Investment and the markets during COVID-19: Wealthcast Episode 01

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Recorded on 14 April 2020

This transcript has been lightly edited for clarity.

As financial planners, what do you see as the economic impact from COVID-19 globally, in the UK and in South Africa?

Mike Abbott: The impact of COVID-19 is obviously massive and very significant across the globe, definitely in the UK, in the US and Europe. We’re only starting to understand the impact that took place in China as they begin to normalise. And on the UK side, as we go into 2021 next year, we’ll have the interplay between a COVID-19 recovery and the real Brexit actually starting to happen. So there’s obviously concerns about how those two issues interact with each other.

But the thing that’s notable and unusual about this coronavirus recession that we’re going into now is just the sheer velocity of the economic downturn. It’s unlike anything we’ve ever seen before. The latest projections on the US side are that GDP could contract anywhere between 24% and 35%, which is double any previous record, so the velocity is incredibly severe and therefore one would hope for a fairly quick recovery when it comes, but that’s really the really unusual aspect of this crisis so far.

Niel Pretorius: What we haven’t seen as yet, which will probably only start coming to light through the next quarter, is the actual earnings figures on companies both domestically and internationally. So I think there’s still a bit of a shock to come, which will probably introduce volatility we might not have seen yet, but certainly ongoing volatility. South Africa’s really just right at the start of all this. They have had some input, their reserve bank is coming in, they’ve lowered some barriers to the banks to be able to lend, but liquidity’s going to be a key issue going forward.

MA: I would agree, Niel. What is also interesting is from the South African side, the package that’s been put forward to try and deal with the coronavirus is about 1% of GDP, whereas the package that you’re looking at on the US side is about 10% of GDP. So there’s a significant gap there, which is going to hamper the recovery for South Africa.

NP: Oh absolutely. The big difference is that South Africa doesn’t seem to have the capacity to deal with this properly. We’ve seen what’s happened to the government through the last 20 years, so where’s the money actually coming from? And then we had the double whammy with the downgrade that has now finally happened, and the potential for deeper downgrades to happen from the other rating agencies as well, whilst we are trying to deal with this.

Sean Ritchie: What does the stimulus package look like for the United Kingdom?

MA: The UK stimulus package, I believe, is around 8%. On a call with Goldman Sachs last week, quite a few of the economists have had a look at what they call the income gap. The income gap is the difference, the expected loss of national income as a result of the lockdown, and the size of these packages that have been put forward. In Europe, the UK and the US, that gap is actually quite well matched. So the loss of national income compared to the packages that have been put forward have been quite well matched. The question therefore is about how long the lockdown actually goes on. Because if the lockdown is quite short and we’re all back to work and sort of normalised by June, then those stimulus packages look to be what was required. In South African terms they’re well short of what’s required. But it all depends on how long the lockdown goes on.

There’s been a lot of talk in the press around V-shape vs U-shape recoveries, which do you think is more likely?

MA: Initially starting out it looked like a V-shape recovery was possible because the infection wave in China end-to-end was about three and a half months, but over time what’s become clear is China was better able to execute on the lockdown, just by the nature of the culture in that society, the degree to which the state is able to control people’s movements and monitor it and how much data they’ve got.

The more successful a lockdown, the quicker one is able to return to normal, and the lockdowns have not been nearly as successful in other parts of the West – most significantly in the US where the lockdown hasn’t been complete or total at all. The real question is: If one doesn’t do a lockdown or isn’t able to do the lockdown properly, then do you end up with a problem going for much longer? That’s really the issue at play here.

At the moment it’s looking more like a U-shaped recovery and the question is, depending on how long the lockdown goes on, you might get real damage to the structure of the economy, which will then hamper the recovery. But if the lockdown doesn’t go on too long, then we should just have an income gap and not an actual solvency crisis. And then the recovery can really take place; we should see some pretty interesting month-on-month GDP improvements.

