By: Dave Mohr and Izak Odendaal, Old Mutual Multi-Managers, Old Mutual Wealth
April was the cruelest month, but not for Equities
The Covid-19 rollercoaster was still tearing through global financial markets in April, but the direction was largely up. Following the incredibly quick and deep declines in equity prices in March, April saw a strong rebound. This despite the fact that large parts of the global economy remain in lockdown, and the economic damage caused by it becomes more apparent by the day.
To use the example of the US economy, the world’s largest, the US government reported a 4.8% annualised decline in the first quarter. This was the worst quarterly decline since the 2008 recession. And since the lockdowns only went into effect towards the end of March, the second quarter is likely to show a far worse decline. In the five weeks between 26 March and 30 April, a record 30 million Americans applied for unemployment benefits. More jobs have been wiped out than created during the historically long economic upswing that started in 2009. For the US jobs market, April truly was the cruellest month, as TS Eliot wrote a century ago in The Waste Land, a poem he penned while he and his wife were recovering from the Spanish Flu.
Across the Atlantic, the Eurozone contracted at an annualised rate of 14.5% in the first quarter, the biggest decline since the formation of the monetary union in 1999. The Eurozone performed much worse than the US since it introduced social distancing earlier in March than the US, particularly in Italy and Spain. However, as in the US, large parts of the economy remained shut for the whole of April, and lockdowns will only be gradually lifted during May. In other words, the second quarter is likely to be even worse.
Chart 1: Quarter on Quarter % Growth in the US versus Eurozone, 2006 – 2020
Source: Refinitiv Datastream
And yet, the S&P 500 returned 12.8% in April, the best month since 1987. Granted, the sharp declines of March have not been made up yet (if you decline by 30%, you need to grow by 43% to get back to where you were). But on a 12-month view, the S&P 500 is flat, hardly a catastrophic return.
The Eurostoxx 600 index gained 6% in euros, and is still 17% below where it was at the start of the year. The picture is similar for the Japanese Nikkei 225.
The MSCI Emerging Markets Index gained 9% in dollars in April, limiting the year-to-date loss to 16.5%. The FTSE/JSE All Share Index returned 14% in rand in April, the best month in 17 years.
The US market clearly led the pack, and was largely responsible for the MSCI All Country World Index – which combines developed and emerging equities – returning 10.7% in April.
Chart 2: Global equity indices in 2020, rebased to 100
Source: Refinitiv Datastream
Why? Firstly, it is useful to remember that the market does not have a mind of its own; it is simply the weighted average outcome of millions of individual decisions. It is easy to come up with explanations after the fact that no-one anticipated beforehand.
Unprecedented policy response
One factor surely is the unprecedented fiscal and monetary policy response, which has reassured investors that worst-case scenarios have been ruled out. A repeat of the 1930s Great Depression will most likely be avoided. To again look at the example of the US, the Federal Reserve cut interest rates to near zero. It has grown its balance sheet by $2 trillion dollars by injecting liquidity in several key funding markets, buying bonds and creating new lending facilities.
When all this is over, the balance sheet will probably have grown by another $2 trillion. On the fiscal side, Congress approved a $2 trillion rescue package that included provision for $350 billion in support for small businesses. This programme quickly ran out of money, and a further $484 billion has been approved. The scale of these interventions would have been unthinkable a few weeks ago. Even more impressive is the speed at which it has all happened.
The peak in infections in the US and Europe is adding to relief, probably on a very personal level too. Lockdowns are being eased in the next few weeks, and economies should start recovering.
The equity market is clearly looking beyond the very steep current declines in current economic activity and corporate earnings to a recovery later this year into next year. Other markets are not so sanguine. When a futures contract on West Texas Intermediate oil price turned negative, it grabbed headlines. This anomaly should not distract from the massive oversupply in the oil market. Longer-dated futures are still positive, but well below levels seen just a few months ago. The contract for delivery in December – when the world should be well on its way to recovery – is trading at $27 per barrel, half of where it was in mid-February.
