Fund Q2 2020 Return YTD 2020
Obsidian SCI Balanced Fund (B1) 15,5% -5,6%
Obsidian SCI Equity Fund (B3) 17,0% -9,0%
Obsidian SCI Multi Asset Retail Hedge Fund (A1) 14,7% -4,7%
Obsidian SCI Long Short Retail Hedge Fund (A2) 16,2% -5,4%

Highlights

  • A sharp but narrow rebound in global equities.
  • Our funds participated but emerging market (EM) bias blunted performance.
  • Big potential upside from EM assets if pieces fall into place.

The quarter that was

Equity markets are often criticised for not paying attention to their underlying economies. Of course, they remain irritatingly aloof when chastised for doing so. The rebound in global equity indices through Q2 2020 has again brought this conundrum to the fore. With the S&P 500 a few points away from where is was at the beginning of 2020, is Covid-19 playing out in a parallel universe? Here are some of the hypotheses put forward to explain this rally born in the throes of a pandemic.

  • Vast fiscal and monetary stimulus will limit the damage to corporate earnings.
  • With first world bond yields near zero, equities will remain the preferred asset class.
  • People are becoming mobile faster than expected, with pockets of rising economic activity the result.
  • Better treatment protocols are reducing Covid-19 death rates, bolstering consumer confidence and economic activity.
  • Retail investors took the chance to invest in household names who’s share prices had fallen precipitously.

All of the points above have probably played a part in the rebound we’ve seen. However, looking at equity index levels around the world and declaring Covid-19 a non-event is naive. If you want to find the devil, look at the detail.

Source: Bank Credit Analyst, June 2020

As you can glean from the graphic above, not all equity markets were created equal in this pandemic; those with large information technology (IT) weightings have fared best; those without have largely remained in the doldrums. Drilling down into the US market in particular (next chart), there’s further evidence that the recovery has been reserved for only a few corners of the market.

Source: Alpine Macro, June 2020

Which sectors have been left behind performance wise? The table below lists the YTD returns for each subsector on the S&P 500 at the time of writing. As you can see, there’s a wide dispersion of returns.

 Sector 2020 YTD $ Return
Information Technology (IT) 16,5%
Consumer Discretionary 11,1%
Telecommunications 3,7%
Healthcare 0,8%
Materials -3,6%
Consumer staples -3,7%
Real Estate -7,8%
Utilities -10,3%
Industrials -14,8%
Financials -24,4%
Energy -38,0%

A similar trend of divergent returns can be seen on the Johannesburg Stock Exchange. Prosus and our resources index are up 59% and 7,7% respectively for the year. Contrast those returns with our banking index which is down 39% YTD, our general retailers index down 37%, our property index down 34%, our industrials index down 34%, our construction and materials index down 26%. No matter which global equity index you examine, these asymmetric returns are omnipresent.

The behaviour of the US bond market suggests that equities should, indeed, still be in negative territory for the year – yields have not rebounded to pre-Covid levels, reflecting the worry that economic activity will remain suppressed for longer, with a sustained negative impact on corporate earnings.

But in the same breath, Chinese bond yields have been ticking upward steadily and are now approaching pre-Covid levels. It seems likely that Chinese yields are rising because the virus is under control in their country, with the demand side of their economy starting to gaining momentum. Is this the economic roadmap for other countries coming out of lockdown?

Adding to the bullish case for economic activity is our Global Economic Indicator, which can be seen in red, alongside the US and Chinese 10-year bond yields, in the next chart. As a reminder, our indicator is comprised of global PMI data which talks to manufacturing activity in particular. It has rebounded sharply.

Obsidian economic indicator bounces

Source: INet, Obsidian Capital, July 2020

Copper is another indicator pointing to a recovery in global economic growth, down only 1% YTD. Oil is still down 35% for the year, but it rose sharply, up 56%, in Q2. There are many of these conflicting signals at play. But our assessment of the situation is that the majority of the global equity universe is still reeling from the impact of Covid-19 and that economic activity looks to be re-accelerating.

How we fared

When Covid-19 emerged we failed to reduce our very pro-global growth, pro-emerging market positioning that we had coming into 2020. We took the full pain of the fall in Q1.

Our participation in the bounce during Q2 was largely a result of holding onto our pro-growth positing. However, because we favoured emerging market assets – who generally require synchronised global growth to perform – we did not experience a technology-type bounce in our portfolios.

