Market Update – 16 March 2020

With global markets in turmoil as a result of COVID-19 we have reassessed our investment outlook across asset classes. This is a particularly difficult time to evaluate the impact of the virus and resulting economic fallout on asset prices and there is a wide range of scenarios which can play out. Market volatility is reaching levels not seen in recent memory.

We have outlined three levels of outcome (High, Middle and Low roads) to illustrate the range of outcomes and to provide a balanced view on how to consider investment risk and portfolio positioning at these stress points.

High Road

The virus is constrained effectively through the various measures we are seeing being rolled out (travel bans, social distancing, isolation and quarantining, banning of mass gatherings, hygiene awareness amongst others). Over the next weeks and months these restrictions are gradually lifted and with government fiscal support we see some support for asset prices. Additional stimulus (construction spending for example) could then add more positive support over the medium term as the shock of the event recedes and companies return back to work as normal. Under this path you may still see some corporate failures but these would tend to be limited in impact and contagion. Consumer and investor sentiment would recover off a low base. Countries will have extended themselves further in terms of debt issuance and we face a “lower for longer” inflation and interest rate outlook. We may face a technical global recession for a period of time.

In simple terms, asset prices are temporarily depressed as a group, some assets will be severely impacted but these will be limited in number, and we will see a commensurate improvement as risks subside and clarity around the impact of the virus is observed.

Middle Road

Economic conditions are restrained for a longer period of time, resulting in second and third round effects which impact asset prices more materially. Company debt defaults spread across sectors and regions. This would impact the ‘risk off’ trade more severely. Government stimulus does not have the desired impact as investors and companies hold back on any form of investment, further causing liquidity to leave the market. This reinforces through distressed selling of assets in high risk areas (High yield bonds, growth type equities, highly indebted assets, emerging markets, etc) as well as in relatively illiquid areas (credit, property). The drawdown is deep and sustained for a meaningful period. There is no real place to hide for investors apart from cash.

Low Road

In the Low Road scenario, we see a greater contagion effect on asset prices, channeled through high debt levels and an inability to repay by corporates and possibly countries. Debt levels globally are at record high levels and government and company balance sheets are already stretched. A sustained economic slowdown knocks-on to all levels of the financial sector. Investors withdraw from investment markets, exacerbating the liquidity problem. We see widespread capital losses, investor capitulation, high default rates and the second, third and fourth round effects (lower property prices, gating of funds, etc). This is a real disaster scenario, which we have seen in the recent past during the GFC (2008/2009).

All three options deliver quite negative outcomes for investors. However, the question looking ahead is ‘how much is already in the price’?

The chart below shows how asset classes have moved since the start of the year:

Highlights:

• Many asset classes now rate as cheap. Within equities, cheap on a historic basis needs to be weighed up with prospects on a forward looking basis. We generally observe that the earnings cycle has been turning globally for some time, and this crisis will expedite the fall in corporate earnings and profitability. As such, we require meaningful discounts on equities to offset the fact that the future outlook is weak as highlighted in the scenarios above.
• Haven assets (e.g. DM bonds) are now even more expensive as governments have cut rates to try and support their respective economies. These bonds have offered good protection in a crisis, however looking ahead what potential upside is left? EM bonds (including SA) have sold off quite aggressively. This is reflected through the risk premium being materially weaker (a typical feature of a risk-off trade, rather than a base rate or currency impact). There are likely to be good opportunities here if the EM countries can avoid the Low road scenario above. With credit spreads widening so much they are starting to look attractive, however the risks are substantial.
• The US$ initially weakened 5% off a relatively high base as the Fed cut rates, however we have now seen this recover as a
  pure flight to safety has caused investors to buy dollars. The Rand is significantly weaker as a result.

Given these moves in valuations alongside escalations in risks, we have adjusted our investment outlook to reflect the step change in prospects for asset classes. Broadly, we have upgraded equities but taking into account a significant step-down in future earnings. Where we remain negative is the US, where high initial valuations have derated but not to levels which are appealing yet. We remain very negative on global bonds and credit type investments. We also retain a negative view on global property. Global cash is also negative, given its negative real yield going forward (unless there is deflation).

Locally, we have upgraded equity (low valuation, low in earnings cycle), property (pure valuation levels), and bonds (oversold, high
real yield).

We are assessing the potential trades as a result of these changes on client portfolios. While our initial reaction is that this is an opportune time to buy, we do need to consider the scenarios above as potential outcomes where it makes sense to retain a more defensive position. We are guided by valuations, and in many cases we are seeing compelling levels, albeit with higher risks attached than usual.

There is also significant market volatility making it exceptionally difficult to base an investment decision. For this we rely on the underlying funds to react timeously to protect capital, and to take on opportunities where they make sense.

In addition, we are watching the various fund categories for signs of stress. Income funds are one example where credit spreads are significantly affected, and we are likely to see drawdowns in income funds. This does have the potential to spiral as previously communicated.

Summary

In times of stress we revert to the basics:

• Be aware of our behavioural biases which are pushed to extremes at times like this.
• Follow our research and investment process to avoid making reactive decisions.
• Trust the managers we select and have confidence in their abilities.
• Ensure we are appropriately invested, by avoiding excessive risks and having ample diversification.
• Take comfort from having the luxury of an investment horizon.

Last but not least, times like these provide the opportunities for future wealth creation.