Sasfin Quarterly Review – March 2020

Entire industries are on the brink of disaster, millions of jobs have been lost as companies have been forced to shut their doors, stock markets have crashed and an economic recession of global proportion seems inevitable. Governments have responded with massive stimulus packages in the hope that industries can stay afloat, businesses might survive, jobs can be saved and asset prices can stop their freefall. However, until there is greater visibility as to the impact of the virus, it is almost impossible to make a prediction on the markets. Some investors are hopeful the recession will be painful but short-lived but this may not necessarily be the case.

What started out as a couple of cases of pneumonia in the Chinese city of Wuhan quickly morphed into a Chinese epidemic and is now a worldwide pandemic. Entire industries are on the brink of disaster, millions of jobs have been lost as companies have been forced to shut their doors, stock markets have crashed and an economic recession of global proportion seems inevitable with the word, depression, being used in a lot more in conversations. Governments have responded with force, launching monetary missiles and fiscal bombs in the form of massive stimulus packages in the hope that industries can stay afloat, businesses might survive, jobs can be saved or those that lost jobs can make it through periods of unemployment and asset prices can stop their freefall. More importantly (perhaps) countries around the world have encouraged their citizens to practise social distancing, with many governments introducing some form of “lockdown” where citizens are advised (some ordered) to remain indoors and not leave their homes unless it is for essential purposes.

How did all of this start? During the month of December in 2019, doctors in Wuhan, a populous city located in the Hubei province in central China, noticed a development of unusual cases of pneumonia. On the eve of the new year, these cases were reported to the World Health Organisation (“WHO”). A week later Chinese officials ruled out the possibility that this was a recurrence of the SARS virus that originated in China during 2002-2003. Instead, officials announced that they had identified the virus as a novel coronavirus. On the 11th of January, the newly-identified coronavirus claimed its first victim, a 61-year old man. Over the next two weeks, cases of the virus began to be reported outside of China - in Thailand, Japan, South Korea and the US. By the end of January, close to ten thousand new cases had been reported worldwide, over 200 deaths had been recorded and Chinese authorities had closed off Wuhan, cancelling planes, trains, buses and ferries. At that point, the WHO had declared this a public emergency of international concern. A month after claiming its first victim, the disease caused by the coronavirus received its official name, Covid-19.

Since then, we have seen economic activity come close to a standstill. Government and State enforced lockdowns have forced many businesses to close their doors, specifically those within the services industry. Whether enforced or not, consumers are avoiding public places, staying home and avoiding travel. Many supply chains have reached logistical bottle necks or even collapsed. Entire industries have been brought to their knees.

For the period of time that the virus appeared to be isolated within China, stock markets were not overly concerned. During February, the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite reached record highs of 29,569; 3,394; and 9,838 index points respectively, as large US Banks reported record earnings not seen since prior to the Great Financial Crisis (“GFC”) in 2008/9 and Tech companies such as Amazon and Microsoft reported record sales as their respective cloud businesses continued to grow at double-digit rates. However, as news began to spread that Covid-19 was no longer just a Chinese threat and was becoming a global threat, investors began to panic. Adding fuel to the fire, was the news that the OPEC countries, specifically Russia and Saudi Arabia, were no longer in agreement in terms of supply production, sparking a collapse in oil prices. This was the catalyst that sent markets into free-fall.

Global stock markets lost trillions of dollars in value. The MSCI AC World Index, a broad measure of global equity market performance declined 21.7% over the quarter. In little over a month the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite were down by more than 33% as US stocks shed over $12 trillion in value. Stock markets were extremely volatile moving up and down by at least 4% for six consecutive sessions, the longest streak since 1929. Circuit breakers, a mechanism that temporarily halts trading of an in instrument on an exchange to curb panic buying or selling, were repeatedly triggered. Significant stimulus packages which steadied liquidity and provided hope of a recovery were introduced which led to these indices recovering somewhat. However, for the quarter the Dow Jones Industrial Average (-23.2%), S&P 500 (-20.0%) and Nasdaq Composite (-14.2%) were still significantly down. Certain sectors were harder hit than others. Energy was one such sector as the S&P 500 Energy Index declined 49.6%. The Shale gas boom in the US which began fifteen years ago led to the United States becoming the largest producer of oil in the world. However, with the WTI (West Texas Intermediate) Crude Oil price, a benchmark for North American oil prices, falling 66.8% to $20/bbl, many of the US Shale gas producers - particularly the smaller ones - face the prospect of bankruptcy. Often these producers are highly leveraged and the current price level of $20/bbl is well below their breakeven cost.

