It surely feels like we are navigating a maze at this stage. Not only the uncertainty around the virus and what the world will look like after this pandemic, but also the uncertainty around markets and how sentiment has largely been driving activity.
Adding to this would be the different views and opinions from analysts and economists. An example of this is the opinion of large research houses such as S&P and BCA which are both agreeing that we have already entered a global recession, but how the recovery will play out, is up for debate. While some are talking of a V-shape recovery (a bounce back), others are of the opinion that we will see a U-shape recovery (we have a longer trough and only then a recovery). The mixed views and uncertainty presiding in the current conditions, make it very difficult to decide whether any changes to a portfolio is viable.
We acknowledge that risks remain on both sides of the coin. Should you move to a negative economic view and thus reduce risk assets, it could mean that you lock in some of the losses permanently. Should the recovery come through much quicker and with a larger magnitude, it may cause even more damage to the return profile. Should you however be too early in your positive views there might be more downside pain, which can be just as detrimental.
The bottom line is that these are unchartered waters. We’ve learnt to use the term ‘black swan event’ for times like these. Everything we read in textbooks and were taught in courses, applies to normal situations. De-risking a portfolio when you expect normal market corrections and re-risking a portfolio when valuations tell you to do so, is a sound investment decision. However, only in normal economic conditions. What we are experiencing now are far from normal, and we should also reconsider that a new normal might be in place in the post-virus world we are facing. Black swan events make investments so much more difficult, as there’s no place to hide. Asset classes that were once known as safe haven assets, might no longer hold such status. Fundamentals often don’t hold true and valuations seems meaningless. These are just some of the challenges faced in an abnormal economic environment.
THE MACRO SCENE
As an investment team we make use of our own robust macro research framework. This framework aids us in making top-down investment decisions. The macro process also filters through to an asset class valuation process.
In our research framework we make use of four broad indicators/themes which are then divided into sub indicators. We use the indicators to monitor four economic blocks namely China, USA, Europe and South Africa.
The difficulty is that any sound top-down investment process would try to make use of leading indicators in order to pre-empt business cycles and recessions. Our process will work well to indicate when normal movements in the business cycle occur, such as a market correction or an upswing. The process, however, does not tell you when black swan events will occur. The indicators we monitored indicated during December that a neutral asset allocation should be followed. The world economy didn’t seem too healthy, but lagging indicators such as GDP, inflation and unemployment seemed contained in the developed economies. Sentiment indicated that the US consumer felt very wealthy and very content with conditions, and even business confidence globally was in a fairly normal range. An indicator called the VIX indicator, which measures the fear in the stock market, was at normal levels and even in Europe, indicators (although not overly positive) were remaining at similar levels throughout the latter part of 2019. The only threat we added to our framework in December was the Coronavirus, but even then, it was only limited to the Chinese economy. It wasn’t until February when the epidemic became a pandemic, that the numbers suddenly changed for the worse.
One very interesting leading indicator to consider, and one we use in our research, is the Purchasing Manufacturing Index (PMI). This number is broken down for manufacturing companies and the services sector. It is basically a feedback of business activity and drives economic conditions. This number was still very much in line with expectations in January, and only at the end of February did the numbers start to raise concerns about the state of the world economy.
THE SOUTH AFRICAN ECONOMY CHALLENGED ON ALL FRONTS
The SA economy was already in a technical recession when the pandemic started. We entered this uncertain and bizarre economic times with negative GDP numbers, record high unemployment and structural challenges. Now, the outlook for the SA economy seems even more bleak, and although the markets rallied quite a bit from the all-time low for the year, more dark clouds are forming. Moody’s downgraded South Africa (though this was anticipated) and with the announcement of the 21-day lockdown, further deterioration in consumer sentiment, job losses and overall spending in the SA economy can be expected.
The only silver lining so far seems to be that inflation might surprise on the downside, as the fuel price decrease could contribute positively. Furthermore, there’s been a lot of relief for debt holders. Not only did the banks come on board to provide debt payment holidays, but we also saw the 200 bps rate cut by the SARB, which was a relief for debt holders. However, this is not necessarily enough to save the SA economy and more bad news, such as the infection rate of the Covid-19 virus suddenly increasing; the SA government approaching the IMF for financial assistance (though there’s two sides to this argument); an increase in the already wide budget deficit; a further weakening of the ZAR and an extension of a lockdown, could lead to the SA economy being one of the few economies to not see a V-shape or U-shape recovery, but an L-shape recovery. This means our current recession deepens and we remain at recessionary levels for much, much longer.
POSITIONING PORTFOLIOS FOR DIFFERENT OUTCOMES
Amity has made some changes to our portfolios since the launch of the goals-based philosophy. Income solutions were launched, and mergers of some funds have already taken place. Within the CIS fund range, we also made asset allocation calls and reviewed managers to be in line with the outcomes based strategy. Except for these changes and the launch of the new outcomes based models, we have also re-evaluated our manager selection within our target return models and for most of the first quarter, done extensive research on these managers by means of a new and improved evaluation tool.
During December our asset class valuation report started to signal a sell recommendation for our local listed property holding. This change was made earlier this year and we moved away from our neutral asset allocation in order to accommodate this decision.
We also had to decide whether we should move to a complete negative economic and asset allocation position given all the information provided in this article. The reason we have decided not to do so, was first and foremost the risk overlay that we already have in place. At a neutral asset allocation there’s a strong risk overlay on the funds, which translates to the fact that even at our neutral allocation, we are not fully invested in equities and already more defensive than most of our peers. A move away from this position to a negative position would have meant that we reduce our growth assets. The only growth asset we have thus reduced, was local listed property.
Within our defensive positions we also had to re-evaluate the asset class positioning, given that not even defensive assets were spared during this sudden market crash. The extremely high bond yields we are seeing, partly due to liquidity constraints in the market and lower interest rates, were viewed as opportunities for us to increase our bond exposure slightly. Given concerns around the credit space and liquidity constraints in the credit market, we decided to also tilt away from this asset class in favour of bonds.
One of the ongoing debates in our investment team, would be the offshore holdings within our funds. Given the weaker rand, we lagged some of our peers who had substantial offshore exposure. However, given the current levels of the rand as well as the negative outlook for the US and European economies, making offshore calls now should be done with caution. Reducing offshore allocation is not something we are considering given that we are already underweight in this regard. What we are considering though, is the use of the dollar as a safe haven asset; passive funds vs active funds; offshore property and the outlook abroad for this asset class, and finally, asset class valuations.
IN THE MIDST OF CHAOS, PRUDENCE IS INVALUABLE
Though we face bizarre market movements and extreme reactions from pretty much all asset classes, one thing is certain: we face uncertainty and a new normal. The most challenging part remains that even the most trustworthy fundamentals seem to be of little value. Until a clearer picture is formed of the new world post this virus and economic crisis, we acknowledge that opinions, data points, forecasts, consensus views and analyst views will change almost daily. This means that things are happening more swiftly as news and views are updated and we need to interpret the information to be in a position to alter our own views to ensure the best potential outcomes but being cautious to not allow emotion to influence investment decisions. In times like these it may be good to heed the advice of Benjamin Graham: “The essence of investment management is the management of risk, not the management of returns.”