NP: Yeah, I tend to agree with that. There’s been talk in South Africa from some of the commentators that they could be looking at an L-shape recovery, given all these structural issues that they are facing at the moment, and the likely end of the lockdown itself. It’s just been extended. How long can it continue for? People need to get to work.

You can lock down a person but you can’t lock down the need for them to access food and to access water, etc. There is a time where you just cannot manage it going forward.

SR: There’s also the huge potential for unemployment as many small businesses can’t actually survive an extended lockdown.

MA: Correct. This is why it’s all about the period of time that the lockdown goes on. Because at that point when businesses fail and when a large part of your SME sector – the biggest employers globally in all the different economies is the SMEs – starts having mass failures with investors getting wiped out both on the equity and the debt side, people are left without jobs; that part of the economy actually shrinks. Its capacity to employ is damaged. You can’t have a robust recovery because that part of the economy has actually disappeared. That’s why this lockdown period of time is absolutely where all the discussion needs to be at. I know the IMF are planning on making comments on that at their global stability briefing.

SR: What does China’s economy look like now that they’re coming to the end of their lockdown period and are starting to reduce restrictions?

MA: At the moment, the economic damage looks like a 10% shrink in GDP. That seems to be the consensus estimate by various economists. But those are economists outside of China that are trying to estimate this based on purchasing managers indexes and the like.

The geolocation data that comes out of China, which is significantly dense data (it’s really good data) suggests that China is back to 90% of normal in terms of movement of people and movement of goods, but the contraction looks like it was 10%, which for an economy of that size is absolutely huge.

SR: What kind of impact do you think this is going to have in the current power struggle between the US and China?

MA: China has come out of the whole thing looking a bit better than the US, and in terms of a country that’s able to protect its citizens from something like an epidemic, they were able to move more quickly. Yes, I know they have been blamed by the US for allowing the whole thing to start in the first place, but certainly once they realised what they were dealing with, the lockdown was really effective. But in terms of how it will play out in the geopolitics, I honestly have no idea.

NP: Yeah, the difference in the lockdown between China and most of the Western world is just the different political system that we have. They’re a far more totalitarian state, the people are used to obeying orders and the army and the government will lock them down and keep them there. Whereas us in the West, we have a bit of a different outlook on life, a lot more liberal. You’ll see Americans protesting that gun shops are supposed to be open – this is apparently essential to have in the time of a crisis like this. It’s just the totally different viewpoints that the different societies have. I think, that makes all the difference.

We’ve seen it in South Africa as well. Lockdown is lockdown, but there seems to be a bit of a history of not obeying the law or having necessary respect for the law and it’s how the different governments deal with it at the end of the day. What’s the political situation look like afterwards? That’s anybody’s guess at this point.

What has been the impact you’ve seen on investments that you manage for clients?

MA: Well, looking through our portfolios, specifically our Core and our Core Plus models, the three-month number is obviously the interesting one. In our Core models you’ve got everything from our most conservative model being down one odd percent to the more aggressive ones being down 15% over three months. These are significant drawdowns, but interestingly these portfolios looked at through the Rand, just for South African resident investors, in terms of their offshore investments, are positive across the board with the least aggressive or the most conservative portfolios having the better returns. Our near cash portfolio in Rand terms has done 17% over three months. That just shows you how the Rand has moved against the Pound, for example, and the Rand moving against the Dollar has been even more significant. We have seen drawdowns in these portfolios; the markets themselves are down around 25%-30% depending which index you look at, so these are fairly significant drawdowns, but there could be quite, in terms of velocity, there could be quite a strong recovery at some point when the market starts to price in the world beyond COVID-19. And the thing that the market is struggling to get a handle on is that whole V-shape, U-shape recovery issue and whether there is going to be long-term damage to these economies.

NP: A lot of it has been okay still. The portfolios that we do manage haven’t behaved in line with expectations, what we would expect them to do given the market circumstances, and we should see them on the rebound behave in those exact same ways. The fact is that these kind of drawdowns have occurred before and they will occur again in the future. That’s a simple fact. But it’s a question of managing, not panicking, making sure that that the investment philosophy or policy that you do have, wherever you are on the risk scale, that you don’t go and tamper with it in times of like this.