Travel related stocks were pummelled. As air travel grinds to a halt, airline stocks halved as the Dow Jones US Airlines Index declined 51.6%. Stocks connected to the airline industry will feel the impact of an effective shutdown of the airline industry with Boeing in particular set to struggle. Cruise Line stocks came off even worse as their stock prices fell off a cliff, declining by over 70%. Hotel groups did not sell-off as steeply, but travel bans, vacant hotel rooms and an evaporation of travel bookings has seen the Dow Jones US Hotel and Lodging REIT Index decline 52.8%.

Banking stocks are cyclical in nature and tend to go up and down with expectations for the economy. As the virus continued to spread and business closures grew, it was inevitable that this would weigh on business and consumer spending. A bleaker outlook for the US economy mixed with a concern for the banks’ exposure to the above-mentioned shale gas and travel industries (which could lead to significant write-downs in loans) caused US banking stocks to decline more than the broader indices as the KBW Banking Index declined 40.3%. Captains of Industry in the banking segment were quick to point out that compared to the GFC, banks had taken many steps to de-risk their balance sheets and were much better capitalised, levels of gearing had been significantly reduced, with less exposure to high-risk exotic assets and there was more than sufficient liquidity to address potential market stresses.

While just about every sector sold-off during the crash, there were areas that held up relatively well. On the hopes that biotech and pharmaceutical companies will develop a cure or treatment for the virus, healthcare stocks were not as badly battered with the S&P 500 Health Care Index “only” declining 13.1% for the quarter. Consumers raced to their local stores to stock up on essentials as panic buying set in. The S&P 500 Consumer Staples Index was down 13.4% for the quarter. The S&P 500 Technology index dropped 12.2% as technology stocks, specifically those related to networking and video conferencing held up well, with some even achieving modest gains. “Stay at home” stocks such as streaming, gaming and online specific retailers were also not as badly affected.

In Europe it was a similar situation as the FTSE 100 (-24.8%) and STOXX Europe 600 (-23.0%) both experienced significant sell-offs. Concerns of falling economic growth and customers defaulting saw the STOXX Europe Banks index decline 39.8%. Break-even prices for European oil companies are generally higher than their Middle Eastern and American counterparts. While European oil majors are better capitalised than the US Shale companies and their operations are more diversified, the Brent Crude price level of $20/bbl is well below their breakeven threshold. This has placed their cash flows under significant pressure and forced them to suspend their buyback programs as they attempt to conserve cash. The STOXX Europe Oil and Gas index ended the quarter down 33.1%.

As economic activity declined with the prospect of contractions in economic growth, commodity prices have come under pressure with large declines in aluminium (-16.9%), copper (-22.6%), nickel (-19.4%), platinum (-22.6%) and zinc (-19.9%). Surprisingly, iron ore (-3.6%) has held up reasonably well. Travel restrictions and lockdowns in China made it difficult to source and transport the metal domestically forcing steel producers to rely more heavily on overseas suppliers. In addition, many of the Chinese steel mills are located on the seaboard, away from the centre of the outbreak, making it more feasible for the workforce to resume production. Additional support for the iron ore price has stemmed from the lack of scrap steel collection in China due to the industry’s reliance on migrant workers. This has forced steel mills to use more primary materials, such as iron ore, in their furnaces at a time when shipments from Australia and Brazil have been weak because of heavy rain. Palladium (+22.2%) and rhodium (+76.9%) prices continue to remain disconnected from platinum. Although both palladium and rhodium fell with the rest of the markets, they have both made strong recoveries. Supply-side concerns stemming from the increased regulation of emission standards for combustion engines in China and Europe continue to drive up the prices of these two metals and with South Africa going into lockdown the supply concerns have become more serious as the country is one of the few places in the world where these metals can be found.

Prior to the market meltdown, the South African economy was already in decline. In February it was reported that South Africa’s 4Q2019 GDP had declined and this was the third consecutive decline in the country’s GDP, which meant that the country had technically slipped into a recession. Between February and March, the JSE All Share Index lost over a third of its value but has recovered slightly, ending the quarter down at 44,490 (-22.1%).

Much like its US and European counterparts, we saw significant sell-offs in banking stocks with the JSE Banks Index down 42.6%. For the period ending December, South African banks reported low-to-negative growth in earnings which showed a sharp rise in credit losses, particularly for Nedbank. Over a period of twelve months, Nedbank’s market capitalisation has shrunk by 67.1% as concerns over its exposure to the property market continue to mount. On the 16th of March, Investec completed the de-merger of its asset management business which has been renamed Ninety-One in reference to its founding in 1991.

