The novel coronavirus (COVID-19) outbreak has caused a global economic and stock market rout this year with a sell-off in all asset classes and extreme market volatility. Commodity markets were not spared, with the price of Brent Crude oil plummeting as pressure on oil demand, due to the pandemic, was exacerbated by a disagreement between OPEC and Russia regarding supply cuts.
Central banks globally have been proactive in battling the impact of the virus. The US Federal Reserve (Fed) announced two emergency rate cuts, bringing the bank borrowing rate back to near zero, and has rolled out other emergency measures including relaunching large-scale asset purchases (quantitative easing).
Elsewhere, France has guaranteed EUR300bn in loans to businesses while Italy, Germany, Japan, and Spain have introduced hundreds of billions of dollars in government relief. In South Africa (SA), several measures were announced to assist the economy including a R500bn stimulus programme and the SA Reserve Bank (SARB) cut the repo rate twice, bringing it down to 4.25%.
So, the big question being debated across SA and the globe is what is priced in, and whether the next big leg will be up or down. The reality is nobody has any idea in the very short term and timing the market is extremely difficult, if not impossible. However, we can be certain that the short term will be massively volatile, and it is not for the fainthearted. Our focus therefore is to emerge from the inevitable recovery positioned optimally.
The impact of the new coronavirus has been wholly underestimated and is now becoming apparent. The medical impact has many different scenarios and projected outcomes, but what is certain is that the short-term reaction will be material and the earnings of many companies will be under pressure until the world normalises. Lockdowns have been instituted, travel is grinding to a halt, gatherings of any type are being cancelled, and supply chains are being disrupted. Many quality global companies will have a short-term decline in their earnings, and many will incur losses. The worst-case outcome is a freeze in consumer expenditure, but this too will return.
While the 2008 global financial crisis was started by toxic lending in big global banks, this time around it is about an expected sharp drop in demand due to COVID-19 fears, the lockdown and pressure on consumer hibernation. For many companies, this sharp drop in turnover will lead to losses and, for those that started the crisis overgeared, there can be a permanent loss of value (by having to have rights issues or having to sell their crown jewels at the wrong time). Some companies will face bankruptcy, and this is where authorities are stepping in to provide support.
For certain businesses, the impact of the crisis could be devastating, resulting in massive losses and a permanent diminution in value (e.g. airlines, hospitality industries, hotels etc.). We are actively avoiding adding any new holdings of companies in these industries to our portfolios. However, for the most part, this will be felt through a few poor quarters and a subsequent recovery.
Still, this does not mean that there could not be more short-term pain. We fully expect markets to be volatile for the foreseeable future as economies re-open and we get to see the likely uneven nature of the recovery, with the biggest potential cloud being a second round of infections and movement restrictions. Nevertheless, for now, markets are well supported by stimulus and the realistic prospects of some normalisation of economic activity in the foreseeable future.
In the near term, SA financial assets have also been tossed about by this crisis and it looks like we will go where the crisis goes. If it escalates, we see more financial pain, however, if it abates SA should start to heal. The currency will be less help on foreign direct investment, but we believe that a combination of attractive yields and a likely strengthening rand will attract foreigners to our bond market.
Companies’ balance sheet strength is one of the key variables for us in these uncertain times. Looking at our favourite counters, four companies come to mind that have entered the current crisis with very strong balance sheets – AVI, Mr Price, Bidvest and BidCorp. However, we note that these companies are all facing significant headwinds due to the lockdowns and we are expecting some very depressed earnings numbers from all these businesses over the short- to medium-term. Nevertheless, longer term, these companies are well placed to take advantage of an improvement in the operating environment, either by acquiring quality businesses at depressed prices or by getting their operations up and running faster than their competitors.
We remain reasonably constructive on platinum group metals (PGMs), but we are keeping a close eye on the recovery of global vehicle sales post the global lockdowns. We think the PGM market is still reasonably balanced even after the slump in global vehicle sales. While we are reluctant to take a significant position in the sector, we still see it as offering reasonable value.
Gold is the most difficult commodity to forecast as demand/supply dynamics have no bearing on the price. We thus cannot advocate that we are in any way in a better position to predict the gold price from any other market participant. But, taking a more macro view, it is difficult to imagine a world more suited to a gold price rally.
With central banks printing money at unprecedented levels and governments stepping forward with significant fiscal stimulus, markets will be awash with liquidity. Yet, corporates may grapple with liquidity issues as they struggle to generate top-line sales during, and after, the various lockdowns. Financial market liquidity will thus have to find a home, and equities may not be the only preferred asset class, with investors also looking at bonds and physical assets (even cash). The poor state of global economies and, consequently, worlds governments, may force investors to clamour into the few liquid physical assets available.
At times like these, gloom is abundant, but it is also when real money is made by the brave. The SA market has crashed after having already effectively crashed (particularly the SA Inc. component of the JSE). Valuation levels are becoming absurd and bargains abound on the JSE. But we must always be alert to the fact that financial markets are not logical and actions by authorities around the globe can have a massive impact on global markets and economic activity.
So, how do we approach the market? Our investment strategy is as follows:
- Rid our portfolios of companies where permanent value can be destroyed.
- Rid our portfolios of those shares where balance sheet issues exist (unless the valuation more than factors this in).
- Keep a core portfolio of quality, growth businesses where we are happy to ride out the market cycles.
- Keep enough cash to be able to take advantage of irrationally priced opportunities.
- Keep a cool head.
For long-term investors who do not wish to draw cash this is becoming a great opportunity, but fortitude is required.