- 2020 characterised by extreme volatility,
- Global economies transitioning from recovery to momentum,
- World economy awash with liquidity,
- Covid-19 vaccine ‘cavalry’ arriving but immense risks remain,
- Risk asset valuations are rich but alternatives are lacking
A year to never forget
2020 will go down as one of the most volatile years on record. As a house, we initially underestimated the violent impact that the Covid-19 virus would have on financial markets when it first appeared on our radar in early 2020.
At the time – it feels like a decade ago – we were positioned for a stronger global manufacturing cycle; we were very constructive on commodity prices; and we anticipated equities and emerging markets to be the asset classes of choice through 2020.
We were caught off guard as the market collapsed in the face of escalating economic restrictions put in place to curb the spread of the virus. But in hindsight, we managed to satisfactorily weather the storm by maintaining our material exposure to risk assets during the initial bloodbath, benefitting fully from the subsequent rebound in financial markets. Importantly, we believe we have restored our long-term track record.
As always, we believe we could have done better. But we’ll take the portfolio returns we generated last year and move into 2021 with the confidence that our process and philosophy fortified us against capitulation in what will go down as one of the more fearful years we can remember.
Industrial production with (stimulated) legs
Global industrial production is broadly back to pre-pandemic levels after all but disappearing in first half of 2020 due to the synchronised global lockdowns. The rapid nature of the initial collapse was matched by the rebound in the second half of the year as major economies reopened.
The overall level of global industrial production (IP), as it stands today, is important in piecing together an outlook for 2021. It can be argued that pre-pandemic global IP levels were relatively low after falling precipitously since March 2018. Its decline was largely due to a cyclical and material destock in the world’s supply chain, which was further aggravated by the Trump-inspired trade war against China initiated in early 2018.
Taking the relatively low base of global IP into account, alongside the fact that both global monetary and fiscal policy remains staggering and stimulatory, and you have an environment where further gains in synchronised global IP, similar to what we saw in the latter half of 2020, is a real possibility.
The first chart below illustrates how interests rates around the world remain at record lows; the second shows how aggressive China have been in using fiscal stimulus to pull their economy out of the doldrums.
All-time low in global interest rates
Massive global fiscal support throughout the pandemic
The global economy has responded to the stimulus and, as we enter 2021, it has already enjoyed several months of synchronised recovery; we anticipate this trend to continue for at least the first six months of 2021.
Historically, this stage of the economic cycle is supportive of commodity prices, a weaker US dollar, and rising developed market bond yields.
US bond yields to close the gap on synchronised global growth
Source: INet, Obsidian Capital, January 2021
Of course, there are risks.
Whilst the ingredients for synchronised growth are in place, it would be remiss to overlook the ongoing risks associated with the spread of the Covid-19 virus. In early 2021, will see the arrival of the vaccine ‘cavalry’, bringing with it realistic hope that the world can begin to turn the corner in its battle against the all-consuming pathogen.
However, inadequate logistical infrastructure and limited vaccine quantities (at least initially) are likely to frustrate many countries’ efforts to reach the level of immunisation needed to reduce the spread of the virus (herd immunity), as well as the growth-crimping fear that stalks their populations.
Global gaps in access to Covid-19 vaccines are raising concerns that the continued spread of the virus will breed more contagious and/or dangerous versions of the pathogen, weakening the healthcare response, resulting in an economic recovery that staggers rather than soars.
To be sure, the vaccination programs, already underway, will make the situation better. But there is still far too much uncertainty to foresee a near-term eradication of the virus.
The road ahead is likely to be long and bumpy, with major regions of the world having to sporadically enforce temporary lockdowns until their vaccination programs reach critical mass. The table below illustrates when, using current rates of inoculation, the high-risk portion of key developed county populations will be vaccinated.
Uneven roll-out of Covid-19 vaccines expected
As a result of the fear and uncertainty the pandemic has brought to financial markets and their respective economies, we envisage that both governments and central banks will err on the side of caution for the foreseeable future, maintaining their ultra-stimulative policies. We would, therefore, anticipate global growth to remain synchronised at least into the first half of 2021.
We enter Q1 2021 with positioning broadly consistent with the previous quarter;
- Rand to appreciate in real terms against the US dollar
- Global equity to outperform cash and bonds
- Emerging market equity to outperform developed market equity
- SA domestic and resource shares to outperform
The rand has strengthened significantly since April 2020. But despite its impressive move, it remains undervalued against the US dollar. South Africa is enjoying one of the most buoyant commodity cycles in decades, reflected clearly in a record trade surplus. The continuation of buoyant commodity prices should provide an underpin for further appreciation of the rand against the US dollar.
A record SA trade surplus
Source: Bloomberg, Obsidian Capital, January 2021
With global interest rates at all-time lows, and inflationary pressures that are likely to gradually increase through 2021, we see better value in select global equities than competing bonds and cash.
We do acknowledge that, due to the significant liquidity that has been injected into the world economy during the pandemic, many risks assets and specific equity sectors have had valuations pushed to very elevated levels. Whilst we do not anticipate an imminent reversal in the excess global liquidity, we are wary of exposing the portfolio to excessively valued sectors.
Unprecedented liquidity in the US economy
Source: INet, Obsidian Capital, January 2021
We believe that a weaker US dollar and relatively undervalued emerging market equity, coupled with continued synchronised growth, should support the relative outperformance of emerging market equity over their developed market counterparts.
Within SA, we remain biased towards resources and domestic-facing equity counters. For the latter, we believe there to be a healthy margin of safety as we enter 2021 given their significantly diminished earnings bases and the potential that provides for future growth.
Significant portfolio transactions during the final quarter of 2020 included the following:
- a switch from Prosus to Naspers;
- increased exposure to Brazil through purchases of Banco ITAU due to its meaningfully undervalued currency;
- an increase in our holding of Exxaro;
- introduced NEPI Rockcastle due to its relatively healthy balance sheet and significant yield;
- moderately reduced equity exposure through the introduction of ALSI futures; and
- within fixed income, longer duration R209’s were marginally reduced in favour of shorter duration R186’s.
Global risks are plentiful going into the new year – foremost in our minds is the world’s inability to get Covid-19 infections under control. A resurgence of infections in China would also be a significant, negative risk.
On the home front, the lack of follow through in SA business and consumer confidence, despite aggressive monetary policy, highlights the lack of real reform and the ever-present threat of crumbling infrastructure (viz. Eskom). In addition, the continuation of our underwhelming management of the Covid-19 pandemic, experienced to date, will also need to be factored into our outlook.
In summary, the behaviour of financial markets during the first half of 2021 should largely mirror what we have witnessed since mid-2020. Thereafter, a slower Chinese economy and a higher global IP base could provide opportunities to reallocate our current positioning.