There are decades when little happens, and then there are weeks where decades happen – Vladimir Levin
March 2020 – after 25 years of working in the financial services industry, never have I experienced a month where so much has happened, with such brutality, and which is bound to have such a lasting effect on not only our country, but the world. Of course, there have been bad months – October 1987 and September 2008 are the two that quickly spring to mind. However, March 2020 has certainly redefined our understanding of “bad months”.
GLOBAL AND LOCAL MARKETS
The most jarring aspect of the COVID-19 market crisis has been the unprecedented expediency of the crash. As illustrated in Graph 1, it took approximately 20 trading days for global equities to fall 35%. In comparison, the 2008 Global Financial Crisis (GFC) and 2000 Dot-com bubble, took roughly 240 and 380 days respectively to reach these same levels as illustrated in Graph 2.
Graph 3 below gives some perspective of the extent of the “crash” that took place in SA domestic equity markets.
A MONTHS OF SHOCKS
The global and local economy has been hit by numerous shocks as the coronavirus spread rapidly.
- Supply shock
As China locked down the city of Wuhan, followed by several others, it caused major supply disruptions across the world. China is after all the world’s factory, supplying inputs for firms across the globe. It appears as if China is slowly getting back to work as the rate of new infections is declining, but it will take some time for its factories to clear the backlogs.
Meanwhile, producers in other parts of the world are now shutting down as the virus spreads further. Supply should bounce back eventually once the virus passes and workers return to their posts to start tackling the massive back-orders. The risk of course is that their clients might have gone out of business for a lack of stock to sell, or a lack of customers to sell to.
- Demand shock
The demand shock was also initially concentrated in China. People who are forced to stay at home spend less. This is especially true if they are wage workers whose incomes have fallen substantially. Outside of China, the tourism and travel industry felt it first, as millions of Chinese visitors stayed put. With flights across the world now cancelled, hotels and restaurants are empty and workers in these industries are losing wages, tips, and worse, their jobs. Italy and Spain took the drastic action last week of closing all but the most essential shops. Major sporting events are taking place behind closed doors, or are just outright cancelled. The summer Olympic Games must surely be at risk too, for the first time since the Second World War.
- The oil price shock
As the coronavirus continued its worldwide spread, it became clear that global growth would be much slower in 2020 than initially thought. As a result, demand for oil would also be lower than previously thought. The widespread expectation was therefore that Russia and the OPEC countries, led by Saudi Arabia, would agree to output cuts to prop up the oil price as illustrated below in Graph 4.
When no deal could be reached, Saudi Arabia launched a price war against Russia, and particularly against the high-cost US shale producers. Coming completely out of the blue in an already fragile environment, the oil price slumped by a third.
This sharp market sell-off was compounded by a disagreement between OPEC and Russia around the need for production cuts.
On balance, lower oil prices are good for the world economy, since consumers tend to spend more of every dollar saved than oil producers spend on every dollar earned. But as we saw in 2015, when a similar price war erupted, the market stress is immediate.
Locally, we got a taste of this with Sasol. It was already under pressure, having borrowed heavily to fund its mega project ethanol cracker in Lake Charles, Louisiana.
Much like Eskom’s Kusile and Medupi, the Lake Charles plant is years behind schedule and billions over budget. Oil below $40 per barrel puts enormous strain on Sasol’s ability to service this debt, never mind turn a profit. Its share price has fallen 85% this year, pricing in a rights issue. Sasol is (was) a big share on the JSE and a cornerstone in many local investment portfolios.
- A confidence shock
Unlike previous episodes of market turmoil or economic stress, this is incredibly scary on a personal level. While most people infected with the virus experience only mild symptoms, and the vast majority make a full recovery if they receive good healthcare, the fact remains that it is deadly for a small percentage of its victims. Images of crowded hospitals and doctors in hazmat suits instil a deep fear. The dread of waiting while the virus comes our way has a medieval feel to it.
The US consumer has long been the engine of global growth, but the outbreak, the measures taken to stem its spread and the sentiment shock is about to seriously challenge that role. Apart from this, investors around the world have seen declines in their financial net worth as markets plummeted. This is bound to have a negative impact on the willingness and ability of consumers to spend (known as a negative wealth effect) and for businesses to invest. Low interest rates don’t help much if there is no appetite to borrow.
We will get important early clues from China as to how consumers respond now that the worst is seemingly over. Is there an explosion of pent-up demand for goods and services? Or do they remain deeply cautious and keep their wallets closed? Will they dare to go out to restaurants and movie theatres, board planes and trains and be out and about? Or will the fear of a secondary outbreak keep them rooted at home? The answers to these questions will be very important in determining how quickly the global economy can bounce back once the outbreak subsides.
- A financial shock
In this highly uncertain environment, markets slumped further last week as the realisation of the seriousness of the situation grew. Major equity indices are now in bear market territory, typically defined as a 20% peak to trough loss. The 20% fall is a bit of an arbitrary cut-off. A more useful way of classifying a bear market is perhaps a deep decline in equity values that takes a more than a year or two to recover, and is associated with an economic recession. In other words, while most investors can sit out a short, sharp correction, a long, drawn-out decline can cause real financial damage as well as psychological stress. It is obviously too early to tell.
