By: Maarten Ackerman, Chief Economist and Advisory Partner, Citadel
Will investment fundamentals return in 2021 or will the great disconnect of 2020 continue?
As we enter 2021, the market’s recent bout of festive cheer will have left many investors feeling upbeat. However, do not allow yourself to be carried away by the market’s high spirits. While there are many reasons to feel positive about the year ahead, it is equally important to note what markets seem to have forgotten – namely that the pandemic and its consequences are not yet behind us.
Globally, there is a clear disconnect between market cheer and the economic situation on the ground, as many businesses and households remain under pressure while the global economic recovery slowly grinds forward. Unemployment levels have risen worldwide, placing pressure on consumer income which will, in turn, impact on businesses and corporate profitability. Additionally, many companies and consumers will come under intensified pressure following a second wave of lockdowns, as seen locally and in Europe and the United Kingdom (UK).
That said, all is not doom and gloom. Monetary and fiscal stimulus continue to underpin markets, buoying sentiment and valuations. And Joe Biden’s presidential win has been seen as market positive, particularly in terms of global trade relations, with many looking forward to seeing him and his administration settle into the White House this month.
Then, the speed with which COVID-19 vaccines have been developed and are being rolled-out represents a significant psychological victory over the virus. While the vaccines are not an immediate cure for the global economy, their availability has boosted hope for a swifter-than-expected return to normality.
Will SA finally face its fiscal demons?
Against this backdrop, South Africa has been basking in the glow of risk-on sentiment, the benefits of which are perhaps most evident in our local bond and currency markets. But, much like holidaymakers who allow festive cheer to tempt them into spending freely on credit, South Africa’s bill will eventually come due, forcing government to return to reality and face its fiscal demons.
So far, foreign investor support from the local bond market together with the IMF’s loan have kept the country from feeling the worst effects of the pandemic’s devastation. But the holiday will eventually end, and government will need to tighten its belt significantly at the end of the three-year fiscal framework, or towards the end of 2022 and moving into 2023 – especially as its first IMF loan repayment will come due.
Even before COVID-19 hit, South Africa had travelled a long way down the road towards a fiscal cliff on the back of an unsustainable and unhealthy government budget – the pandemic simply accelerated the journey to the precipice. If we are to avoid a sovereign debt crisis or the risk of defaulting on our loans, government will urgently need to implement long-awaited structural economic reforms, and markets will be watching for evidence of action rather than simply more talk over the next 12 months.
Where can investors turn?
Despite the many headwinds still facing markets, it is important for investors to keep in mind that with the economic trough behind us, the COVID-19 reset means that we are now entering the upswing of a new business cycle. Although the road to recovery may be long, this is a positive for global equity markets, as companies usually only make sustainable losses during extended recessions or depressions.
Furthermore, Biden is expected to borrow heavily to extend support for the US’ social programs, resulting in a softer dollar, which should in turn support riskier assets. And with interest rates and the discount rate pushed to historic lows, cash and bonds hold little attraction for investors seeking growth, thus stimulating further demand and adding support to equity markets.
To understand this trend, it’s important to note that in a world of negative real rates, leaving money in cash in the bank is no longer “safe” in terms of achieving above-inflation growth. After all, given the amount of debt currently in the financial system, it is highly unlikely that central banks will normalise rates over the course of 2021. Instead, central banks are more likely to keep manipulating the short-end of yield curves, or to keep interest rates below inflation or close to 0%, in order to afford the debt generated by unprecedented fiscal stimulus.
The reality is that, given current yields, investors would need 900 years to double their cash investments, underscoring just how expensive cash currently is. Likewise, while US bonds – a traditional safe haven – do still offer some yield, as well as diversification benefits and protection, it would take just over 100 years for investors to double their investment in this asset class.
So, with cash and bonds providing neither investment protection nor safety, investors need to consider alternatives that offer some protection while still providing cash-beating returns. The Swiss franc and Japanese yen represent some attractive options, as do gold and potentially cryptocurrencies. Additionally, given the lack of alternatives, having a core allocation in global equity markets still makes sense at current valuations in order to achieve portfolio growth in excess of inflation.
Understanding the risks
Equity investments are not without their risks, especially as many companies will face a challenge to earnings in the coming months, placing pressure on dividends and share prices. Perhaps the biggest risk is that central banks will withdraw stimulus before companies are able to generate reasonable profit numbers.
Picking quality, fairly valued companies with a low risk of default or going bankrupt will therefore be particularly important in this tough economic environment. Additionally, investors need to look for companies that are well positioned for a post-pandemic world, and that are also well positioned for a world in which the fourth industrial revolution is gathering momentum – companies that can innovate, add new technologies and potentially act as disruptors. Investors would therefore do well to consider investing with active managers and investment professionals who can help to navigate the difficult landscape, rather than simply just choosing passive investments.
SA lagging economically as it speeds to the cliff
In terms of the local market, it’s important to recognize that South Africa is currently lagging behind its peer group economically, and once the risk-on rally has faded and markets look past global drivers, our looming fiscal cliff and debt issues are likely to be reflected in our asset classes.
The majority of earnings produced by JSE-listed companies are generated outside of South Africa. However, headwinds in the global environment could filter through to the local exchange as well, while a deteriorating fiscal situation and structural economic issues could hamper the prospects of those companies which operate only in South Africa. Investors thus need to look for exposure to those companies that offer some immunity against the local environment.
Investors should also bear in mind that where the JSE in the past has acted as a useful proxy for emerging markets, as more and more emerging markets become Asia-Pacific focused, they should consider adding other emerging market exposure to achieve true diversification.
It is also worth noting that, while the local bond market is one of the few in the world that may generate positive returns for investors in 2021, this should be treated with caution and investors should rather consider taking profits or even go underweight.
Bond yields were trading around 9% in March 2020 and, following the Moody’s downgrade to sub-investment grade, these yields exploded to 13% to compensate investors for the higher risk of government default. Since then, however, yields have returned to 9%, seemingly indifferent to the fact that our fiscal situation has significantly deteriorated due to the pandemic, and that our budget deficit will be twice the size anticipated at the start of 2020. In light of this, it is highly unlikely that the local bond market will continue to trade at current levels indefinitely.
Prospects for the rand
The fact that the rand is trading below R15/$ clearly reflects international factors such as the US election outcome, vaccine developments and an abundance of liquidity. The first bump in the road, however, will be the February Budget Speech, which is likely to remind investors of our poor local economic fundamentals.
Eventually, as investors wake to South Africa’s economic reality, the rand will come under some pressure again. So, while the rand is currently enjoying the benefit of global tailwinds, it is likely to weaken during the course of the year. However, the extent of this weakening will ultimately depend on government’s progress on fiscal reforms, without which we could see the local currency head north of R18/$.