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Provided by the South African National Department of Health
FOR ASSET ALLOCATION
Alwyn van der Merwe
Director of Investments
Mar 25, 2020
The number of both infections and deaths has escalated materially since early March. In an in-depth study by Imperial College, it was observed: ‘The global impact of COVID-19 has been profound, and the public health threat it represents is the most serious seen in a respiratory virus since the 1918 H1N1 influenza pandemic.’ The authors argue that over the short term, the situation can be managed by mitigation measures that will protect those most at risk of severe disease from infection. They suggest that suppressing the transmission of the virus will require at least the physical distancing of the entire population in order to reverse epidemic growth ‘until a vaccine becomes available (potentially 18 months or more)’.
Given this view, we’re likely to see serious economic fallout as a result of measures introduced to suppress the virus, both globally and in our own country. Globally and locally, many small businesses will not survive. This will obviously have a knock-on effect on economic growth, unemployment and the short-term profitability of the wider business community.
Governments have already responded aggressively by implementing measures to mitigate the effect of the virus and by providing economic stimulus to counter its dire impact on economic activity. Unfortunately, in South Africa, the risks are more pronounced as our economy is already in a recession. From a fiscal perspective, there’s very little room for Finance Minister Tito Mboweni to provide meaningful stimulus to our struggling economy. The South African Reserve Bank has announced a one percentage point cut in the policy rate, which should bring some relief.
After ignoring the initial news on the virus, financial markets responded very aggressively as it spread – and the immediate economic consequences were easily observed. Global equities, as measured by the MSCI World Index, are down 30% from their peak recorded on 20 February 2020. Locally, shares are down 34% over the same period.
US treasuries initially reacted in an uncorrelated way as those yields declined aggressively. However, the strength in global treasuries was short-lived as government bond yields gave up all their gains over the past week. Commodity prices didn’t escape the carnage as the oil price fell all the way from US$50 per barrel to below US$25 almost overnight. The darling commodity of 2019, palladium, lost 43% of its value from its recent peak. The surprise to many gold bulls was that even the gold price fell 13% from its peak.
We argued from late 2018 that the global economic upcycle was in an advanced stage and that equity markets were similarly in late bull market territory. Unlike the bull market of the late 1990s and 2007, we didn’t consider equity prices to be in bubble territory. However, risks were starting to build. Within our equity portfolios we reduced the cyclicality by selling platinum shares, trimming diversified miners and increasing the cash levels marginally. None of these actions looked particularly smart, as platinum shares performed exceptionally well in 2019, Anglo American and BHP Billiton steadily advanced, and equities outperformed cash.
In the multi-asset portfolios, we introduced an underweight position in equities early in the year and mirrored the equity themes in these portfolios. It didn’t work for most of last year. As the equity bull market continued late in the year, with the benefit of hindsight we should have trimmed further, but as equity prices weren’t in bubble territory we believed we’d already reduced the risk in the portfolios adequately.
And then the virus hit financial markets.
One could argue that our portfolios were ‘correctly’ positioned, with higher cash levels and lower cyclicality. However, when an external shock of this magnitude hits economies and markets, no portfolio will have enough dollar cash. Although the positioning in our client portfolios was generally more defensive relative to competitors, it didn’t protect the capital value of portfolios over the short term. For older clients who rely on income derived from these portfolios, this is particularly cumbersome. It is, however, true that our client portfolios responded better than those of most of our competitors – particularly those who ignored valuation and favoured narrative.
The speed and magnitude of the sell-off in financial assets suggests that fear and panic drove investor behaviour. Extreme intraday price movements reflect desperate actions by market participants. Following in-depth discussions and stress-testing of individual company financial models, we at Sanlam Private Wealth have decided to use some of the cash in our equity portfolios to add to local equities and to reduce the underweight in equities in the multi-asset portfolios. Of course, we are very aware that some might argue that we are too early in adding equities to the portfolios given the continued uncertainty regarding the economic fallout as a result of the virus.
As the sell-off was largely indiscriminate, it also allowed for restructuring of the equity portfolios where it was possible to buy higher-quality assets at deep discounts, while we could reduce lower-quality assets. Our actions included the purchase of Anglo American, which now trades at a deep discount to our intrinsic value despite lower than cash market prices in our commodity assumptions. We’ve also added Bidcorp, which we sold earlier at around R320 per share. Of course, the Bidcorp model will be tested while the impact of the virus remains relevant for human behaviour.
In our multi-asset portfolios, we held substantial cash positions. As explained above, we’ve used some of the cash to buy shares. However, we also increased the duration of the fixed interest exposure following the sell-off in South African bonds. In short, we’ve used the opportunity to acquire quality assets at material discounts to intrinsic value.
As the humanitarian impact, economic outcome and resultant implications for businesses remain uncertain, many commentators and clients may criticise our decision to buy shares and increase exposure to government bonds. Analysts and investors will continue to wrestle with these issues. Our guess is that the narrative is only likely to change once a vaccine can be successfully rolled out to combat the virus. Before this happens, investors will have to deal with the derived negative economic consequences – which might be very ugly.
In time to come, we will no doubt look back at this crisis – as we did after 1998 in South Africa, 2001 globally and again 2007/8 with the global financial crisis – and recognise that financial assets traded at extremely deep discounts and provided attractive buying opportunities.
We’ve often said that a financial crisis creates unique buying opportunities as valuations are very attractive. We have taken the first steps and will continue to utilise expected continued volatility to enhance the growth potential in our client portfolios. Intellectually, this is easy to understand, but emotionally it’s very tough to overcome the fear associated with the crisis. It’s our firm view that our clients won’t regret these purchases when they look at their portfolio values in a few years’ time.
Sanlam Private Wealth manages a comprehensive range of multi-asset (balanced) and equity portfolios across different risk categories.
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