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Decades of turmoil in half a year

Jun 9, 2020

The year is not yet halfway through, but it feels as if decades of turmoil have been compressed into it already. By Izak Odendaal and Dave Mohr, Investment Strategists at Old Mutual Wealth

Decades of turmoil in half a yearAs the clock struck midnight on 31 December, apocalyptic bushfires were still raging in Australia. A few days later, the killing of Iranian general Qassem Soleimani by a US drone strike stoked fears of all-out war in the Middle East.  President Trump became only the fourth US head of state to be impeached, but was acquitted in the Senate in mid-January.

Around the same time, reports of a new deadly coronavirus emerged from the city of Wuhan in China. We all know what happened next. Arguably the worst pandemic since the Spanish Flu of 1918 spread across the globe, causing a historic economic collapse exceeding that of 2008 and perhaps rivalling the Depression of the 1930s.

To this list we can now add widespread, sometimes violent, anti-racism protests, as famously rocked the US in 1968. New York City, the heart of global finance, went from coronavirus lockdown to riot curfew almost seamlessly. While anger over racial injustice has long simmered, it is no surprise that it exploded now, in the midst of the coronavirus turmoil, when millions of Americans have lost their jobs.

What’s next?

Wary Americans might wonder what the hurricane season, which usually starts in June, will have in store for them in this historic year – hopefully not a repeat of the great storms of 2017 (Maria), 2005 (Katrina) and Andrew (1992).

November’s presidential election feels a lifetime away. US elections usually don’t matter much for markets, but a strong showing by Democrats could result in a reversal of Trump’s tax cuts, which would dent the after-tax profits of US companies. Indeed, growing inequality and corporate influence are likely to be key themes of the election.

History in the making

Elsewhere, history is also being made. China took steps to finally end Hong Kong’s autonomy. This, on the eve of the annual remembrance of the Tiananmen Square massacre, is sure to fire up pro-democracy protests, and ratchet up the tensions with the US. Last year’s trade détente seems unlikely to hold.

In Europe, talks are underway to launch European Union bonds to fund the post-pandemic recovery, an important if tentative step towards the fiscal unity that should have accompanied monetary union all along. If implemented, it will substantially reduce the risk of a disorderly collapse of the single currency.

However, Europe and the UK are also still busy negotiating the post-Brexit world. An incredibly difficult task in the best of times, it now has to happen without face-to-face meetings. Unless UK Prime Minister Boris Johnson requests an extension (he has until the end of the month to do so), the possibility of a ‘hard’ Brexit at the end of the year remains. This would surely compound the economic problems faced on both sides of the English Channel.

On the African continent, a new Ebola outbreak in the DRC adds to the misery of one of the poorest nations on earth, even as they struggle with the spread of the coronavirus.

Long and bitter winter looms

Here at home, a long and bitter winter looms as fatalities from Covid-19 climb and intensive care units fill up. Thankfully, the disease has not proven as deadly here as in some other countries (around 2% of confirmed cases).

While the initial hard lockdown slowed the spread of the coronavirus, particularly from overseas visitors or returning South Africans, it did so only temporarily. Community spreading is now well entrenched and Level 4 lockdown was not as effective as hoped.

The government made the agonisingly difficult decision of moving to Level 3 to lessen economic hardship, knowing that it could cost lives. There is a raging debate whether this has come too early or too late.

The fact remains that there is no playbook for dealing with this crisis, and policymakers had to make difficult choices quickly with limited knowledge or foresight.

As the debate intensifies over how to recover from the economic calamity and then chart a new course of sustained rapid economic growth, we can only hope that our government will listen to economic experts as much as it followed the advice of medical experts in responding to the viral outbreak.

These are unsettling times of turmoil, and our hearts naturally fill with aching for the suffering of our fellow human beings around the world and at home as they face grief and despair in the wake of the Covid-19 and other socio-economic crises.

Out of touch?

The ongoing rally on equity markets can therefore seem very jarring, and indeed it has been the subject of a string of articles even in the financial press.

To some, it will evoke the stereotype of the pin-striped Wall Street movie villain Gordon Gekko and his ‘greed is good’ mantra. But of course, most investors are simply ordinary folk, trying to stretch their rands or dollars a bit further. This money is largely managed on their behalf by institutional investors such as ourselves, but within certain limits. Institutional investors are given a mandate by their clients, and have to operate within its guidelines.

In fact, financial markets have also experienced years of drama in the space of a few months. The year started on the optimistic note that global growth was finally accelerating. Then came the lockdowns and the fastest equity bear market in decades. In fact, no market was spared, and there was significant volatility even in safe-haven bond markets at the height of the crisis.

US oil prices even briefly turned negative. But the recovery in equity markets has also been historic. The chart below compares the US S&P 500 Index with previous bear markets. This time has been different. Why it has been different, when the economic collapse has been off the charts, requires some explanation.