Fortunately, despite panicked selling, the basic plumbing of the financial system – liquidity, payments, settlements, trading, lending and so on – has functioned relatively smoothly thus far. The major banks are in a much stronger position and can absorb some of the stress of their borrowers, rather than add to it. This is a major difference compared to the 2008 Global Financial Crisis and will be very important in supporting the economic recovery when the viral outbreak subsides.
ON THE DOMESTIC FRONT
- The oil price, the Rand and SA’s investment downgrade
There is a sliver of good news for South Africans already reeling from an Eskom induced recession. Apart from the Sasol debacle, South Africa should benefit from the much lower oil price. Headlines read “ SA’s biggest fuel price drop in history” – the irony of this was not lost on South Africans just as they entered lockdown!
As illustrated in Graph 5 below, the rand has predictably weakened in line with other emerging markets, however, it has fallen by a lot less than oil. The rand price of oil is down 40% from the start of the year.
Lower imported oil prices should help the economy in the following ways:
– it reduces the import bill,
– makes it cheaper for Eskom to run diesel generators, and
– will leave more money for consumers and businesses to spend elsewhere.
Importantly, a lower inflation outlook gives the SA Reserve Bank scope to follow other central banks in cutting rates further, that is, until we were downgraded by Moody’s investor services. In a move that was widely expected, Moody’s cut South Africa’s debt to sub-investment grade on Friday night, 27 March 2020 – and so South African investors took yet another extra punch.
Both the local and foreign currency denominated debt ratings were cut from Baa3 to Ba1. Placing South Africa’s sovereign rating firmly in the realm of “junk bonds”. Moody’s also retained their negative outlook. Their statement highlighted South Africa’s “continuing deterioration in fiscal strength and a structurally very weak economic growth”.
COVID-19 (along with the various shock’s mentioned above), together with our downgrade, resulted in severe market turbulence and caused global and local investors alike to sell all liquid assets (any asset that is not risk free), which at one stage in March even meant a sell-off in US Treasury Bonds and Gold, the so-called ‘safe haven’ asset.
Consequently, SA experienced a R63billion outflow from SA Fixed Interest markets as global investors sold our Government Bonds. In a bond market dominated by sellers, problems are likely to occur.
And so, on one particular Monday in March, representatives of large local and global banks were not willing to price SA Government Bonds due to the market imbalances.
The mark-to-market yields of long-dated SA Government Bonds spiked to nearly 13% at one stage, indicated in Graph 6 below. The South African Reserve Bank (SARB) intervened two days later and started purchasing SA Government Bonds from the market-effectively ‘printing money’ to affect these purchases. Unprecedented times! As soon as we have more sellers than buyers in credit markets, bond yields spike higher and the capital price of the longer duration assets reduces due to the inverse relationship of bond yields to bond prices.
And so many of our investment clients have been asking: “We understand that equities (shares) markets have crashed, but why did the prices of flexible income managers fall between 2-5% in March?”
The extent of the price falls depends on the nature of the assets the fund manager held and the duration of these assets. If they held short duration assets, the capital price movement was less severe relative to a fund that’s holding longer duration assets. Generally, shorter duration assets in South Africa yield lower than longer duration assets.
Our downgrade is undoubtedly bad news for South Africa, its corporates and its citizens. However, the country has been in sub-investment grade territory before and managed to build its way up to investment grade.
- This can be done again.
This will require South Africa to address the structural issues holding back its economy – urgently fix the Eskom crisis, sort out the education system, address the inflexibility of the labour market and high public wages, invest in infrastructure and tackle unemployment and inequality.
I have no doubt that our lock-down, as necessary as it has been, will be creating a socio-economic disaster that we have yet to have experienced in our fragile democracy. We will be faced with the most trying times over the coming months.
- But I also know about the tenacity and spirit of South Africans.
At the time of writing this article, I have the noise of my neighbours’ kids (6 and 4) banging pots and pans in congratulations of their Dad who has just finished a 21km run in their garden (300m per lap)!
The leadership shown by our President during the current COVID-19 crisis is inspirational and has the potential to serve as a catalyst to get all South Africans working towards a prosperous future.
- Let’s not waste this crisis.
In the words of our “cometh the hour, cometh the man” president:
“We shall recover. We shall overcome. May God bless South Africa and bless Her people”
***This article was compiled using the following sources:
- The five Coronovirus shocks by Dave Mohr and Izak Odendaal for Old Mutual Multi-Managers. Original article here
- The downgrade will add to challenges for South African investors – Old Mutual Corporate Consultants commentary. Original article here.
- The Dilemma of Mispricing in the Fixed Interest Market by Roeloff Horne for Milton Optimal. Original article here
- Monthly Update, South African Edition, PortfolioMetrix. Original article here.