the Saudi-Russian price war, but the rand price of oil is still 30% lower than a year ago. Food prices can also be currency-sensitive, since even though we tend to produce what we consume in South Africa, wheat and maize are traded on global markets.

For other imported items, the question is simply whether local retailers can afford to pass the higher prices on to consumers. They’ve struggled to do so in recent years, since pushing up prices in the tough competitive environment risked losing business. Given the completely depressed state of the local economy, pricing power is likely to be even more diminished.

Therefore, inflation is likely to decline rather than increase in the coming months, allowing the Reserve Bank some room to cut rates further.

Balancing the risks

This in turn suggests that money market returns will decline at precisely the point when many investors are flooding into these products.

It is not for us to say that doing so is wrong. People are frightened and might be right that the worst is not over. It is just that switching out of funds that have experienced losses into funds that are likely to experience diminishing returns seems counterproductive.

Money market offers stability in turbulent times, but there is no upside. Legendary investor Howard Marks put it well recently, saying that there are two investing risks: the risk of losing money, and the risk of missing opportunity.

Every investor must assess – based on their age, resources, income, financial aspirations, number of dependents, ability to live with volatility and other factors – how to balance these risks. You can eliminate either risk, but doing so exposes you entirely to the other. So we must balance the two.

The best way to balance these two risks remain diversified portfolios.


 



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