Investment

November 16, 2020

The end of the beginning

By: Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr

One of UK Prime Minister Winston Churchill’s most famous lines comes from a speech he gave after the defeat of German forces at the battle of El Alamein in November 1942. He noted that “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” He was right. An eventual victory against the Nazis seemed inevitable at that point, but it would still be another gruelling two-and-a-half years off.

Two medical news items last week suggest that it is the end of the beginning for the coronavirus pandemic too. For the first time, we can now envisage a life without social distancing, not tomorrow or next month, but one day. And since markets are forward-looking, they leapt up in excitement.

Vaccination situation

Pfizer and BioNTech announced that their vaccine achieved 90% success against coronavirus in a large-scale trial. There are eight other serious contenders in the final trial stage, but this is the first vaccine with proven efficacy. Next step is regulatory approval for use, which could happen before year-end.

The challenge will be production and distribution. The vaccine will need to be stored at -70 degrees, which is going to be a challenge in developed countries and close to impossible in poor countries. Simply producing enough doses for high-risk individuals could also take months. Pfizer and BioNTech say they could have 30 to 40 million doses of the vaccine ready before the end of the year, but since two shots per person are needed, this will cover only 20 million people at most. Production can be ramped up to 1.3 billion doses next year, but even at this pace covering the entire global population will take years.

It is astounding how quickly a successful vaccine was developed. That same ingenuity will now have to be applied to the logistical side of things.

Fortunately, there are other promising vaccine contenders, and if they get regulatory approval within the next few months, a decent portion of the global population could be covered by this time next year.

The other noteworthy news item was the emergency regulatory approval for the use of Ely Lilly’s antibody treatment bamlanivimab for people who are at risk of serious complications but not yet hospitalised. This may not be a game changer by itself, but adds to doctors’ growing toolkit in treating Covid-19, the disease. There’s no doubt the light at the end of the tunnel is growing brighter.

Good news comes in threes

The excellent medical news followed the earlier positive market response to the US election outcome. With the count finally over, Joe Biden has won a sizable majority of Electoral College votes. The various legal challenges President Trump has launched are therefore unlikely to make a difference. Trump’s own Department of Homeland Security has called it the most secure election ever, with no evidence of systematic fraud or interference.

The problem is that the longer Trump drags out the inevitable and refuses to concede defeat, the more nervous investors could become. What investors want most, however, is another sizable fiscal injection soon. If it happens before the January inauguration, Trump will at least be able to claim he did his bit for the economy on his way out.

But bad news too

Before getting carried away by the good news, there is bad news to process. The number of Covid-19 cases in the US and Europe continues to rise rapidly, potentially impeding economic activity. With all the excitement around the election, it has been easy to overlook the fact that new cases and hospitalisation rates are setting new records in the US.

Although a nationwide lockdown remains very unlikely, some areas are closing bars and other high-risk venues, imposing curfews and urging people to stay at home, particularly over Thanksgiving. And while it seems that some state and local governments in the US, as well as the Federal Government, have all but given up combating the pandemic, consumers might still decide to restrict their movements voluntarily and cut back spending.

Locally, President Ramaphosa expressed concern at growing infection rates in the Eastern Cape and warned South Africans to be vigilant over the festive season when people traditionally gather with friends and family. However, rather than tightening restrictions in response, they were eased further. The opening up of borders for all international travellers with a negative Covid-19 test is welcome, but the usual flood of European visitors escaping the Northern winter is still unlikely this year.

Chart 1 shows the stringency index developed by Oxford University’s Blavatnik School (higher values indicate more restrictions). France and the UK have almost returned to April levels, while South Africa’s strict lockdown has eased significantly.

Chart 1: Stringency index for selected countries

Source: Refinitiv Datastream

Investors are therefore caught between the prospect of a vaccine-assisted recovery at some point next year, but a decline in activity while the virus currently rages. Additional fiscal support will be a vital bridge between now and then. Monetary policy remains accommodative, and the heads of major central banks last week again reiterated they are monitoring developments closely. However, lower interest rates won’t convince more people to go to restaurants or music concerts.

