Global markets are showing few signs of settling down, with sentiment vacillating between hopes for a sharp ‘V-shaped’ global recovery and continued concern about the economic impact of the novel coronavirus. On the one side, we have countries around the world slowly emerging from severe economic lockdowns; on the other, the reality is that the virus is still very much part of our lives as the reported global infection number climbs above 10 million.
In addition to the Covid-19 outbreak, there are many other factors stoking uncertainty. These include continued trade tensions between the US and China, the question of who will win the US presidential election later this year, and doubts about how effective government stimulus programmes will be in reviving economies around the world.
Despite this volatility, the quarter has not been a bad one for investors on global markets. The S&P500 Index, for example, ended the second quarter near the levels at which it opened the year, despite a 30% fall to its low on March 23. The question to ask is whether current valuations are justified given the short to medium-term economic outlook.
At Dynasty, we do not second-guess short-term market movements, but remain concerned about an apparent disconnect between market valuations and the earnings expectations for the year ahead. We fear that markets are not taking into account the sharp falls in company earnings that we will see for the year, and furthermore anticipate a more challenging economic recovery as cautioned by Jerome Powell, Chairman of the US Federal Reserve.
This is especially the case in sectors such as aviation and tourism, where many investors are betting on a faster return to normalcy than it may be realistic to expect. Apart from funds searching for returns in a low interest rate environment, we believe that speculative trading by retail investors on platforms such as Robinhood, is partially driving the markets at present.
Such an environment should give every investor pause for thought. In our view, the price: earnings ratio for many stocks is currently too high for comfort, and we do not anticipate a return to normality in earnings for a couple of years. Before I talk about how we are positioning our clients for this environment, let us take a look at the South African market.
South Africa: Expect Volatility
As we have noted in our market updates for the past couple of years, economic growth in South Africa remains weak, government debt continues to climb, and tax revenue collections are decreasing. Covid-19 and the severity of the national lockdown add more pain to the mix, with GDP forecast to shrink 7.2% for the year and projections that tax revenues for 2020/1 will be R300 billion below the initial target.
The result is an anticipated Debt-to Gross Domestic Product (GDP) ratio of almost 82% for this year, compared with the 65.6% that was projected in February. Finance Minister Tito Mboweni’s uninspiring budget adjustment speech indicates that there is little appetite in the ruling party to use this crisis to push through urgently needed, market-friendly economic reforms. On the contrary, the drumbeat for ‘radical economic transformation’ may grow louder.
What is more, as welcome as government’s R500 billion stimulus programme and the South African Reserve Bank’s responsiveness to the crisis were, they are likely to be inadequate for the scale of the challenge the country faces. South African companies have collectively announced retrenchment programmes that will cost tens of thousands of jobs, and many small enterprises are expected to close.
The combination of a spiralling health crisis, rising unemployment, weak consumer spending, and low business and consumer confidence means the JSE is likely to have a rocky few months ahead. For that reason, we continue to have a bias towards offshore investments, despite the fact that we have not been externalising any funds for clients since March as the rand had a dramatic sell-off and, based on our analysis, began to price in excessive South African-specific and global risk-off discounts. We are targeting a level of R16.50/$ to resume externalising funds. That said, the JSE has proven to be relatively resilient, ending the second quarter at similar levels to the beginning of the year.
Positioning your Portfolio with a Focus on Risk Mitigation
Against this backdrop of high stock market valuations and continued uncertainty, we are taking a cautious approach to the management of client funds: We are doubling down on our philosophy of investing in quality, in the belief that well-run companies with strong management teams and predictable earnings in counter-cyclical sectors will continue to do well. Conversely, we are happy to forego the steep recovery that may take place in companies which are in severe distress at present, but which represent a high-risk strategy.
We recognise that many of our clients are sitting on cash and may wish to re-enter the market. For our more conservative clients, we have a temporary solution whereby we are able to obtain a substantial yield pick-up versus USD cash on a low-risk basis, with the objective of deploying the cash in the event that a pullback in equity markets were to occur.
For clients who are already exposed to the market via our Proprietary Funds, we have taken the decision to purchase portfolio insurance for the next 12 months to shield our investors against the possibility of a severe market correction.
This also means that less conservative clients currently invested in cash will be able to re-enter equities with a significant level of downside protection on their portfolios, as opposed to sitting on the sidelines as we wait for an air of normalcy to return to our world.