By: Izak Odendaal and Dave Mohr, Investment Strategists Old Mutual Wealth
The Covid-19 crisis is unprecedented in modern financial and economic history. There have been financial crises, recessions and bear markets before, but the scale and nature of this interruption to daily life and economic activity is on a completely different level.
Hundreds of millions are in forced or voluntary isolation, businesses are closed and travel is grinding to a halt. The reason for this is simply that those countries such as Italy that were slow in implementing ‘social distancing’ measures now find their hospitals completely overwhelmed. While most cases of Covid-19 are relatively mild, around a fifth require intensive hospitalisation. The isolation measures are thus absolutely necessary, but never before have governments deliberately shut down large parts of their national economies in peacetime. And they are all doing it at once.
As a result, the global economy is likely to experience a very sharp contraction in the first half of the year. Already data from China shows a decline in broad economic activity from consumption to production and travel of 20% to 30% from levels a year ago. The good news is that China has for the first time reported no new local infections. As life slowly returns to normal there, it will provide important clues to how quickly economic activity can rebound. Europe is still in the teeth of the crisis, while North America is a few weeks behind Europe. Firms in the US and Europe are shedding jobs at an alarming rate, and are bound to eventually produce economic activity numbers as ugly as China’s.
Chart 1: China retail sales and industrial production, year-on-year growth%
Source: Refinitiv Datastream
It is clear that companies and households around the world will need substantial and targeted cash injections from their governments to stay afloat during the isolation phase. Government will have to be the buyer, spender and payroll-provider of last resort, or risk an avalanche of bankruptcies and a surge in unemployment.
Several such initiatives were announced over the past few days, most notably a plan making its way through the US Congress to send $1 200 cheques directly to households as part of a trillion dollar stimulus package that includes loan guarantees to struggling companies.
Dash for cash
The dire shortage of cash is also straining financial markets. It makes sense that equity values reflect the declines in company revenues and profits. But there is further pressure due to forced selling. At this point, investors are selling what they can, not what they want, namely the most liquid securities. Fund managers facing withdrawals, companies needing emergency funding and banks managing balance sheet risks all need cash.
Worryingly, the past few days have also seen investors dump developed market government bonds to raise cash. As the price of these bonds fall, their yields have increased.
Desperate for dollars
There is one form of cash desired above all others: US dollars. The dollar has surged against other currencies as the world scrambles to find dollars to maintain day-to-day activities, but also to service the estimated $12 trillion in dollar-denominated debt that was borrowed outside the US in recent years. Those companies that have dollars are holding onto them tightly. Central banks have implemented many crucial interventions in recent days, including an expanded and more flexible quantitative easing (QE) programme from the European Central Bank (ECB) and the Bank of England cutting rates to the lowest level in its 325-year history. But one of the most important is likely to be the Federal Reserve expanding dollar swap lines with other central banks to allow them access to sufficient dollars to provide liquidity in their own financial systems.
Chart 2: Rand-dollar exchange rate
Source: Refinitiv Datastream
The stronger dollar helps explain the further slide in the rand. The rand blew out to record lows of R17.50 against the dollar last week, and it was not alone among currencies falling against the greenback. Once again. South African investments have been victim to a global crisis not of our making (in fact, our government has handled the outbreak relatively well). The local equity market has slumped along with others. Unfortunately, unlike the US market, the JSE did not fall from a high level. Rather, the collapse of the past few weeks follows a sustained period of underperformance (again, this was in line with other markets in Europe and elsewhere outside the US).
However, the biggest negative for local investors has probably been the sharp fall in bonds, leading to a jump in yields. Normally as an economy enters a recession, bonds rally while equities fall, providing a diversification benefit to investors. This time, bonds have been hammered by global investors demanding a significantly higher spread over safe US government bond yields to compensate for the increased perceived risk. The blowout in this spread is not unique to South African bonds. Spreads have widened substantially for corporate bonds and other emerging market government bonds, irrespective of rating.
The sharp jump in our government bond yields have therefore been in line with other similar countries. Unlike with Nenegate in December 2015 when there was a similar sell-off, this time it is not the market worrying about junk status (the likely Moody’s downgrade has now become completely irrelevant), but rather a rush to get out of any perceived risky investment. If it is short-term in nature, the impact on government finances will be small. If yields remain elevated, it will place tremendous pressure on government finances as the National Treasury has a substantial amount of new borrowing and rolling over maturing debt to be done. So far, it has been able to issue new debt (albeit at elevated yields) in its weekly auctions without trouble.
The deepening recession implies that government will have to expand borrowing over and above what is already budgeted for as tax revenues decline. Now more than ever, we cannot afford wasteful and irregular spending. Every rand needs to be put to very good use, since it will have to be borrowed at a punishing interest rate. Debt levels are going to rise across the globe, but governments in the developed world have the luxury of borrowing at close to record low interest rates.
The bond sell-off hurts conservative investors the most, and they will be tempted to switch out into lower volatility cash products. As with equity investors, the motivation is completely understandable, but the risk is locking in losses. Unlike with equities, holding on to South African bonds despite the short-term losses has three advantages: firstly, if you bought bonds at the start of the year, your capital values have declined, but you will still be earning roughly 9% interest. Secondly, global interest rates close to zero should exert a gravitational pull on our yields once the worst of the crisis has abated. Thirdly, lower inflation and interest rate cuts will make bonds more valuable over time. Under these circumstances, bonds can bounce back quickly.
The SA Reserve Bank’s Monetary Policy Committee has already come to the party, cutting the repo rate by 100 basis points to 5.25%. This is still well above the SARB’s projected average inflation rate of 3.8% in 2020 and 4.6% in 2021. And of course, households and business loans are not linked to the repo rate, but to the prime rate that is 350 basis points higher. More rate cuts are on the cards.
The MPC has long feared a rise in global risk appetite or increased fiscal deterioration would cause capital flight and a weak rand and has maintained high interest rates as insurance against such outcomes. Both worst-case scenarios are now playing out, but the reduction in the inflation outlook and the deep rate cuts by the Fed and others has given it the space to act. Fortunately it acted.
As the MPC statement rightly pointed out, monetary policy can “ease financial conditions and improve the resilience of households and firms to the short-term economic implications of Covid-19”, but it can’t improve the potential growth rate of the economy on its own. For this to happen, government needs to show the same resolve in implementing growth-enhancing structural reforms as it has in tackling the virus.
Chart 3: South African interest rates %
Doing nothing is also doing something
Amid all this uncertainty, markets continue to be extremely volatile. It is impossible to know when and how this ends. The general view among commentators is that we need to see a flattening in the new infections curve and forceful stimulus measures. But if this is the consensus view, it will be priced in well in advance of it happening.
The one lesson we can draw from history here is that markets will turn around long before conditions on the ground do. We are therefore extremely reluctant to sell out of equity positions – even if there is further downside risk – because by the time we decide to buy back, the market will have rallied already. This is a recipe for selling low and buying high, and even professional investors should be wary. Missing the first few weeks of a rebound can seriously damage the long-term returns from equities.
But there are still more questions than answers. This is a new virus, and until there is a vaccine or proven treatment, the risk of a second or third wave of the outbreak remains. We are therefore also not adding to equities yet, even though valuations are increasingly attractive. The volatility of the past two weeks has been unparalleled, making it dangerous to try and trade actively. The urge to take action in a crisis is enormous, but investors should remember that doing nothing is also doing something.