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- Covid-19 is the trigger, not the cause, of the global recession
- Volatility and risk revaluation after years of complacency
- Long-term asset class performance expectations improve
- The coast is unclear in the short term
- Value in South African real interest rates
- Mature conditions for active management and hedge funds.
We have warned about volatility and low investment returns for a long time. The coronavirus is just the trigger to push the global economy and financial markets into a period of correction, lower returns, and increased volatility. We are never likely to predict the exact cyclical trigger and we did not predict the virus. However, we were aware of the underlying imbalances in the financial markets and the global economy pointed to the need for this correction long before the coronavirus occurred. While painful correction is what we need to create a better and more sustainable outlook, long-term performance expectations are improving, but we are still cautious and expect new challenges in the coming quarters.
We can’t avoid our problems forever
Following the longest and weakest cycle of economic expansion on record, the United States (US) economy will recession in 2020. The 2009-2020 cycle was 11 years compared to the five-year average after the World War II, and real GDP expanded 2.6% annualized during this cycle compared to the postwar average of 3.9%. It seems contradictory, but one reason for the unusually weak cycle was deliberate attempts to avoid a recession. Policymakers used low interest rates and debt to stimulate the economy as much as possible. Developed market interest rates fell to their lowest levels recorded in the most recent cycle and debt-to-GDP levels are at their highest levels since World War II, highlighting the excessive use of monetary and fiscal policy. . This is not just a phenomenon of the United States or the developed market. South African interest rates also fell to their lowest levels recorded during this cycle and debt levels to their highest level.
Hiding behind debt creates risk and complacency
Debt suggests a preference for consuming today, rather than in the future. This makes you feel better today than you should, for example, a binge of credit weekend shopping. The persistent use of debt and interest rates is unsustainable. It is also dangerous because the low cost of debt induces less sensible investment and spending decisions. For example, cheap debt can make a risky business venture look profitable, an expensive luxury car look affordable, or a leveraged investment in a speculative asset class seems prudent. These mistakes accumulate before recessions like dead wood that accumulates between wildfires. Regular forest fires burn dead wood, allowing the ecosystem to quickly rejuvenate and stay healthy.
Regular intervention to postpone short-term difficulty leads to a build-up of dead wood and increased pain when it is finally turned on. Regular forest fires cause the risk to be correctly assessed and a healthy dose of skepticism keeps the risks under control, while the longer the cycle continues, the greater the degree of complacency. Built-in economic errors reduce productivity, which is an important and under-appreciated cause of the downward trend in world economic growth.
During boom times, it is difficult to see dead wood, but once the correction arises, it is easily visible. Many countries and companies will have their credit risk reduced during this recession. These downgrades should have taken place many quarters before the recession, but low global interest rates and reduced global volatility made the more inflated credit ratings look nice. The debt reductions of the South African and UK government in March 2020 are just two examples of this dynamic.
Cyclical challenges dictated defensive positioning
The late stage in the economic and financial market cycles advocated a defensive position in recent quarters. However, the absolute return return for most investors is likely to be poor and difficult to digest. Among South African asset classes, only nominal bonds and cash outperformed inflation in the past five years.
Globally, yields were still low, but were supported by an annualized 8% rise in the US dollar against the rand in the past five years. Despite the benefit of exposure abroad, the actual return experience for South African investors in the past five years is comparable to the rare negative returns experienced around 1992 and 2012. This graph shows the performance of generic regulation 28 Portfolio of South African pension funds with 45% in SA capital, 25% in SA bonds, 20% in global capital and 10% in global bonds.
Prospects improve as we discover bugs
The long-term performance outlook improves as equity market prices correct lower. By discovering our problems and admitting they exist, we can solve them and invest in a better future. 5-year real-income expectations on global equities recovered to 7% annualized at the end of March 2020, while South African equities expectations recovered to 5%, which is encouraging but not blatantly cheap. South Africa’s weak outlook for economic growth remains a constraint on South African equity. A better long-term return prospect does not eliminate the possibility of more short-term pain.
Mature conditions for active management and hedge funds.
Asset managers who exceed the next few months should exceed their benchmarks in the coming years, taking advantage of market dislocations. Hedge funds have benefited under these conditions and with added value. Unlike active management, many publicly traded funds (ETFs) have been illiquid lately. It is frustrating for investors to experience illiquidity within the vehicles that were sold for their liquidity characteristics.
The externalities of the fall in developed market bond yields
Illiquidity has also become a challenge for the main US fixed income markets. USA We will remain cautious about the broader market outlook until these US dollar financing challenges are alleviated. Weak growth and low prospects for interest rates have resulted in a dramatic drop in bond yields in developed markets. The lower these yields, the more pressure on the long-term yield prospects of these bonds, posing a challenge for pensioners and insurers in developed markets. At some point, these lower returns will force investors to take allocations elsewhere. Non-growth sensitive storage assets of value, such as precious metals, are a likely beneficiary.
Extreme real rate spreads in South Africa
The dramatic weakening of South African government bonds makes real yields attractive. South African bonds are yielding more than 10% above their US counterparts and could yield annual returns of more than 5% in the coming years. The South African rand exploded to R19 / $ in early April 2020, its highest levels on record and two standard deviations from its purchasing power parity valuation. The challenges within the US financing markets. USA They imply that the pressure could remain on the rand in the short term, but this type of extreme currency valuation is remarkable and an opportunity for some.
Opportunistic value emerges but caution is still recommended
Global authorities will try to bypass economic and market correction by doubling low interest rate policies and expanding government balance sheets. We are aware that these can boost the financial markets in the short term, but we are also aware that these policies reduce the potential for long-term growth because they intervene in the market compensation mechanism and the reallocation of capital, which is so badly needed. urgency. These policies have already been overused, so the market should be more skeptical when evaluating their effectiveness. There is a balancing act between long-term opportunities, short-term risks, much-needed corrections, and policymakers who want to avoid adjustment. We continue to balance these factors, through our risk management framework, allocating a wide range of opportunities, and using asset allocation to support clients on their path to their savings goals.
Rob Price is Head of Asset Allocation, Alexander Forbes Investments.
