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Infectious pessimism says Old Mutual Wealth

By: Izak Odendaal and Dave Mohr, Old Mutual Wealth

Investment is an exercise in optimism. You put away your hard-earned money in the belief that you’ll get a larger amount back at some point in the future. However, that belief is often fragile since our brains are hard-wired to worry. Anxiety and stress helped our ancestors navigate a very dangerous environment.

Those who always expected the worst, that the rustle in the bush was a lion, were more likely to survive and reproduce than the optimists who assumed it was probably nothing. This is the setting your brain evolved in, and it functions as if you are still in it even if you are extremely unlikely to be killed by a predator (or some other prehistoric threat) today.

And so in today’s technologically advanced world, investors still react to news with the same fight or flight response as our ancestors on the savannah.

Going viral

The latest source of angst for investors is the outbreak of a deadly coronavirus in Wuhan, China’s seventh largest city. On the eve of the Lunar New Year, when an estimated 100 million Chinese made their annual journey to visit their families, the virus has spread not only around the country, but has already been reported as far away as the US. It seems eerily similar to the late 2002 outbreak of Severe Acute Respiratory Syndrome (SARS), which also originated in China, and spread around the world and infected 8 000 people. SARS killed almost 800 people and had a negative impact on economies in Asia in particular, as well as on financial markets. But in hindsight this impact was muted. It occurred towards the end of the long 2000 to 2003 bear market in global stocks.

Chart 1: Global equities during the SARS outbreak

Source: Refinitiv Datastream

Epidemiologists have long warned of the “big one”, a lethal contagion on the scale depicted in Hollywood movies. Nobody knows if and when that will happen. The World Health Organisation has said it is too early to declare the spread of the Wuhan coronavirus a global health emergency. Somewhat ironically, it is our hyper-connected, dense and globalised world that makes such contagion possible. (Our ancestors on the savannah had to fear predators and hunger, but not viral pandemics.)

In a situation like this, the benefit of an undemocratic state is that it can make unpopular decisions. Wuhan and a dozen other cities in China are in lockdown. The downside is that information tends not to flow freely up and down the bureaucratic chain and to the wider world.  However, compared to the SARS outbreak, which the government initially tried to cover up, the approach of the Chinese authorities seems to have improved. They have acted with far greater speed and openness than in 2002/3.

Investors have grown increasingly nervous in recent days, but bear the backdrop in mind. Global equity markets have rallied strongly over the past four months and many investors will probably want an excuse to take some profits. The fear of a contagious disease is as good as any. Although other disease scares over the past few years such as Ebola, H1N1 and avian flu were devastating for the people involved, they caused only short-lived wobbles on markets. Investor sentiment was hurt more than underlying economic activity.

The real test will be whether there is a large and sustained disruption to the daily lives of consumers and business across the globe. As tragic as it has been for victims and their families, this still seems unlikely at this stage.

Improved outlook

In fact, the outlook for the global economy keeps improving. The International Monetary Fund tweaked its global economic forecasts slightly, titling its report “Tentative Stabilisation, Sluggish Recovery”. Global real (after inflation) economic growth declined from 3.6% in 2018 to an estimated 2.9% in 2019. The IMF expects economic growth to increase to 3.3% and 3.4% in 2020 and 2021 respectively.

Chart 2: IMF economic growth estimates

Source: IMF

Forecasts tend to be wrong as much as they are right. Like any everyone else, economists cannot see the future, only make a reasonable guess as to what is most likely to happen. Still, there are some interesting shifts in how the IMF’s army of economists see the world. US economic growth is expected to decline gradually from a robust 3% in 2018 to 1.7% in 2021, partly as the one-off boost from tax cuts fade and other headwinds start to build. Meanwhile, growth in the Eurozone is expected to improve, particularly in Germany, which is expected to recover from 0.5% in 2019 to 1.4% by 2021.

In terms of the world’s most populous countries, the IMF expects a continued gradual decline in China’s official growth rate, from 6.6% in 2018 to 5.8% by 2021. Some believe India can pick up the slack, but its economy needs to overcome serious headwinds that saw growth fall from 6.8% in 2018 to 4.8% in 2019.

Latin America, largely dependent on commodity exports and capital inflows (like South Africa), is expected to see growth rising to 1.6% in 2020 from the 2019 estimate of just 0.1%.

The IMF estimates that the local economy only expanded by 0.4% last year (we’ll only know the final number in March), and that this year it will expand by 0.8%. The glass-half-full view is that such an outcome would represent a doubling of the growth rate. But this is cold comfort. We need to grow by 1.5% to keep pace with population growth. While real growth has been bumbling along between 0% and 1% for the past five years, the big problem remains the stunning decline in nominal economic growth. Nominal growth (adding back inflation) declined from around 8% five years ago to only 4%. This extent of this shock is widely underestimated. Inflation has therefore declined to around 4%.

In fact, South Africa’s consumer inflation rate in December was exactly 4%. It improved from 3.6% in November largely due to higher food and fuel inflation. Excluding these items, “core” inflation fell to 3.8% year-on-year in December, the lowest rate since June 2011.

Chart 3: South Africa consumer inflation

Source: Stats SA

The biggest component of core inflation is the cost of housing. This is measured in the form of actual rents, as well as the implied rent homeowners pay themselves. These two items both increased by less than 3% in the year to December.

The main persistent source of upward pressure on inflation (food and fuel prices are volatile) has been administered prices, largely controlled by the various arms of government and unresponsive to market pressures. These prices rose by 7.4% in the year to December.

All in all, the combination of a weak consumer demand, intense competitive pressure, low global inflation and technological disruption has greatly reduced the pricing power of local businesses. In other words, they are losing the ability to set their own selling prices freely. Average inflation for the 2019 calendar year was 4.1%, the lowest since 2005 when it was pushed down by a very strong rand.

Sift the signal from the noise

Investors are continuously bombarded with news, especially now in the internet age. Of course nobody can predict the future, and for that reason it would be as foolish to bet the farm on any single trend as it would be to respond to every news item that flashes across our screens.  The challenge is to sift the signal from the noise, identity which developments are likely to be fleeting, and which seem persistent.

The coronavirus, like the assassination of General Soleimani earlier in the month, are examples of entirely unpredictable events that hopefully have a short-lived impact on markets. The decline in inflation locally is something that gets less media attention but has far-reaching consequences for the local economy and its financial markets.

To name but three: lower inflation means lower revenue growth for local companies, lower tax revenue for the government (who will need to adjust spending to lower inflation), but also lower interest rates (albeit with a lag). Current high bond yields, therefore, present a very attractive buying opportunity as the market has not adjusted to the reality of structurally lower inflation yet. We saw a similar lag in other countries.

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