The world as we know it has changed dramatically over the last two months, with the COVID-19 pandemic and lockdown strategies causing extreme volatility on the markets. Presenting to clients via Zoom webinar, Andrew Lapping looked at the global and local context, portfolio performance and opportunities that are emerging.
Local investment update: Summary
The speed of the global economic slowdown is unlike anything seen in recent history. High frequency US data indicates that US fuel demand is down 37%, while the real tragedy is in the increased unemployment claims. Thirty million people have claimed unemployment benefits in the US. In France, where the private sector workforce is 20 million people, 10.2 million of those are currently being paid by the government. South Africa’s slowdown is even sharper: Google driving statistics indicate that SA driving is down around 90%, amongst the sharpest contractions globally. The informal nature of South Africa’s economy means the job and income losses will probably be greater than in developed markets.
The fiscal and monetary response to the current crisis is unheard of: In the past 10 weeks alone, US$13 trillion in stimulus packages has been announced. This compares with a total of US$2 trillion for the whole of 2009 during the global financial crisis (GFC). There is much debate as to the long-term effect of this stimulus - some argue the result will be inflation, while others believe the crushing debt load will lead to deflation. We have not bet our portfolio on any single outcome; rather we look to invest in a range of assets that will do well across many different scenarios.
The South African government has announced a R500bn stimulus package and the South African Revenue Service (SARS) has noted it expects tax collections to fall by about R250 billion in FY2021. Just these two factors will add 15% of GDP to the county’s debt load.
Sentiment was negative towards South Africa prior to the COVID-19 crisis; the lockdown and economic collapse have caused foreign investors to flee. As a result, the rand is the second-worst performing currency, year to date.
Portfolio performance and positioning
The Allan Gray Stable and Balanced Fund returns have disappointed over the past three years, with the Stable Fund returning 4.2% per year and the Balanced Fund 1.3%. This is clearly unsatisfactory as we strive to generate solid real returns for our clients. Both these funds experienced sharp drawdowns in March but have subsequently recovered most of the drawdown, with the Stable Fund down only 2.8% year to date. Asset prices were extremely correlated in the March collapse, with basically everything falling, except for cash. The stability of cash is very appealing, but future returns could disappoint: The Reserve Bank recently cut interest rates by 2% and, unfortunately, cash is not a good hedge against inflation.
The sharp fall in bond and equity prices means the return outlook is much improved. Yes, the economic situation has deteriorated sharply, and the risks are very high, but we think these risks are discounted in asset prices. For example, real returns of 4% are achievable for inflation-linked bonds – a very low risk asset. Our conservative estimates for returns are 12% from the Stable Fund and 15% from the Balanced Fund.
Where is the value?
On a purchasing power parity basis, the rand looks weak. We repatriated funds from offshore to invest in local assets, when local assets were very cheap in March.
South African bonds look to be good value, particularly when compared to cash. The 15-year government bond trades at an 11.5% yield to maturity after peaking at 13%, while three-month deposit notes yield 4.5%. There is no doubt that the outlook for fiscal management and government debt issuance is not good, but the 7% spread over cash offers a good margin of safety. The spread over cash means the yield on the 2035 bond can sell off by nearly 100 basis points over the year and still outperform cash.
Inflation-linked bonds are one of our most preferred asset classes particularly in the Stable Fund where they account for 10% of the Fund. The 10-year inflation linker yields 4% real to maturity: a great return with low risk.
We are excited about the potential returns from the shares we hold. We are focusing our research efforts on South African companies that we think are robust and will survive an extended downturn but are trading at distressed valuations.
Many businesses are trading at multi-decade valuation lows. To be sure, the risks are great. However, on the balance of probabilities, we think the low valuations discount the risks. The depressed companies include South African banks. Banks are leveraged financial institutions and very sensitive to economic activity. Our local banks are well managed and have very healthy capital ratios. The medium term will be tough, but we believe they will come through this crisis and, in time, generate excellent returns for long-term shareholders.
Weighing up risk and opportunity
Risks are extremely high and correlated. Rather than company-specific risks, almost all businesses are facing the same risk of a revenue collapse. However, where there is risk and fear, good value can emerge: We are looking to take advantage of this value by accumulating under-priced assets. Above all, capital preservation is paramount. This does not mean rushing to cash, which can lose its value in an inflationary environment, but rather owning undervalued real assets that will grow in value in many different scenarios.