Perhaps the biggest area of concern is the property sector, with the SA Listed Property Index declining 48.9% over the quarter. With the lockdown in place, stores and offices have been forced to shut their doors. With no customer foot traffic, retail stores will face significant cash flow pressures and will be unable to pay their property rentals let alone staff salaries. Many retail tenants, notably Edcon and Foschini, have already notified their landlords that they will not be paying their rent. The lack of rental income in the future has placed significant pressure on property REITs who have in turn notified shareholders that they will have to suspend distributions, a key source of return for shareholders. In order to maintain their status as REITs, companies are obliged to pay 75% of their distributable income to shareholders as dividends. Maintaining this status will prove difficult for the REITs and they are engaging with the JSE to find a solution for this issue.

The severe decline in the price of oil has been devastating to Sasol. Already struggling with issues at its Lake Charles Chemicals Project in Louisiana USA, the rapid decline in the oil price has placed overwhelming pressure on Sasol’s cash flows and its ability to meet its debt obligations, so much so that it may need to raise additional capital to keep its pipelines flowing. Sasol’s share price has been decimated. Over this past quarter, Sasol’s share price has declined 87.8%. At its peak in 2014, Sasol was worth over R400bn, today it is worth a slightly less than R23bn.

To add salt to South Africa’s already bleeding wounds, Moody’s finally downgraded South Africa to junk status. One might have hoped for some sympathy from the rating agency but the downgrade was a long time coming. Issues over low growth in the short and medium term, which have been exacerbated by covid-19 and the ensuing lockdown, high interest rates and growing budget deficits coupled with tax inefficiencies all contributed to the downgrade. The consequence of this downgrade will see South Africa fall out of the World Government Bond Index forcing those that only hold investment grade debt to sell large amounts of local debt. However, the impact may not be as severe with some arguing that South Africa was effectively downgraded in 2016 following the “Nene-gate” debacle.

History has shown that during market crashes investors flock to safe-haven assets such as US treasuries and gold. This time was no different. Investors rushed into US treasuries which saw yields fall to record lows. The US 1-month treasury yield temporarily dipped below zero and is now 1 basis point above zero. The 30-year treasury yield dipped below 1% for the first time in its history and is currently sitting at 1.32%. What was unusual about this crash is that we saw the strange event of treasury yields and stock prices moving in the same direction as treasuries sold-off in tandem with stocks, correlations raced toward one. Prior to the US Federal reserve’s (“Fed”) intervention, the treasury market was not functioning normally. High-frequency trading (“HFT”) provided much of the liquidity to treasury markets in recent years. For HFT to function, it requires certain conditions to be present such as tight bid/offer spreads, sufficient market depth and stable correlations. As markets continued to fall at rapid speeds and volatility picked-up significantly, HFT was side-lined as the inputs it needs to function were not present. This caused an evaporation in liquidity and also put the humans back into the helm but this time there were fewer of them than before the GFC and the treasury market is roughly three times larger today.

A second somewhat strange occurrence was the performance of gold during this flight to safety. Although the price of gold increased to $1,583/ozt (+4.2%) during the quarter, it actually sold-off during the panic. However, the sell-down was due to liquidity constraints. Investors incurred significant losses, specifically those with leveraged strategies that led to margin calls. To cover their losses, investors were forced to liquidate more liquid positions, namely gold, which in turn put downward pressure on the price of gold.

Governments around the world have introduced significant stimulus packages to steady markets, protect citizens’ finances and (hopefully) prevent economic disaster. The US in particular, has been quite active in introducing stimulus mechanisms. Using the monetary tools at its disposal, the Fed has: cut US interest rates to zero; announced $1.5tn in repo operations in order to improve liquidity in the market; opened up swap lines with the European Central Bank (“ECB”), Bank of Japan (“BoJ”), Bank of England (“BoE”), and Swiss National Bank at reduced rates to assist with US Dollar funding; launched a commercial paper funding facility to support the flow of credit to households and businesses; launched a primary dealer facility to offer overnight funding with maturities up to 90 days; established a money market mutual fund which will support the flow of credit to households and businesses and set up temporary US Dollar swap lines with nine other central banks.

However, these monetary tools on their own will not be sufficient to stimulate the economy - and the US government is well aware of this. Extreme fiscal measures will be required and that is why a $2.0tn package has been put forward. This is more than twice the package that was passed by congress to ease the recession resulting from the GFC. The $2.0tn package dubbed the “Cares Act” will see $500bn flow to corporations of which $58bn is designated for the embattled airlines.