MA: Absolutely. When we tested our models prior to this, when we revised our methodology back in 2014, we tested these models back 30 years, and a balanced investor should at any time be willing to accept between a 17% and 23% drawdown in order to enjoy the upside of a balanced portfolio, which over a 20-year period has been about 7% in Pound terms. These drawdowns are not unusual in terms of bear markets numbers that we’re used to seeing. What could be the case with the coronavirus is that these drawdowns are very short in duration. This could be one of the shortest bear markets we’ve seen because it’s been a very severe drawdown and there is a good possibility that the world will return back to normal – certainly a form of normal – in a fairly short order.

How has the weakening of the Rand infected investment decisions for South African-based investors?

MA: Well, the Rand is obviously a very significant bellwether for South African investors looking to invest offshore because that’s the trade that is a one-way trade. It’s only done once, so therefore you price in and build in that return or that exchange rate at that point in time.

We did a roadshow just before this all kicked off in South Africa and a lot of the investors that were ready to move funds have chosen to wait. The problem is that we’ve had a downgrade between now and then and as a unit we’ve been warning about this downgrade being inevitable for about four years now and that at some point the fiscal position would deteriorate. It wasn’t actually the coronavirus that caused the downgrade, it was going to happen anyway – but you've now got a double whammy of an investment-grade downgrade at the same time as you’ve got this risk-off crisis where fund managers around the world go into risk-off mode and start buying US treasuries. That’s why you’re seeing a strength of the Dollar, which has weakened the Rand. The Rand is a risk currency, so that’s why it has weakened. It’s not obvious that the Rand will come back to levels that people are used to seeing before. Where there’s a huge pull to risk off, most benchmarks around the world will over correct – go too far and then come back a bit. I would encourage South African investors not to see the Rand and Pound, for example, in terms of 18 to one going forward. Post downgrade we’re not going to see those numbers for some time and if we do, that will just be for short periods of time. Everyone should be adjusting their expectations for a weaker Rand going forward. It may not stay where it is now, but I don’t see it returning back to 18 and staying there for long periods of time.

NP: In the short term, you’ll probably see it further weakening. There was a bit of a rally or a bit of a bounce last week, but that hasn’t done anything major if you look at the barriers that they were trying to push. I had a long conversation with one of the large banks and they reckon that in the short term, looking mid-year, the Rand will be pushing 24 to the Pound. It should come back at some point, but to what level? Again, there’s so much dependent on what happens with the coronavirus response. We had the downgrade. The median rating could go down further, which would put further pressure on the Rand, and in the short term I don’t think you’ve got any place to hide in the Rand. If you’re a long term investor in South Africa, there are some serious choices you need to make, both in terms of the Rand as well as diversification: Do I remain only in SA and forgo the rest of the world, with the hope of just looking at currency, or what do you do in those cases? Those are very hard decisions to get people to make and come to terms with what their strategies might be.

SR: Because we’re very much in a fundamentally different situation compared to the last time the Rand hit these levels in 2016.

MA: We are in a different position, but it’s also worthwhile for Rand investors to remember, … our Portfolio One, which is a 100% fixed income, so it’s global fixed income, is denominated in Pounds. That portfolio in Rand terms has done 181% over 10 years. Now that’s through a period where offshore interest rates have been very low. That’s the return over 10 years one can generate by just having no risk at all by being in hard currencies. You’ve got to weigh that situation with the current movement of the Rand in context, that there is an opportunity cost for being in Rands for South African investors because of the riskiness of the currency and the fact that the currency moves by these magnitudes whenever there’s a global event.

