Hindsight, foresight and change at the speed of light


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









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

Hindsight, they say, is 20/20 vision. This being the year 2020, it turned out to be truer than ever before. For investors, and all of us really, there was so much about this year that was unpredictable, surprising and shocking. 

With 11 months of the year now past, and in our penultimate note for 2020, we can look back at what investors might have known and could have done. In the end, just sitting tight amid the uncertainty has once again proven to be the right course of action.

Historical impact of pandemics

Who knew? We are now in the season of forecasts as big investment banks, asset managers and news magazines turn the spotlight on the year ahead. This time last year, no-one predicted a global pandemic.

How could they have? Historian Peter Frankopan appeared on the cover of Prospect magazine in December warning of our vulnerability to a pandemic and the far-reaching historical impact of such plagues. But even he had no idea what was already emerging in Wuhan, China, and how chillingly right he would be.

Once news started spreading of this new mystery virus, there were lone voices who warned it could be very serious. With hindsight, we should all have listened to them, investors and policymakers alike.

The economic slump brought about by near synchronised shutdowns of so many economies was literally off the charts.

And yet, even if you had known that there would be a pandemic, how could you have known that the global equity benchmark (MSCI All Country World Index) would be up 14% this year? Of course, if you sold out before the March crash and then bought near the bottom, your returns would be spectacular. But knowing where the trough is, is always difficult.

Things were looking really scary at the time, not just on markets but in terms of the physical threat to human health. Recoveries normally occur when economic conditions are still very bleak and uncertain, but each and every time there are 100 reasons why it is too soon to get back into the market. Until it is too late.

In fact, the temptation for many would have been to sell out after the crash, seeking the perceived safety of money market products and the like.

With central banks slashing interest rates, including in South Africa, where the Reserve Bank lobbed 300 basis points off the repo rate, the safety of cash yielded a much-reduced return.

Investors who sold after the plunge would have suffered both sellers’ and buyers’ remorse because what followed from late March onwards was an epic recovery in equities, currencies, commodities, corporate credit and emerging markets – what has been termed the ‘everything rally’.

Chart 1: The everything rally

Source: Refinitiv Datastream

Central banks to the rescue

The massive injections of liquidity by central banks and the promise to do what it takes to prevent financial meltdown was enough to stabilise markets and set off the recovery.

The US Federal Reserve, in particular, launched nearly a dozen different lending programmes. In many cases, they’ve gone largely unused, the mere knowledge of their existence enough to calm nerves.

As US Treasury Secretary Hank Paulson said in 2008, in the midst of another crisis, ‘If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out‘.  This time round, the Fed and its peers used their bazookas, but also made it known that there were still plenty of mortars, tanks and cannons in the munitions warehouse.

The Bank of England even briefly deployed the nuclear option – directly lending to the government, bypassing the bond market. Unlike in 2008, the fiscal policy response – government spending – was also rapid and massive.

The central banks were not the only reason for the rally. For one thing, as bad as the slump was, the recovery has been solid, though uneven.

Chart 2 shows the global economic surprise index, measuring data releases against expectations. If the line is above zero, the data has surprised on the upside. By May, when the lockdowns started to lift, the direction of the index recovered rapidly.

Secondly, expectations of good news on the vaccine front were met and exceeded in November with announcements of not one but three very effective candidates (one of which now has authorisation to be used in the UK, with other jurisdictions set to follow in the next few weeks).

Meanwhile, the US election loomed as a source of uncertainty for much of the year. Though incumbent president Trump has yet to concede (it is unlikely he ever will), the world has moved on and investors are looking forward to a period of relative stability and fiscal largesse under Joe Biden.

Chart 2: Citigroup Global Economic Surprise Index

Source: Refinitiv Datastream

Finally, and importantly, while various asset classes moved higher as measured by their respective benchmarks, each benchmark hides an enormous dispersion. The K-shaped economic recovery is very much reflected on markets.

Winners and losers

Take the local example. The FTSE/JSE All Share Index returned 10.5% in November, which pushed its 2020 return into positive territory at 2.6%.

The first few days of December added more gains. However, there is still a massive dispersion between the three traditional sectors on the local bourse.

Industrials returned 8% in November, lagging the other major sectors somewhat as Naspers/Prosus was flat. Year-to-date, however, industrials are ahead of resources and financials with a 13% return.

Resources shares rallied in November as commodity prices apart from gold increased. Resources returned 10.9% in November with all sub-sectors positive except gold mining. Resources returned 10.7% in 2020 to date.

Financial shares were strongly positive in November with a 17% return, led by the banks. However, the sector was still 25.8% in the red year-to-date at the end of last month. Financial shares tend to be more focused on the domestic economy and sensitive to long rates, and it shows in the relative performance.

