The great lockdown recession of 2020 has set so many unprecedented records (first bad then good) that people will have case studies for years to come.
We are asking ourselves: Will the economy recover? Will inflation return? Can we handle all the debt?
These are some very important questions that we need to address in order to construct a well-diversified portfolio for these extraordinary times.
We now mostly know just how bad the second quarter of 2020 was. The United States (US) gross domestic product (GDP) number came out at a staggering -32.9%.
Will we see a ‘V’ shaped recovery going forward? As economies re-opened after severe lockdown restrictions activity has certainly picked up. The latest ‘second-wave' of infections among certain countries (US, Euro area, Australia) have stalled this positive momentum. We therefore see more of a Nike ‘swoosh’ recovery; initially quite strong but then tapering off.
It will probably take the global economy at least two years to recover to 2019 GDP levels. Certain industries that were negatively impacted by the lockdown, like the tourism and aviation industry, might even be permanently damaged. Others like the property sector might take a lot longer to recover. Human behavior has adapted to the new reality; we now work from home effortlessly and buy our goods online. No wonder the Information Technology (IT) sector is the star performer globally.
We have experienced a deflationary world for several years now. As our global GDP forecasts are somewhat below consensus, we would expect this deflationary theme to continue as output gaps take a while to close.
But over the medium term, we believe that all the reflationary measures introduced, like the unprecedented fiscal as well as monetary stimulus, will eventually get inflation moving towards the central banks’ target levels (of about 2%) (for the developed world).
We have been US dollar bears for a while now, and it seems as if this theme is starting to play out.
Why are we negative on the dollar?
Firstly, based on our models the dollar is currently expensive. Secondly, the US slashed interest rates aggressively since the crisis, thereby reducing the interest rate differential between the US and other countries making dollar holdings relatively less attractive. Thirdly, the dollar is a counter-cyclical currency, so as the world recovers from this crisis and economic activity picks up, the dollar should weaken. Furthermore, the US will end up with massive twin deficits that will need to be financed, putting added pressure to the currency.
Unfortunately, South Africa was already in a recession as we went into the pandemic, so it had a lot less ammunition to support its economy.
We expect the economy to contract by 8% this year, but to recover in 2021 with 3% growth. Furthermore, energy availability (or the lack thereof) adds downside risk to these numbers. One big positive upside surprise would be the implementation of structural reform programmes which has been spoken about a lot, but implementation has been virtually non-existent.
The other positive has been lower inflation, which enabled the central bank to cut rates aggressively by 300 basis points so far in 2020. Further cuts are possible.
By far the biggest concern of this recession is the damage done to our fiscal position. The main budget deficit is now expected to reach -14.6% of GDP versus just 6.8% tabled in the February budget. Total debt to GDP is expected to peak at 87.4% in 2024, assuming Treasury’s projections. We would argue that it might even be a bit worse than that. Fortunately, we have received some loans from international agencies such as the International Monetary Fund (IMF) that should relieve some short-term funding pressure. These loans, although relatively attractive from an interest rate perspective, will just add to our ever-increasing debt burden in the future.
How are we positioned?
So, it’s clear from the above that we are probably more cautious on the global and South African economy than consensus. We therefore prefer growth and defensive quality stocks over high cyclical values stocks.
We are underweight SA equities for this reason. Although we are concerned about the debt metrics in SA, we feel that most of this is priced into our attractive real rate curve and are therefore overweight SA bonds.
We are maximum overweight on our offshore allocation as we see more opportunities elsewhere.
Within our offshore allocation, we are neutral on equities, favouring Asia ex Japan over developed markets. We are underweight fixed income, preferring investment grade credit over negative yielding developed nations, as well as a slight overweight position to China local currency bonds. We also have an overweight position in gold, and we are underweighting the US dollar.
Markets are extremely volatile, and we expect this to continue well into US elections in November. Trade wars should intensify, and Brexit fears remain. It is important to diversify in these uncertain times.