You’ll also know that we’ve been bullish SA bonds (relevant for our multi-asset portfolios only) for some time, predominantly on the long end of the curve (10- and 20-year paper). Those yields compressed meaningfully during Q2, but again it was bittersweet; our bonds have underperformed their counterparts in the likes of Brazil, Mexico, and Russia.

And as you can see in the next chart, the long-end of our yield curve didn’t compress nearly as much as the short-end. We put this down to the very real possibility that our government defaults on their debt repayments down the line if drastic economic reform remains absent.

Short end of SA yield curve compresses, long end reflecting worry

Source: INet, Obsidian Capital, July 2020

Our pro-growth view meant that we also held a reasonable weighting in our domestic resource counters which did very well during the quarter, wiping out most of their losses YTD. The component in our portfolios that held us back was our exposure to SA Inc. counters like Lewis, Astral, Motus, Pick n Pay, Clientele, Massmart, and banks.

We saw an opportunity to pick up US technology exposure during the height of the market volatility. Their rich valuations had previously prevented us from buying them. Alphabet and Facebook were the two meaningful additions; both made positive contributions to our returns during the quarter.

Whats next?

The most important question for us to answer at this juncture is whether the value on offer in our domestic market is a trap. We can see the structural issues that are impeding South Africa’s growth. And the impact of Covid-19 is likely to amplify the problem, potentially for many years to come.

But the valuations are extremely attractive. Using Standard Bank as a proxy for SA Inc. (banks are the sharp end of this subset), you can see just how cheap these shares have become.

SA domestic equity historically cheap

Source: INet, Obsidian Capital, July 2020

For those of you unfamiliar with these valuation models, in black is the actual share price, in bold red is the fair value based on the growth of SBK’s earnings, and the dotted blue line is the PE ratio. Historically you’ve made money from these levels of undervaluation.

Staying with Standard Bank chart above, the 2008 period is worth examining. Earnings collapsed (falling red line) as the GFC played out. But the market looked forward, pricing in the recovery even as earnings fell. If/when a legitimate vaccine is approved, might the market again do the same? We want to be there if it does.

It’s important to grasp the idea that once Standard Bank reports their losses, their earnings base will reset at a much lower level from which it’s mathematically easier to grow. And even though that growth might leave them below where they were pre-Covid, the market is likely to reward them, nonetheless. This applies to all SA Inc. shares that can show earnings growth.

We remain relatively bullish on our domestic resource counters. As the world begins to re-accelerate from the prevailing slump, albeit in a higgledy-piggledy fashion, commodity prices should find support; supply also remains tight across select commodities. These counters provide a nice hedge in the unlikely event that the rand weakens substantially from its current level of undervaluation.

The next chart again plots our Global Economic Indicator, this time alongside the World All Metals Index. We expect broad economic activity to keep ticking upwards as Covid-19 is brought under control; this should in turn provide continued support for commodity prices. And if the US dollar weakens, then they’ll really light up.

Commodity prices to find support as global economy rebounds

Source: INet, Obsidian Capital, July 2020

An underlying assumption in any portfolio with an emerging market bias is a view that the US dollar is vulnerable. We’ve held such a view since early 2016, and while the greenback hasn’t strengthened materially since then, it also hasn’t weakened. Much of the attractive valuation in EM assets has remained under lock and key as a result. This is a trend that may continue.

But the narrative of a burgeoning US budget deficit (not helped by the $2 trillion stimulus package now in play), and the persistent current account deficits, are starting to come to the fore. Might this finally be the catalyst that gets investors to question the reserve currency status of the greenback? As you can see in the chart below, no currency has this luxury forever.

Source: DoubleLine, July 2020

The big picture

Our investment mantra is to marry valuation with the cycle. We need the latter to be supportive to unlock the former. As things stand, we have plenty valuation support in our portfolios; it’s the cycle that we’re grappling with. Are we witnessing the early stages of synchronised global growth? Will that growth be explosive or gradual? And will the macroeconomic relationships of old still hold their ground in this new world?

For our portfolios to perform well, we need a weaker US dollar, synchronised global growth and a realisation by the market that Covid-19 will eventually subside. If these pieces fall into place, we believe there is significant upside to be earned from the cyclical emerging market assets that currently populate our portfolios.