INVESTING OFFSHORE AFTER THE ROUT

By Jaco Visser

The rand cushioned the blow of the global stock market rout for many local investors. Now the question is how stocks and bonds will emerge from the largest sell-off in a generation.

When markets tank, and subsequently rebound somewhat, the broad questions investors will ask are what they should have done during the rout and what they should do once it’s run. The coronavirus pandemic has wreaked havoc across global equity and fixed-income markets, with uncertainty about the future economic fallout only adding to investors’ anxiety. But one global piece of advice from various fund managers rings clear during these tumultuous times: Stick to your initial investment strategy.

Where such a strategy included exposure to offshore assets, whether shares or bonds, the same advice applies.

“The foundation of any investment strategy starts with the right long-term structure based on your time horizon and risk profile,” says Anet Ahern, CEO of PSG Asset Management. “If that was inappropriate to start with, it is much more difficult to navigate the current situation.”

Anet Ahern CEO of PSG Asset Management

And difficult the current situation is. The MSCI World Index, which tracks 1 643 stocks from 23 developed countries, declined by as much as 31.8% since the beginning of the year before rebounding 24.3% to settle at 15.2% down for the year by the time of writing (see table on p.31).

The MSCI Emerging Markets Index, which constitutes 1 404 stocks from 26 emerging countries, dropped 32% during the initial sell-off since the beginning of the year and subsequently rebounded by

16% for a year-to-date return of -21.1%. These are, however, general indices and most fund managers follow a bottom-up approach to stock selection. As in any portfolio, it is wise to have some form of protection against extreme market events, such as the current coronavirus pandemic.

During periods of heightened volatility, everything – except dollar cash – seems to fall, cheap assets get cheaper and usually noncorrelated sectors sell off in tandem, explains Ahern. This makes investors doubt the principle of a diversified portfolio, she says.

“The pain of opening the latest statement and seeing your assets decline, even if only on paper, induces the temptation to move to cash,” Ahern says. The best hedge for most investors remains correct risk profiling and diversification, she says.

Building in protection

Most funds utilise strategies to hedge themselves. That is also the case with offshore funds where the volatility of the rand can either boost a portfolio or diminish it in a heartbeat. There are several strategies that can be used to hedge against market downturns too.

This varies from put options, put spreads and fences that offset the downside in risk assets such as equities and bonds, says Kurt Benn, head of the balanced franchise at Absa Asset Management.

Kurt Benn Head of the balanced franchise at Absa Asset Management

“Rand hedge strategies are the cheapest and arguably the most effective strategy, especially when applied to developed market bonds,” he says. “This is generally the safe-haven asset class of choice when investors get fearful.”

In times of market stress there “is no substitute for high-quality government bonds”, says Michael Adsetts, deputy chief investment officer at Momentum Investments. “In equity market sell-offs, prevailing yields tend to fall, and the price of these instruments goes up.”

Arno Lawrenz Global investment strategist at Ashburton Investments

The S&P Global Developed Sovereign Bond Index, which includes locally-denominated government debt in developed countries, returned 2.06% since the beginning of the year. The S&P 500 Bond Index, which tracks the corporate debt of the constituents of the S&P 500 Index in the US, returned 2.3% this year. It is noticeable that this index fell by 13.6% between 6 March and 19 March to reach a low of 445.3 points on the latter date. It has risen by 12.5% since.

“The issue with these securities – such as US Treasuries and UK gilts – is that as prevailing yields are low, they look pretty expensive most of the time,” Adsetts says. “The diversification benefit for a portfolio is huge, however, so you have to look at them as a form of portfolio insurance. A little expensive to own when things are going well but you will be glad you had them when the going gets tough.”

Christo Lineveldt, investment specialist at Coronation Fund Managers, also touts the benefits of diversification, especially before a market event such as the coronavirus sell-off.

Christo Lineveldt Investment specialist at Coronation Fund Managers

Diversification is an essential strategy when constructing robust portfolios. However, one of the unique features of the coronavirus pandemic rout has been the universal sell-off of almost all asset classes, even gold, he explains. “Only cash and developed market bonds managed to preserve capital,” he says.

Shifting to cash

As investors piled into fixed-income assets, both offshore and locally, the question arose whether this move benefits them.

“If you’re a long-term investor, then absolutely not,” says Lineveldt. “Shifting from risk assets to fixedincome assets implies an attempt at timing, and timing the markets successfully is near impossible in a normal environment, not to mention during a crisis.”

The shift out of equities into fixed-income assets was driven purely by fear, says Arno Lawrenz, global investment strategist at Ashburton Investments.

“Given that the Covid-19 pandemic was of necessity a completely unknown factor, this meant that the ramifications – both economically and in a healthcare sense – would be similarly completely unknown,” he says. “Accordingly, faced with not just uncertainty, but with complete lack of knowledge, one could argue whether selling equities and buying fixed income was a rational thing to do.”

The primary effect of moving from shares into fixed income during a market downturn is that it can turn a temporary loss into a permanent one.

Taking the decision to move your funds from equities to fixed-income assets may, in addition to doing it without sufficient knowledge and amid uncertainty, lead to permanent losses.

“The primary effect of moving from shares into fixed income during a market downturn is that it can turn a temporary loss into a permanent one,” says Sangeeth Sewnath, deputy managing director of Ninety One (previously Investec Asset Management). “While the return from fixed income at that point in the market seems tempting, it is almost inevitably lower than the potential return as equity markets digest information calmly and return to normality.”