Similarly, the bond market isn’t pointing to any sort of robust economic rebound. The US 10-year Treasury ended the month at 0.6%, close to record lows. The UK equivalent ended the month at 0.18% and for Germany, the same rate was -0.5%.
However, these ultra-low interest rates do make equities more attractive. Even with companies expected to cut dividends to build cash reserves, investors can earn more income from equities than developed market bonds, with equities offering built-in inflation protection too. Bonds, in contrast, seem very exposed to even modest increases in inflation in coming years.
These are not easy questions to answer. The equity market might have run ahead of itself. But history also shows that market crashes bottom out well before the economy does. In fact, conditions on the ground and apparent economic prospects are often extremely bleak when the market turns. It might seem jarring, but that is how it has worked. This may perhaps be the case now; only time will tell. Therefore, the most sensible approach is to always have equity exposure consistent with long-term objectives, since turning points cannot be predicted. But at the same time, diversification and regular rebalancing help limit the downside for when the equity market does get too excited.
Cut three times
Back home, the South African government’s credit rating has been downgraded by all three major ratings agencies in quick succession. Even before the Covid crisis, ratings agencies were concerned about the rapid increase in government debt and the lack of progress in addressing this.
The Covid crisis will make this situation much worse. Increased spending will be required on health, social assistance and business support. South Africa’s rescue package will require additional borrowing of around R170 billion. Despite the rescue plan, South Africa’s economy is still expected to contract sharply this year, and tax revenues will nosedive (some of the lost revenues are self-inflicted due to the ban on tobacco and alcohol sales). The ratio of government debt to national income (GDP) could easily reach 80%. This is not alarmingly high by itself, but was as low as 30% 11 years ago. The rapid growth is worrying.
At the same time, most countries will see large increases in public debt and associated downward pressure on credit ratings due to the global recession.
Moody’s downgraded the government’s rating on 27 March to Ba1. The outlook is negative, meaning another downgrade is possible. Fitch cut its rating on 3 April to BB, also with a negative outlook.
S&P Global was the last to move, cutting the foreign currency debt rating to BB- and the local currency rating to BB last week. It is the only agency to rate rand-denominated and hard currency-denominated debt differently (in theory a country is less likely to default on local currency bonds).
Of the three, Moody’s decision was the most consequential, since it resulted in a drop from ‘investment grade’ to ‘sub-investment grade’ (junk status). This means South African bonds are no longer eligible for inclusion in the FTSE World Government Bond Index (WGBI) as of the end of April. Funds that track the index therefore had to sell their holdings. Many commentators spent the better part of five years worried that we would see massive outflows as a result. Estimates ranged between a few billion to several hundred billion rand that would be yanked from the bond market, causing yields to spike and the rand to slump.
Chart 3: South African 10-year government bond yield, %
Source: Refinitiv Datastreem
However, the market clearly priced all this in long ago and South African bonds rallied over the past few days. Since the long-feared Moody’s decision, the 10-year government bond yield fell from 11.2% to 10.5%. The All Bond Index returned 3.7% in April. Markets downgrade in real time, while the ratings agencies do so after the fact. In the end, WGBI exclusion happened not with a bang, but a whimper (to borrow another TS Eliot phrase).
What can we learn from this?
There is still a tremendous amount of uncertainty at home and abroad. It is becoming increasingly clear that we will have to live with the coronavirus for some time, but what exactly that entails, and how well we can co-exist is still unknown. Still, there are three key take-outs from all the above. The one is that the things we are most worried about are usually priced into markets already. It is the things we are not worried about that catch us off guard and lead to panicked selling. Secondly, local markets will follow global markets up and down. There was no good news for the local economy in April, with Level 4 lockdown only a modest improvement on Level 5. Still, our bonds and equities rallied. Thirdly, when markets turn, they do so quickly and without warning – and yes, sometimes seemingly without logic. This cannot be timed.