The extraordinary market movements of 2020
by Sanlam Investments
The recent market correction has had a long run-up. It started with the US-China conflict and Trump viewing China as an unfair partner in the economic growth equation. As these countries raised tariffs, trade patterns shifted and other countries too increasingly looked towards their own economic self-interest at the expense of the globalisation agenda. Globally, economic growth had already been slowing after a long period of expansion post the GFC. With growth weakening sharply, further conflict was inevitable. For example, Saudi Arabia and Russia both largely depend on oil revenues for their economies. Earlier this month, Russia refused to cut production. In response, the Saudis then decided to step up production, which had a dramatic impact on the oil price, sending it below US$37 per barrel. Should this level be sustained it will have a dramatic impact on oil producing economies.
The oil price collapse has not been the only reason for the extraordinary market movements in the past month. Equity markets worldwide have responded negatively to the spread of the coronavirus, the uncertainty around its fatality rate, and the reduced output as factories and schools in the affected areas closed down and travel plans were cancelled. Central banks have already started cutting interest rates in an attempt to avert a recession. Most major equity markets had their worst decline of the past decade and the rand weakened to nearly R17 to the US dollar on 9 March (with some recovery since then).
We now look likely to enter a period of economic contraction in many markets, which is likely to weigh on commodity prices and emerging market currencies specifically, and could have significant repercussions for oil producing countries and emerging market countries with high debt levels – particularly if these need to be serviced from external sources.
What does this mean for your fund?
The dramatic drop in the oil price has had a significant impact on the share price of Sasol, a share in which Sanlam Investment Management (SIM) is modestly overweight. We are of the view the oil price will recover, although remain below our long-term price for an extended period of time, but that the company will be able to trade through what is no doubt a difficult period for oil producers globally. Sasol is able to withstand an oil price of US$40 per barrel for an extended period of time, but should the oil price remain below US$35 per barrel this could create some issues for the company. Chemical prices may follow oil lower, and this with a sustained very low oil price and low refining margins could result in Sasol reporting negative free cash flow for the financial year ended 30 June 2020. If the above-mentioned depressed oil and chemical price scenario lasts till the end of 2020, then we would expect Sasol to breach its debt agreements. Rand weakness does, however, act as a buffer when emerging markets get sold off.
We are taking a pragmatic approach to Sasol, recognising there is significant upside to our intrinsic value, but also there are significant risks outside of the company’s control. As such we have chosen to remain with a modest overweight position in the stock. An extended global bear market could put significant pressure on the company, although Sasol should be able to significantly reduce its debt over the next three years by curtailing capital investment aggressively and disposing of non-core assets. We have had oil shocks in the past and over time the oil market will recover.
With regard to the broader equity environment we now expect global economic weakness to weigh on the market for an extended period of time. Cyclical shares and companies with high debt levels are more exposed to low economic growth. Banks are unlikely to provide loans for business expansion in this environment. Growth will decline and companies’ business models will be tested. Arguably SA has already been in an extended bear market, although somewhat protected by the international business operations of many of our large-cap shares, including the mining shares. Economic growth in SA is likely to weaken further, putting more pressure on the government to cut spending.
SIM has generally been invested in the more defensive local shares, in commodity producers, mainly the platinum and mining houses, and slightly overweight paper and oil. Within industrials we are overweight tobacco and media (Mainly Naspers/Prosus) whose prospects are unlikely to be impacted by the recent downturn. We expect this downturn will inevitably be followed by a recovery at some point. Investing is for the long term and downturns inevitably create investment opportunities. The opportunity set in this environment is broadening and the JSE is looking increasingly attractive. From a positioning perspective we don’t envisage making significant changes to our equity portfolios. Early on we bought some gold shares, which will now act as a form of insurance, although we remain underweight the sector.
South African bonds have been compellingly priced for some time as local fixed income underperformed the emerging market (EM) rally in 2019 mainly due to SA’s rating downgrade risk and a deteriorating fiscal position. However, inflation has remained lower than expected and even now with the currency closer to R16 to the dollar, inflation risk is mitigated by the fall in oil prices. To 6 March bonds have delivered a positive return year-to-date and clearly show their defensive qualities.
Relative to the bond index SIM was neutral duration at the start of the month and we have performed largely in line with the index month-to-date. We think the sell-off represents good entry levels and we are now going overweight.
EM debt funds suffered their worst weekly outflow since November 2016. The JSE also recorded huge selling by foreign investors last week – a total of R14 billion outflow for the week. We think G7 central banks and governments are going to increase both monetary and fiscal support for their economies but ultimately interest rates are going to stay near zero for much longer. As soon as the volatility subsides the hunt for yield will support EM rates.
Interest rate futures in the US are pricing the federal funds rate to zero by October and for rates to stay at those levels into 2021. With the local economy in recession and likely to underperform given load shedding and a weak external environment, we think the SA Reserve Bank will cut rates by at least 50bps this year. In the short term we have to navigate Moody’s rating announcement at the end of March, so it’s unlikely the Reserve Bank will cut aggressively before this risk event passes.
With credit spreads at multi-year lows and the economy slowing, credit is not appealing, especially given the prospect of aggressive policy easing as the year progresses. So we favour duration over credit. Within our credit holdings, we prefer defensive sectors such as telecoms, healthcare and banks. We are also assessing our holdings to see which firms may face disruptions in their supply chains. We are engaging those firms that source extensively from China and India, which have placed export curbs on certain items, to find out how they are managing possible shortages.
Our credit funds have between 2% and 3% exposure to Sasol, which we bought in 2018.
The impact of the oil price and global equity market collapse will also be felt by multi-asset (balanced) funds. However, the impact is limited thanks to substantial diversification within our portfolios.
In addition, SIM’s balanced and absolute return funds use protective strategies to limit the size of drawdowns in the event of a market collapse.
More on how SIM manages risk
All forms of investing entails taking on risk. SIM considers all the various risks when deciding which stocks or bonds to buy on behalf of clients. We make sure that the potential returns from these assets are well matched to the risk being taken.
In a kneejerk reaction to negative events, such as the spread of the coronavirus and the oil price collapse, share prices often fall rapidly shortly after the event, but return to their true value in the medium to long term. It is part of our philosophy and process to buy assets when they are already cheaper than their true value. So, when a negative event happens there is less room for that asset’s price to fall further (and become even cheaper), leading to smaller (temporary) losses.
What should investors do?
Share price volatility is unavoidable in the world of investing. September 2008 saw world financial markets come under huge pressure due to the subprime crisis. The South African stock market (ALSI) reacted and experienced a severe downturn. However, by mid-November 2009 (14 months later), the ALSI was fully recovered from its lows.
It’s easier said than done, but it’s important to not be swayed by negative news. The most important aspect of investing is to stick to your long-term financial plan. It’s been proven that more money has been lost by investors switching out of portfolios than by the markets themselves when asset prices fall. This is because more often than not investors sell out of a fund at exactly the wrong time and then miss out on the subsequent recovery in asset prices. It’s important to always keep a cool head in investing. And invest with a reputable manager that considers all the risks when choosing assets, to protect your portfolio from permanent capital loss and grow it over the long term.