Globally, the divergence has also been stark. Chinese and US equities far outperformed the rest of the world. Within the US market, the big winners of the pandemic were the tech companies that facilitate working, playing and shopping in the safety of our own homes.

The pandemic has been a boost for these companies. But there is a deeper reason the share prices of these companies have risen so much and were outperforming, even before COVID-19 hit.

In a world of tepid economic growth, companies that generate consistent earnings growth are extremely valuable and with low interest rates, the present value of future earnings balloon.

In contrast, cyclical companies need strong economic growth to perform well. The much talked-about rotation from defensive to cyclical (and growth to value) therefore has two gears: the first is narrowly about pandemic winners and losers, with the vaccines potentially levelling the playing field. (Think of the share prices of Zoom versus an airline.)

The second is more broadly about conditions improving so that the cyclical sectors and companies – and countries, since the US is a growth market while Europe is very cyclical – that have struggled for several years can catch up.

Dollar direction

If there has been a clear loser in the ‘everything rally’ so far it has been the US dollar. This makes sense as a strong dollar is both a cause and a symptom of global economic weakness.

A symptom, because it is still the ultimate safe haven and rallies with rising risk and uncertainty. It is a cause because ample dollar liquidity is needed to grease the wheels of commerce. If dollars are scarce, the wheels turn more slowly.

A strong dollar also tends to put indirect upward pressure on interest rates outside the US, which chokes off growth. We saw this very clearly during the 2011-2017 dollar bull market when the rand weakened and local interest rates increased.

Former French president Valery Giscard d’Estaing, who passed away from COVID-19 complications last week, was probably best known outside France for railing against the ‘exorbitant privilege’ the US enjoyed from issuing the world’s reserve currency.

This was back in the 1960s. The dollar’s role in global trade and finance remains unmatched for now. While this can be expected to fade over time, each of the possible alternatives is problematic.

The euro has too many weak links (like Greece and Italy). The Chinese yuan lacks free convertibility and open capital markets. And though Bitcoin has been on a tear lately, central banks will develop their own digital currencies before any cryptocurrencies can become serious monetary alternatives.

The expectation of an imminent dollar collapse is misplaced therefore – and for some commentators it has been imminent for years now – but that does not mean that the dollar won’t experience cyclical fluctuations.

As the world started breathing out from mid-year onwards, the dollar started falling. It dipped to a two-year low on a trade-weighted basis by end November.

Scanning the current crop of year-ahead forecasts, further dollar weakness seems to be the consensus view. This would be a good outcome for the world economy. Unfortunately, the consensus also has a habit of being wrong. We’ll see.

Either way, it is the behaviour of the dollar, together with commodity prices, that will have far more impact on the rand than local, political or economic developments in the months ahead.

So far, the commodity rally and weaker dollar have pushed the rand to its best levels since February. Many local investors desperately want to know where it is going next, presumably to time an offshore allocation (since few are travelling overseas this year).

It is not prudent to develop an investment strategy based on a forecast of the rand. The currency is too unpredictable.

If you are going to invest offshore based on currency forecasts, you should also have a forecast of what global markets will do. As we said upfront, that is pointless. What we can say is that South African interest-rate bearing assets should outperform their global counterparts over the medium to long term.

From 2000 to today, despite the rand going from R6/$ to around R16/$, local cash way outperformed US cash in rand terms. When buying international equities, remember that in conditions of rising risk appetite and therefore rising global equity prices, the rand tends to appreciate.

What you win on the swings you lose on the roundabouts. We saw that last month, when equities rose and the rand strengthened.

Chart 3: Inverse relationship of US and SA real trade-weighted exchange rates

Source: JPMorgan

As it happened, November was a record-breaking month for equity returns, with double-digit gains across a wide range of countries and benchmarks.

In the local context, equities delivered twice the annual return from cash in a single month. In developed markets it was four or five times. This is clearly not something to expect every day.

However, it is worth remembering that the long-term excess real returns from equities over cash is driven largely by such exuberant months. Miss such months, and you might as well stay in cash.

In conclusion

Equity returns are very lumpy; it is not an asset class that gives smooth or predictable returns over shorter periods. Consider that the long-term average annual local real equity return is 7%, but there are very few years where the return is exactly 7%.

It is usually much higher or much lower. One has to sit through the lean years to reap the benefit of the fat years.

The last few years have certainly been lean from a local equity point of view (global has been much better) but valuations have now adjusted to a point where prospective returns are much better. Also, with inflation having taken a structural step down in our view, real returns also look promising.


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