Small businesses receive $377bn in payments, of which $350bn will be available for new loans. Individuals will receive $560bn split between $300bn in cash payments and $260bn for extra unemployment payments. Hospitals have been earmarked to receive $100bn. The bill also includes $454bn to backstop possible losses in lending facilities set up by the Fed which the central bank could potentially leverage into $4.0tn in lending to businesses which implies a potential stimulus of $6tn, almost 30% of US GDP.

In Europe, central banks have also acted to introduce stimulus measures. The ECB unveiled a €750bn bond-buying program which includes the option to purchase Greek bonds. Germany has agreed a package worth €750bn of which €100bn is allocated to taking equity stakes in companies, €100bn in loans for struggling businesses and €400bn in loan guarantees in respect of corporate debt. France will guarantee €300bn of corporate borrowing from commercial banks and Italy has suspended loan and mortgage repayments for companies and families. The BoE reduced rates to 0.1%, the lowest level in its 325-year history. The central bank said it would also increase its holdings of UK government and corporate bonds by £200bn in an attempt to lower the cost of borrowing. The newly appointed Chancellor of the Exchequer, Rishi Sunak, stated that the government will guarantee £330bn of loans to businesses. In addition, cash grants of £25,000 will be made to retail and hospitality firms to help them survive the period of turbulence. The smallest businesses will be able to apply for grants of £10,000. Even South Africa has introduced some form of stimulus. The South African Reserve Bank began quantitative easing by purchasing government debt in order to improve liquidity in the bond market. Finally, the International Monetary Fund has also signalled its readiness to mobilise its funding capacity of $1.0tn.

Despite the size of these stimulus packages it is uncertain whether they will even be enough to prevent economic disaster. Should lockdowns remain in place for extended periods, that possibility would unfortunately become much greater. Prior to lockdowns, US unemployment stood at only 3.5%. At the end of March, 3.3 million Americans filed for unemployment benefits and at the start of April an additional 6.6 million filed new claims bringing the total close to 10 million, implying an unemployment rate of close to 10%. It is anticipated that millions more could follow, albeit only temporarily. During the GFC, roughly 8.6 million jobs were lost.

Investors are left wondering what they should do now. On the face of it, stocks might look attractive as stock valuations have come down significantly as prices have fallen. This is however only one side of the equation. The other factor, earnings, has not come down yet as companies are yet to report numbers that would incorporate the impact of the virus. More and more companies have begun to withdraw earnings guidance and we have started to see analysts adjusting their earnings outlook to the downside. For the S&P 500, analysts are forecasting a 5.2% decrease for 1Q2020 earnings, a 10% decrease for 2Q2020 earnings and a slight “improvement” for 3Q2020, with a decline of only 1.1%. Unfortunately, it is hard to rely on these forecast numbers at this stage and only once companies commence the next earnings cycle will we have a better sense as to what the short-to-medium term might look like. Dividend yields may also look attractive for stocks, but an increasing number of companies (specifically banks and property companies) are suspending dividends and buyback programs as they look to conserve cash. To further bolster their cash balances, companies are drawing down on their existing credit lines. In March, over 130 companies in the US and Europe have drawn roughly $120bn of funding from their lenders.

Until there is greater visibility as to the impact of the virus, it is almost impossible to make a prediction on the markets. What we do know is that in the US since the late 1920’s there have been twelve bear stock markets with declines of 29% or greater. History has shown that from peak to trough these bear markets have lasted an average of fifteen months. From the bottom, markets returned an average of 52% after one year, and 132% after five years. This is good news for stock investor. The only problem: we do not know where the bottom is and will probably only know in hindsight.

In closing, some investors are hopeful the recession will be painful but short-lived, giving way to a robust recovery later this year. Although the global economy is in a temporary deep freeze, once the virus is contained, people will to return to offices and shopping malls and life will go back to normal. Jets will fill with families going on merely deferred vacations. Factories will resume, fulfilling saved up orders. Investors may need to reconsider this viewpoint. In China, the genesis of the virus, people are starting to return to work and economic activity is slowly beginning to pick-up. However, many Chinese are hesitant to return to their old lives. They are worried about whether it is safe to go outside. Financial pressures resulting from a spike in unemployment has led to a lukewarm response to increase consumption. This is a cautionary tale for those hoping for a quick recovery once lockdowns are lifted.