Dave Mohr | Chief Investment Strategist | Old Mutual Wealth | mail me |
Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me |
A year ago, reality started sinking in that the new coronavirus from Wuhan would not be contained to China. No fewer than 25 countries had confirmed cases, and the first deaths outside China were being reported. On 11 February 2020, the disease caused by the new coronavirus was named COVID-19.
Global equity markets peaked the following day, and they started collapsing in a heap a week later.
Now, 12 months and more than two million deaths later, many equity markets are higher than before the outbreak, even if economic activity and employment levels are still well below.
Living with uncertainty
At the start of 2020, the biggest global risk appeared to be a war between the US and Iran. In fact, that risk has probably been on the Top 10 risks list at the start of each of the past 20-odd years. But it was a non-event compared with what followed.
Most investors ignored the warning signs and underestimated the danger posed by the new coronavirus. The main reason for their complacency was probably the fact that previous viral outbreaks (SARS, MERS, Avian Flu) had only had a limited impact, particularly on financial markets. When faced with something unfamiliar, we tend to look for similar examples from the past.
These can unfortunately be misleading. While worst-case scenarios seldom materialise, sometimes they do. However hard we try, humans cannot predict the future, and investment portfolios need to be able to withstand both foreseen and unforeseen eventualities.
Markets are predictably unpredictable
Financial markets are moved by the unexpected, not the expected. They continuously price in all available information in real time. When the facts or perceptions change, the market changes its mind (paraphrasing what Keynes probably never actually said).
But often markets themselves respond in unexpected ways. Even the handful of commentators and investors who correctly predicted the global pandemic and market crash could not have foreseen the timing and speed of the rebound. That’s the problem with market timing: you need to get the timing right twice, when you sell and again when you buy. Getting only one leg of the trade right is of little use.
Market turning points are extremely unpredictable. Their only consistent feature is probably that the market bottoms well before the economy does. In other words, stocks turn even when the economy is still depressed. Investors who are tempted to wait until things look better ‘on the ground’ risk being way too late.
The real return from January 2020 to January 2021 was close to or even above long-term averages for many asset classes.
For any individual investor, missing such a good year can make a sizable difference to their overall long-term return. We do not know in advance when those years will be. They can even occur during a pandemic or war. It is for this reason that the mantra about ‘time in the markets, not timing the markets’ is true, as tired as it may sound.
Of course the picture is somewhat complicated by the massive dispersion between sectors and investment styles as entire business models have been wiped out, or severely damaged.
It would not have helped much to maintain a concentrated exposure to listed property or a value equity fund or oil futures. These have not recovered, because the underlying economics have changed. For this reason, diversification across sectors, regions and investment styles is important.
Chart 1: Global equity sectors over the past year
Source: Refinitiv Datastream
Unprecedented policy response
In terms of policy lessons, the first is that central banks are not ‘out of ammunition’, as was often argued before the crisis.
There was very little scope to cut rates in many developed countries, but central banks launched into bond buying programmes of unimaginable speed and scale. The US Federal expanded its actions to 11 different facilities.
In the end it used only a fraction of the announced capacity. The mere knowledge that the central bank could deploy its firepower was enough to prevent markets from seizing up.
Quantitative easing was considered unconventional until fairly recently, but is now firmly part of the central banking tool kit. Over the past year, it was employed in economies as diverse as Australia, Colombia, Indonesia and India. Even the ever-conservative SA Reserve Bank bought about R30 billion of government bonds, though this was small change compared to what the others were doing.
Staying with monetary policy, central banks did not just respond to the shock of the pandemic (the sudden stop of lockdowns) but also acknowledged the need to rethink their approach. This was specifically true in the US, where the pre-pandemic economy saw unemployment fall to multi-decade lows without a whisper of inflation.
The thinking was always that a strong labour market would put upward pressure on inflation, and that pre-emptive interest rate hikes would therefore be needed. This is precisely what happened between 2015 and 2018.
The Fed will therefore now allow the economy to ‘run hot’, and raise interest rates only when inflation rises above 2% on a sustained basis until the average inflation rate is at the target. Inflation averaged only 1.5% over the previous five years.
By effectively promising to keep rates low for a long time, the Fed has provided a key support to the equity market. But there are spill-over effects outside America.
It means our own Reserve Bank will not have to continuously look over its shoulder at what the Fed might do (as was the case for most of the previous seven years) and rather set interest rates appropriate for the domestic economy. It also means that, despite the massive fiscal problems we have, there is a gravitational force keeping bond yields down.
Similarly, there were concerns that government debt levels were too high before the crisis. These levels have exploded higher, but with little impact on yields. It is true that central banks have been buying up much of the debt, but private investors have not fled the bond market even faced with the record issuance of new debt.
