Investment Environment May 2020

09.06.20

Coronavirus has wreaked havoc around the World. For Investors this has not only been the cause of massive economic contraction but also a great deal of uncertainty and unpredictability. There are many phrases emphasizing this but the words “new normal” probably encapsulate this best.

In the FED Chairman, Jerome Powell’s words, the US economy has come to an “abrupt halt”. This has been evident in the US jobs reports as more than 33 million Americans have filed for unemployment by mid May. Unemployment has risen to 16%, from a sustained level of 4.4% which was regarded as full employment. Powell and the likes of Goldman Sachs predict US unemployment peaking at 25% later this year.

Consumption generally makes up > 60% of US GDP so it’s not surprising to see the effect on April retail sales falling 16.4% as a result of the rise in unemployment and consumers pairing back discretionary spending given the uncertainties that lie ahead. Manufacturing output was down by 13.7% which is also a record since being measured since the early 1900’s.

 However, for now equity markets have shown a significant bounce.

This has taken valuations back to September 2019 levels but it is important to consider the environment then was very different to now and valuations (by any valuation criteria such as P/E) are stretched with earning declines in 1Q and expected in 2Q 2020 as shown in the graph above. It is also important to be aware of the importance of tech and its influence in the performance of the S&P 500 as shown in the graph below. Without the FAAANM stocks (Facebook, Apple, Amazon, Alphabet, Netflix and Microsoft) this leading index would have shown virtually no returns in the last 5 years. The US markets have led equity markets around the world, as shown in the graph of the MSCI index excluding the US which has shown no returns for the same period. This emphasizes the Fourth Industrial Revolution which has come to the fore during the Coronavirus crisis.

While Coronavirus has dominated economies, the oil industry has been significantly affected by a “perfect storm”: 1) the major oil producing nations chose to disagree in March on cutting supply to match a significant drop in demand.  This caused the price of oil (both Brent Crude and West Texas Intermediary (“WTI”)) to drop significantly.  2) The price of WTI was further punished due to limited storage capacity. We have seen a rebound in both the price of Brent and WTI as oil producing nations agree on cutting supply as well as demand picking up as the world starts to return to work.  While a low oil price is not good for oil-producing economies and companies it should be positive for the world as it translates into cheaper energy supply. Unfortunately, this opportunity has not been as big as one would have hoped given the lock down regulations in place from Coronavirus.

As we have often said, “markets hate uncertainty”, and the current situation is more uncertain and unpredictable than most can remember. The big question is; “Where to from here?” Douglas Investments has taken the view to preserve cash as a war chest and to stabilize portfolios. The remainder of 2020 is likely to be very volatile (and unpredictable) and any gains are off an expensive equity base - this is not what bull markets are made of!

An alternative to cash is Gold (or precious metals like PGM’s) as a safe haven. The huge monetary stimulus from central banks like the Fed is causing some concerns that cash could be debased. Gold is a good hedge and has little opportunity cost in holding it as interest rates are non-existent. Douglas Investments might introduce exposure to Gold using ETF’s where appropriate. The difficulty in owning a safe haven asset, like gold, is one has to be prepared to sell it at the height of the crisis to benefit from its status and this is often difficult to implement.

Obviously, the defensive approach that Douglas Investments is taking in portfolios carries the risk of being left out of the price recovery!!! This is why the balance of different asset classes in portfolios is so important. Economies could turn because of the huge stimulus provided dragging equities up into a V shaped upturn. This can only occur after 2Q2020 GDP’s have been stomached which are expected to be down > 30% for most economies. The graphs below show the GDP decrease vs the normal trajectory - this production is lost forever. The rebound to date has been driven by the enormous Fed stimulus (USD2.2 trillion) and other central banks, as well the suppression of interest rates, which has ballooned the size of the Fed balance sheet.

The world is desperate to return to normal or even a “new normal”. This was illustrated by the announcement of a US company called Moderna that showed positive results of a clinical trial which caused a human immune system response to COVID-19. The trial was performed on 8 humans, which is very limited and should be viewed with caution, but it was enough to cause the S&P500 to jump by 3.2% on 18 May which is its highest level since early March.

Douglas Investments believes better and less risky entry points will come in the remainder of 2020.

South Africa

Government actions on coronavirus have been quick and commendable as shown in the results to date. Unfortunately, the Government’s good record has become tarnished, having seized the initiative to lock down quickly, the unlock has led to very significant frustration and criticism both from business and socially. It will be interesting to see if the frustration is justified but it will be equally difficult to assess as to “what could have been” as this will only be conjecture.

In any event, South Africa will unfortunately be repaying this cost (justified or not) for many years to come. It is well broadcast that the South African budget deficit to GDP will exceed 10% by the end of this year. This is in the face of debt downgrades and a weak Rand as foreign investors head for the hills! A big fear is a debt spiral where servicing the interest on borrowings is so draining, causing economic strain to the extent that there is little left that can be spent on the economy let alone repaying the debt. Fortunately, international agencies like the IMF are providers of low cost debt to enable the likes of SA to cope with some of the cost of this crisis. The weakness of the Rand has contributed considerably to returns from the JSE as shown in the graph below.

It is possible in the wake of the crisis combined with debt downgrades and general bad news that the selling of the Rand has been overdone. The yield curve is also particularly steep as the reserve bank provides alleviation by dropping the repo rates which drags short term interest rates down. Some forecasters are predicting a R/$16.00 to 16.50 towards year end. This could happen as foreigners are attracted to (chase) bond yields and possibly even invest in ZAR carry trades as the developed world interest rates (borrowing costs) are non-existent.

While Douglas Investments advocates using the real yields available in the bond market for Rand investments, we remain convinced investment into equities must be Rand hedged and even into USD trackers.

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