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As we enter 2021, the recent outbreak of market holiday cheer will have left many investors optimistic. However, do not get carried away by the good mood of the market. While there are many reasons to feel positive about the year ahead, it is equally important to point out what markets seem to have forgotten, namely that the pandemic and its consequences are not yet behind us.
Globally, there is a clear disconnect between the joy of the market and the economic situation on the ground, as many businesses and households remain under pressure as the global economic recovery progresses slowly. Unemployment levels have risen around the world, putting pressure on consumer incomes, which, in turn, will have an impact on business and corporate profitability. Additionally, many businesses and consumers will come under increasing pressure following a second wave of lockdowns, as seen locally and in Europe and the United Kingdom (UK).
That said, it is not all doom and gloom. Monetary and fiscal stimulus continue to prop up markets, boosting sentiment and valuations. And Joe Biden’s presidential victory has been seen as positive for the market, particularly in terms of global trade relations, and many are hoping to see him and his administration settle in the White House this month.
So the speed with which Covid-19 vaccines have been developed and are being implemented represents a significant psychological victory over the virus. While vaccines are not an immediate cure for the global economy, their availability has fueled hope for a faster-than-expected return to normal.
Will SA finally face its tax demons?
Against this backdrop, South Africa has been basking in the glow of risk sentiment, the benefits of which are perhaps most evident in our local bond and currency markets. But, just like tourists who allow holiday cheer to tempt them to freely spend on credit, South Africa’s law will eventually expire, forcing the government to come back to reality and face its fiscal demons.
So far, the support of foreign investors from the local bond market coupled with the IMF loan has prevented the country from feeling the worst effects of the devastation of the pandemic.
But the holiday will eventually end, and the government will need to significantly tighten its belt at the end of the three-year fiscal framework, or towards the end of 2022 and into 2023, especially when its first IMF loan payment is due.
Even before Covid-19 hit, South Africa had come a long way down the road to a fiscal cliff on the basis of an unsustainable and unhealthy government budget – the pandemic simply accelerated the journey to the precipice. If we are to avoid a sovereign debt crisis or the risk of defaulting on our loans, the government will urgently need to implement long-awaited structural economic reforms, and the markets will be on the lookout for evidence of action rather than just talking more over the next 12 months. .
Where can investors turn?
Despite the many headwinds that markets still face, it is important for investors to note that with the economic depression behind us, the Covid-19 reboot means that we are now entering the upward phase of a new cycle. commercial. Although the road to recovery can be long, this is a good thing for global stock markets, as companies generally only make sustainable losses during prolonged recessions or slumps.
Additionally, Biden is expected to borrow heavily to extend support for US social programs, resulting in a weaker dollar, which in turn should support riskier assets.
And with interest rates and the discount rate pushed to record lows, cash and bonds attract little growth-seeking investors, spurring higher demand and adding support to equity markets.
To understand this trend, it is important to note that in a world of negative real rates, leaving cash in the bank is no longer “safe” in terms of achieving growth above inflation. After all, given the amount of debt currently in the financial system, central banks are highly unlikely to normalize rates over the course of 2021. Instead, central banks are more likely to continue to manipulate the short end of yield curves or keep interest rates below inflation or close to 0%, to face the debt generated by an unprecedented fiscal stimulus.
The reality is, given today’s returns, it would take investors 900 years to double their cash investments, underscoring how expensive cash is today.
Similarly, while US bonds, a traditional safe haven, still offer some yield, as well as diversification and protection benefits, it would take investors just over 100 years to double their investment in this asset class.
Therefore, since cash and bonds do not provide investment protection or security, investors should consider alternatives that offer some protection while providing higher returns than cash. The Swiss franc and the Japanese yen represent some attractive options, as do gold and potentially cryptocurrencies. Also, given the lack of alternatives, having a core allocation in global equity markets still makes sense under current valuations to achieve above-inflation portfolio growth.
Understanding the risks
Investing in stocks is not without risk, especially as many companies will face an earnings challenge in the coming months, putting pressure on dividends and stock prices. Perhaps the biggest risk is that central banks withdraw the stimulus before companies can generate reasonable profit figures.
Choosing quality companies with fair value and low risk of default or bankruptcy will therefore be especially important in this difficult economic environment.
In addition, investors should look for companies that are well positioned for a post-pandemic world, and also well positioned for a world where the fourth industrial revolution is gathering momentum – companies that can innovate, add new technologies, and potentially act as disruptors. Therefore, investors would do well to consider investing with active managers and investment professionals who can help them navigate the difficult landscape, rather than simply choosing passive investments.
SA is economically lagging as it accelerates towards the cliff
In terms of the local market, it is important to recognize that South Africa is currently lagging behind its peer group economically, and once the risk rally has faded and markets look beyond global drivers, it is likely that our looming fiscal cliff and debt problems are reflected in our asset classes.
Most of the profits produced by JSE listed companies are generated outside of South Africa. However, headwinds in the global environment could also leak into the local stock market, while a deteriorating fiscal situation and structural economic problems could hamper the prospects for those companies operating only in South Africa.
Investors should therefore seek exposure to those companies that offer some immunity from the local environment.
Investors should also keep in mind that where the JSE has in the past acted as a useful proxy for emerging markets, as more and more emerging markets focus on Asia Pacific, they should consider adding other exposure to emerging markets to achieve true diversification.
It is also worth noting that while the local bond market is one of the few in the world that can generate positive returns for investors in 2021, this should be treated with caution and investors should consider taking profits or even underweight.
Bond yields were trading around 9% in March 2020, and following Moody’s downgrade to underinvestment grade, these yields soared to 13% to compensate investors for the increased risk of government default. Since then, however, yields have returned to 9%, apparently indifferent to the fact that our fiscal situation has deteriorated significantly due to the pandemic, and that our budget deficit will be double what is expected in early 2020. In light From this, it is highly unlikely that the local bond market will continue to trade at current levels indefinitely.
Outlook for the rand
The fact that the rand is trading below R15 / $ clearly reflects international factors such as the outcome of the US elections, vaccine development, and an abundance of liquidity. The first hurdle along the way, however, will be the February budget speech, which will likely remind investors of our poor local economic fundamentals.
Over time, as investors become aware of the economic reality in South Africa, the rand will come under pressure again. Therefore, while the rand is currently enjoying the benefits of global tailwinds, it is likely to weaken over the course of the year. However, the extent of this weakening will ultimately depend on the government’s progress on fiscal reforms, without which we could see the local currency heading north of R18 / $.
Maarten Ackerman is Chief Economist and Advisory Partner at Citadel