Meanwhile, the decline in bond yields means the interest burden has not increased for developed countries. The new debt is essentially free.
Consumer behaviour changes
Consumers cut back spending on services that require face-to-face contact and gatherings in large groups.
Savings rates have shot up in countries where government assistance has been ample. This reflects a combination of caution about the future as well as an inability to spend on some of these services. How much of this is permanent is a big question. There are some things that people miss terribly, but others they might learn to live without forever.
Chart 2: US personal savings rate
Source: Refinitiv Datastream
Spending on other areas has increased. Most notably, spending on home renovations and additions have shot up in many countries (including South Africa). Similarly, the big increase in home purchases in suburbs is a global phenomenon, driven by people seeking space and aided by ultra-low interest rates.
Technological leaps
Another lesson is how quickly new technologies can be adapted in a pinch. The obvious example here is online video conferencing (Zoom, MS Teams). These were around before the pandemic, but lockdowns drove their use by office workers.
There is probably no going back. Certainly that is what the relative price shifts of office versus residential real estate tells us.
Needless to say, it is the big technology platform firms that have benefited the most in this crisis. They’ve seen sales and profits jump and share prices even more so.
No-one can argue that they are not expensive when looking at traditional valuation metrics like price to earnings. But these firms are also unique in their ability to continue growing, especially as technological adoption continues to accelerate in previously resistant areas.
Technologies tend to build on one another. Breakthroughs in adoption and development in one area always spill over into other, usually unforeseen areas. This is an exciting prospect, but also scary if you are heavily invested in the status quo.
As much as our lives are increasingly digital, it is worth remembering that the Internet still has a very physical side to it. It depends on cables, microchips, data centres, backup generators, cell towers and much more. A digital economy still needs raw materials and lots of it.
The incredible speed with which vaccines were developed is testament to human innovativeness and creativity.
Recent news reports have focused on the bungling of vaccine roll-outs in Europe and South Africa, but these issues are more political than organisational or logistical. In other words, we can solve big problems if we put our minds to it. For long-term investors, it almost never pays to bet against human ingenuity
The biggest problem humanity faces is of course catastrophic climate change. Here too, the technological solutions largely exist and have advanced greatly. What is needed is continued pressure on politicians to remove the obstacles to their widespread use.
Was China the big winner?
If there was any doubt about China reshaping the world, 2020 should have put paid to that. Despite being the source of the coronavirus, China got the outbreak under control better than any other large country.
Indeed, the contrast between the handling of the pandemic in China and its great strategic rival, the US, is especially stark given how much richer and better resourced the latter is.
This is not to say that China’s autocratic system is better at handling pandemics or other disasters.
It was precisely the restrictions in the free flow of information so typical of dictatorships that caused the outbreak to become first an epidemic and then a pandemic. But China eventually acted with decisiveness and purpose that put the West to shame. As a result, its economy could return to normal much sooner and its stock market has boomed.
Although there has been much talk of China decoupling from the world (certainly during the Trump trade war years), it has actually steadily been opening up its capital markets to the rest of the world.
Foreign investors have responded by piling in. As the global financial system becomes more intertwined with China, the risk of a China-centred financial crisis will grow. It is not another new virus from China we need to fear, but excess private leverage and associated financial shenanigans.
South Africa is still afloat (on global tides)
Two final take-outs on local matters. The first is to note the resilience of our own society in the face of the biggest economic shock on record. It’s hard to imagine a bigger stress test. And while we certainly didn’t pass with flying colours, pass we did.
The country is still standing and the economy is recovering. This is not to make light of the egregious corruption surrounding, for example, purchases of personal protection equipment. But that corruption was uncovered by the media and is now under criminal investigation. There is pushback, and that is how it should work.
The government scored many own goals in response to the virus, being overly harsh in some instances and overly lenient in others. But while the decisions didn’t always appear rational, they were made in accordance with the law, as the Supreme Court of Appeal recently ruled, and largely based on scientific advice. This has not been a case of arbitrary or capricious use of power.
Chart 3: SA bonds and equity returns over the past year
Source: Refinitiv Datastream
Secondly, never underestimate the extent to which global markets can drag South African investments with them. From late March to now, the JSE All Share Index has returned 48% and the All Bond Index 27% (despite the ratings downgrades).
The rand gained 16%. Nothing has dramatically changed in South Africa over that period, except perhaps that the likelihood of the more pessimistic economic scenarios playing out receded.
Global conditions will largely continue to dictate the performance of local investments, but we do have one advantage. South African bonds and equities are still cheap relative to global alternatives. Valuation may not have mattered much over the past year, but we still believe it is a key driver of long-term returns.