Peak to trough declines in US bear markets

For one thing, the promise by the Federal Reserve to effectively backstop the entire financial system in late March is a big reason behind the rally. Other central banks have similarly adopted a “whatever it takes” approach. Last week, the European Central Bank expanded its bond-buying programme by €600bn to €1.35 trillion. Interestingly, while the Fed pledged trillions of dollars of support, so far it has not had to deploy the full amounts in its various facilities. The mere knowledge that the Fed was ready to act was sufficient to get enough investors to take on more risk. We say “enough” because the data on fund flows still shows more money going to bond and money market investments than equities.

Secondly, this has been a very unusual recession in that it was caused by government decisions to shut down their national economies. It stands to reason that as they are reopened, the recession will end.

The hard lockdown phase of this crisis in the world’s largest economies (US, China, Europe and Japan) is virtually over. Life is slowly returning to normal. On Friday, US labour market data showed that the American economy added more than 2 million jobs in May, while economists expected 8 million job losses. While one data point does not make a recovery, it at least suggests the massive job-shedding associated with lockdowns are being slowly reversed (April saw 20 million jobs lost, so still a long way to go).

Equity markets are therefore ignoring the collapse in earnings this year, and pricing in a rebound next year. The big unknown is how much lasting damage the hard lockdowns caused. How many businesses will never reopen? How many jobs disappear forever? How does behaviour change following the crisis?

Thirdly, investors are drawing clear distinctions between winning and losing companies, sectors and regions. To use one example from global listed property, the index for data centres (where companies rent space to store servers) is 50% ahead of the index for retail (shopping malls) year-to-date.

Markets and morals

The expectation that the equity markets should somehow reflect the prevailing mood or acknowledge the anger or sadness of ordinary people is also somewhat misplaced. To state the obvious, a market does not have emotions or a brain or morality. It is not a sentient being. Equity markets were designed so that companies can raise capital and savers could earn a return. They simply add up the often-contradictory views of their participants into an (often fleeting) consensus of what the world is likely to look like in future.

While some individual investors will want to express a political or religious view, most don’t. While some investors will be deeply unsettled by recent events, most will probably look through them.

This point has two implications. Firstly, if you wanted to change the world, for instance to reduce carbon emissions, through your portfolio, it will require an active step on your part. The market is not going to solve that problem on its own, unless there is an incentive to do so. Such an incentive would be a simple change in the tax treatment of carbon emissions, which could lead to a drastic reduction in C02 levels. This will require politicians to act, which in turn requires pressure from voters.

Secondly, be careful in mixing your emotions with investing. This doesn’t mean that you should have no emotional connection to your portfolio. On the contrary, if you feel strongly about the environment, social justice, black empowerment, gun and tobacco control or any other cause, by all means engage with your adviser and fund managers to find products that align with your values. Or at least enquire how ESG (environment, social and governance) principles are being applied in your fund.

Emotions are problematic when they make us turn off logic and lead us to make decisions that turn out to be costly. This includes selling out after the market has fallen because we’re gripped with anxiety, or buying something after a rally because of the fear of missing out. Or becoming so fed up with the state of the country that you take all your money offshore contrary to all diversification principles.

South African All Bond index

A recent example is the Moody’s downgrade to junk status and the subsequent exclusion of South African bonds from the FTSE World Government Bond Index. It was a common refrain that junk status would lead to higher borrowing costs for ordinary South Africans, a collapsing currency and basically something like the end of the world. It hung like a sword over our necks for several years, and was often the first point of discussion in any investment conversation.

Many concluded that it was best not to invest at all given the risk. Yet, since the downgrade, the All Bond Index has rallied 16%, the rand has rallied below R17 to the dollar and the Reserve Bank has cut interest rates.

In other words the things we are most worried about, because they dominate our screens and newspaper headlines, often have little bearing on long-term investment returns. This is either because they will have no long-lasting impact, or because the impact was priced long before the general public started worrying about it.

The one thing the market is good at is processing new information and discounting its implications. With the coronavirus, we should therefore not be surprised that the market recovery happened long before the outbreak was over. In fact the global case-count is still rising, but it is very much a known reality now. By the time most people experienced the physiological impact of the virus, its economic impact was priced in already.

Global Covid-19 cases and global equities

No certainty

Of course no one can say for sure where markets are headed. There are many strongly held opinions, but no certainty. There never is. Therefore, we prefer to remain diversified, with decent equity exposure, particularly in global markets. After all, we know that equities remains the asset class that delivers the highest real return over the long term. It is never a smooth ride with equities though, and a pull-back is quite possible. In the shorter term, local bonds offer a unique value opportunity, and we are overweight. But this is not a time for one-way bets.

This article was based on a press release issued on behalf of Old Mutual Wealth.


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Maya Fisher-French author of Money Questions Answered

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