Waiting to rotate

Still, the market response to the developments of the past few days has been remarkable. Equity markets jumped, but more specifically it was the bombed-out cyclical shares that jumped. This includes energy and travel companies in particular, but also European equities in general. For the first time, MSCI’s index of non-US equities is positive on a year-to-date basis, having recovered all the pandemic-related losses. Meanwhile, some of the pandemic winners, including the big internet platform businesses, saw price declines. Whether this amounts to the long-awaited rotation from ‘growth’ to ‘value’ remains to be seen.

Chart 2: US and Non-US equities in dollars in 2020

Source: Refinitiv Datastream

US long bond yields rose, pricing in a stronger recovery and somewhat higher future interest rates. With short-rates kept low by the Federal Reserve, this amounts to a slight steepening of the yield curve, something bank shares in particular like.

What is notable is that South African bond yields declined sharply, along with other emerging markets. In other words, the spread between emerging market and US yields narrowed as investors become more confident in taking on risk. South Africa’s 10-year government bond yield has declined 50 basis points so far this month to 9%, while the 20-year bond declined 90 basis points. We need more of this. Since the government is expected to borrow an additional R1.5 trillion over the next three years, every 100 basis point decline in average borrowing costs will save R15 billion in interest payments.

Chart 3: South African government bond yields

Source: Refinitiv Datastream

While emerging market yields, and South Africa’s in particular, remain much higher than those of the US and other developed markets, it doesn’t mean investors will automatically or immediately chase the higher yields. They will only do so when they feel more comfortable with the risk environment, including knowing that currency moves won’t wipe out gains from yields. And let’s face it, most investors follow past returns. Therefore, a period of emerging market currency strength could attract more capital, further supporting returns.

What we’ve seen so far this month is South African bonds returning 8% and equities 15% in US dollars. A key contributor is the appreciation of the rand against the dollar. Though it has gained 15% since the start of May, it is still 10% weaker than at the start of the year.

The performance of the rand, bonds and equities is almost entirely due to the increase in risk appetite globally. Yes, there was another high-profile corruption arrest, which points to progress in rebuilding governance and state capacity. However, it is far from being a decisive blow against graft.

There was also some good economic news with mining and manufacturing production numbers confirming the strong third quarter rebound. However, these numbers don’t tell us how the economy will perform in the quarters ahead.

Unemployment will almost certainly be a drag on consumer spending and therefore overall economic growth. Stats SA’s third quarter Labour Force Survey paints a more realistic picture of the unemployment situation following the lockdown-distorted second quarter report. Unfortunately, it is not a happy picture. Compared to a year ago, 1.6 million fewer people were employed formally or informally. The official (narrow) unemployment rate stood at a record 30.8%. The report isn’t completely free of distortion, however, with 2.5 million more people counted as “not economically active” compared to a year ago. They are not working, but are also not considered to be unemployed.

The unique feature of Covid-19 is its uneven impact on individuals. It hits some people like a ton of bricks, while others don’t even know they are ill. It can be deadly to one person and harmless to another. The economic and societal impact is similarly uneven. Some are largely unaffected, especially skilled workers in the knowledge economy who can work from home. Some, especially in the high-tech fields, are actually better off. But many have seen their dreams interrupted or livelihoods destroyed. Unfortunately, those who were vulnerable and struggling economically before Covid-19 were generally hardest hit. Inequality is a pre-existing condition that the pandemic has worsened.

The enemy within

It is therefore easy to get demoralised about South Africa’s prospects, and it has become fashionable to write off South African asset classes. However, we’ve seen once again how they are priced in a global context and can rally when the global environment is supportive. With some further progress on economic and government reform, the momentum can build. This doesn’t mean that South African assets are a one-way bet. It just means a diversified portfolio needs to cater for the scenario where they perform much better in coming years than in the recent past.

Among Churchill’s numerous famous quotes this one is also apt: “When there is no enemy within, the enemies outside cannot hurt you.” Investors are usually their own worst enemies, getting carried away with good news or bad news, and letting emotions dominate logic when it comes to investment decisions.

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