There are some tough decisions for South African investors holding Rands wanting to buy offshore assets. Our view would be to not take the view that there are better days for the Rand down the line simply because the Rand’s now in a very different category for international investors. In the period of time leading up to this, the South African bond market offered very attractive returns for an investment-grade bond market relative to the bond markets in the developed world – in the US, UK, Europe and Japan. About a third of the bonds in the market were offering negative yields, whereas the South African market was offering positive yields in the region of 6%. Going forward, there’s going to be investment opportunities everywhere because all assets have been downgraded, all assets have been reduced in price and therefore will look attractive. I just don’t think that the Rand is going to enjoy that international buy up bringing it back to 18/17 and holding it there.

What should retail clients be thinking about from the personal finance perspective as we move through lockdown?

MA: This kind of sell off is a really interesting opportunity for investors because it was triggered by an external shock; it didn’t come from within the economy. The road to a recovery is a little bit more obvious in this crisis than in any other. Everyone has a very strong desire to return to normal and to continue with their normal spending habits, so there’s a bit more of a clearer path to recovery with this crisis than with others, which suggests that the markets really are offering very interesting value right now.

What we would suggest to clients to think about is setting up new investment accounts or structuring investments, getting anything set up to take advantage of this, even if one has the view that there’s still a bit more of a downturn to come. Let’s say for example one thinks there’s another 10% to go and the worst news is not out yet, the earnings cores haven’t happened so it’s all going to get worse before it gets better. That might be the case, but to do anything in the world of financial planning – create accounts, set up accounts – all of this has to be done virtually through video calls without the postal services at your disposal. It’s much harder to do and it takes longer. We’re very busy with our clients in terms of what I would call “preparedness”, in setting up accounts, getting ready, getting accounts funded, so that we can start phasing in to a market that’s probably quite close to the bottom, or at least the bottom that’s most likely to happen over the next three months.

NP: Yes I would agree fully with that and as Mike says, a lot of our time’s been spent on that with clients, it’s just getting in that position to get into the market. The last thing you want to do is hit the bottom, start the rebound, and you’ve got a month or six weeks to go through before you can get anything set up. You could miss the entire rally.

SR: I think that’s a good spot to start wrapping up. We’ve covered a lot of ground today. Any final thoughts before we say goodbye?

NP: It’s tough times for everybody out there. I look at conversations you have personally with friends and family across the globe. Everybody’s anxious about what’s going on, some of them have lost their jobs, some of them have got reduced incomes and it’s scary for people. It’s a question of realising that at some point this will be over. And governments – they are not perfect, none of them are – are trying their best to handle the situations as best they can. For individuals it’s a case of stay safe, protect what you can, but be ready. When this changes, you want to be part of that change. I think the world will look slightly different once we’re through this, but certainly I don’t think it’s the time to crawl into a hole and just try and stay there. You’ve got to get out and get ready for the new dawn, so to speak.

MA: I would echo one of Niel’s comments there about not forgetting that this is temporary in nature. We’re getting to a point that I would use the label of “peak horror”, of where the virus starts to get very close. Everyone starts to know people who’ve been infected and might know a few people who’ve been lost to the virus, and there’s lots of talk in the press about permanent damage to economies, about not being able to ever be able to return to a world that’s normal. What we’ve got to remember is that in China it was a three-and-a-half month wave. It is a wave, it does have an end. And what’s different year-on-year as we develop as economies around the world, is that we’re moving more towards an information and entrepreneurial economy. This is a global trend. So I just think there is a readiness of individuals of a larger number of the populations around the world to come up with new business ideas and start new businesses and do things in an entrepreneurial way; we’ve never been as agile as a business community as we are now. Our ability to recover from these sorts of things is at the highest that it’s ever been. As long as the lockdown doesn’t go on long enough to create a solvency or financial crisis, we could have a fairly steep recovery and we could return mostly to normal by the beginning of next year. For someone who’s generally quite risk adverse in doing what I do, I’m quite optimistic about the recovery for this one. It’s really important as we get into the darkest hour of this thing to remember that the dawn is not very far away.

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That’s all we have for this edition of the Wealth Cast. If you’re interested in more expert analysis and opinion, please visit us at www.sableinternational.com or you can also email us at wealth@sableinternational.com.