The key question that remains on investors’ minds is how long it will take for Covid-19 to be contained and what is priced into assets.
We point out upfront that it is inherently challenging to quantify the economic and financial market impact of major unexpected shocks, such as the current Covid-19 outbreak. Our view nonetheless is that global authorities have done the right thing in implementing unprecedented monetary and fiscal policy measures that are aimed at offsetting some of the economic damage caused by the pandemic-driven economic lockdowns and to shore up liquidity in funding markets.
Global equity markets have responded strongly to these stimulus measures, as well as early moves to gradually re-open economies, while mid-term economic indicators remain quite depressed.
Unfortunately all the stimulus efforts will not do much to drive a recovery in the global economy for as long as people are not free to move and trade. Financial markets normally look forward a couple of quarters ahead of current economic data and are likely pricing in an economic recovery from 2021.
It is therefore the right time to question if the economy is likely to be the disappointment factor to the current sharp recovery in global financial markets so far. We think that James Bullard, the president of the Federal Reserve Bank of St. Louis, summed it very well in a recent speech: “The shutdown can’t go on forever because if it does, deep into the second half, then I think you risk getting into a financial crisis or even a depression scenario…. And if you get into that I think even health outcomes would be way worse.”
Yes, visibility is currently very low in the global economy and, in turn, global financial markets that are supposed to follow wealth creation over the long term, but investors have to keep investing
…and very uncertain times such as this one may actually present huge investment opportunities.
We believe how to approach investments in this environment depends very much on one’s circumstance and time horizon. Short-term traders and those investing for short-term goals have to be extra careful given the potential for the global economy to disappoint over the next 12 months, while long-term investors have the opportunity to acquire high quality assets at reasonable valuations in certain segments of the market.
The situation in South Africa
There is no doubt that the combined impact of weaker global growth, Covid-19, weaker South Africa government finances and the Eskom electricity supply constraints will present unprecedented challenges to the South African economy over at least the next 12 to 18 months. However our analysis shows that the JSE equity market is a very global index with only 26% of revenue demand coming from South Africa and we expect significant rand weakness tailwinds so far to provide support to rand earnings for the South African equity market.
We also show below that the overall South Africa equity market is now trading at a significant discount to other emerging markets, as measured by the MSCI EM index as well to a broader global index of global equity markets as measured by the MSCI ACWI – despite the fact that the majority of the South African equity market’s earnings are derived from demand factors outside our borders.
Diversification is always in fashion when it comes to investing, but this relative valuation situation suggests that investors should be careful before rushing to offshore markets in search of better returns.
Therefore, while it is not possible to predict with a high degree of confidence whether the global economy will disappoint and which direction financial markets will take,
…we believe the real opportunity for long-term investors is to look for investment opportunities in local and international quality companies with strong balance sheets.
Balance sheet strength and liquidity are particularly key variables to watch for in companies that derive the majority of their earnings from the South African economy given the sharp demand/supply shock from Covid-19 trading restrictions, further country credit rating downgrades and ongoing economic growth constraints. High quality companies normally generate strong cashflows that allow them to maintain strong balance sheets and liquidity through different phases of the economic cycle.
In addition, some industries such as the internet technology sector, food production/retail and communication are seeing pockets of increased activity levels, as restricted human movement skews spending towards these services or goods.
It is for these reasons as well as the significant overall South African market relative de-rating that we believe the greater opportunity is likely to be found in selecting high quality companies that become cheaply valued due to short- to mid-term concerns cheaply valued due to short- to mid-term concerns as well as sectors that are long-term structural market share gainers from old traditional industries.
Overall, it is clear that Covid-19 headlines and economic disruption will be with us for a while and the pandemic will surely have a significant short- to mid-term impact on the global economy. Authorities globally have responded with significant various measures such as fiscal and monetary policy easing to mitigate the impact, but it is important to keep in mind that these measures are only likely to stimulate the global economy when people become free to move and trade again.
We therefore continue to believe that selecting well-capitalised good quality stocks at reasonable prices is likely to deliver better long-term outcomes for investors. Our bottom-up research driven investment process and active ESG (environmental, social and governance) engagement with the companies we invest in are likely to contribute sustainable wealth generation over the long term.
Note: The views above are limited to SA listed equities but long-term valuation also looks supportive for SA listed global companies versus international stocks.
Peter Takaendesa is head of equities at Mergence Investment Managers.