Many believe that that they will be able to step out of the market temporarily and return, but the reality is that while it is very easy to discern the points at which to return in retrospect, it is almost impossible to do so at the time of exit, he says.

Joao Frasco, chief investment officer at Stanlib Multi-Manager, shares a similar sentiment. “Most people never got this timing right, and certainly never ended up protecting capital in the process if they moved to bonds with substantial duration,” he says.

On the other hand, a move into shorter duration assets, with less interest rate risk, would have been the best strategy, he says. “But again, it required perfect market timing, not only in getting out of risky assets, but also getting back in. US Treasuries were the exception as they remain a ‘safe haven’ during times of market uncertainty,” Frasco says.

Offshore allocation

An allocation to offshore assets would have stymied the blow of the market rout to an extent. The rand depreciated by 35.4% this year and reached a low of R19.35 to the dollar on 3 April. This currency weakness supported offshore portfolios when their values are converted back to rand.

“Certainly it makes sense to have had a larger offshore allocation, but this is always an insight with the benefit of hindsight,” says Lawrenz of Ashburton. Against the backdrop of the rand’s depreciation, if you were invested in the S&P 500, you would – at the time of writing – be down roughly 12% since the beginning of the year in dollar terms, but 19% up in rand terms, he explains.

Lawrenz says that an important consideration in terms of performance is that if a crisis is global – as with the coronavirus pandemic – then economically vulnerable countries like South Africa generally have limited ability to respond financially and therefore their currencies generally depreciate. “In terms of hedging against global crises, it then makes enormous sense to have an offshore allocation,” he says.

Absa’s Benn also says that a larger offshore exposure would have translated into better performance and an improved ability to protect an investor’s capital.

“Our asset allocation modelling indicates an optimal long-term allocation to offshore assets ranging between 40% and 50%,” he says. “Given the rand’s inherent volatility, it is prone to bouts of sharp depreciation and appreciation.”

For such large exposure, Benn says they’ll consider a hedged equity strategy. Having an offshore allocation of 50% during a period of “significant rand appreciation is also risky as this will reduce returns in a material way,” he says.

PSG’s Ahern says the extreme volatility in the rand’s exchange rate, fuelled by both specific concerns about SA and worries about emerging markets, showed once again that while purchasing power parity and long-term trends may work in the long term, it is always “wise to diversify your currency exposure”. One of the reasons for this, regardless of the valuation of the rand, SA’s floating currency policy and the fact that the rand is very liquid, is that the rand acts as a shock absorber for local and emerging market sentiment, says Ahern.

Global stocks

The effects of economies around the planet – especially developed markets – grinding to a standstill will work their way through to the stock markets.

The UK’s Office of Budget Responsibility estimates that output in the UK will contract by 35% in the second quarter. Keith Wade, chief economist at Schroders, said in a recent webcast he expects the US economy to contract by between 22% and 25% in the same three-month period. Many companies are reliant on consumer spending to achieve revenue and earnings.

Even as the economic outlook gets more sombre, some investors have taken heart from the easy cash that is sloshing around the globe and its possible impact on company earnings.

“Equities have rebounded sharply from their recent lows driven by unprecedented global fiscal and monetary stimulus,” says Absa’s Benn. “This coordinated global effort has given markets the confidence to look through the coming earnings trough.”

Markets have discounted a V-shaped recovery to the extent that the forward price-to-earnings ratio of the MSCI World Index is higher than pre-pandemic levels, he explains. “This is a little premature as it leaves little room for disappointment,” he says.

Sangeeth Sewnath Deputy managing director of Ninety One

Lawrenz says an important consideration is when a vaccine or, even better, another drug treatment is discovered to treat the coronavirus. “This means the key question is how to exit from a lockdown strategy and how long it will be before that exit is completed,” explains Lawrenz.

Joao Frasco Chief investment officer at Stanlib Multi-Manager

If it takes too long, the economic damage to consumers and businesses becomes larger, according to him. “However, the speed and size of the fiscal and monetary stimulus on a global scale is almost unprecedented,” he says. “This must mean some sort of a backstop for risk assets and so the medium- to longer-term outlook for stocks is largely positive.”

As most fund managers use a bottom-up approach to stock selection, or rather look at a company’s fundamentals and thus prospects before buying it, it is not easy sailing through the murky waters of depressed global shares.

“Right now, it is taking extraordinary effort and skill to determine these [company] prospects, given the difficult trading circumstances forged by near-global lockdown,” says Ninety One’s Sewnath.

“Traditional metrics depending on dividends have been skewed by withheld dividends in key offshore sectors such as banks. The downdraught has pulled down the mighty together with the weak, and there are some very tempting situations, particularly in the North American market.”

Another view holds that before the outbreak of the pandemic, equities in developed markets were correctly priced.

“Our view throughout 2019 and into the crisis was that global equities, especially in developed markets, were fully priced and we were consequently underweight the asset class,” says Coronation’s Lineveldt. “Given the sharp sell-off, we are generally more constructive on global equities going forward as valuations are very attractive.”

Gerrit Smit Head of equity management at Stonehage Fleming

Once the pandemic has passed, he believes that companies’ profitability in developed markets will recover as they benefit from a combination of “unprecedented” fiscal stimulus, record-low interest rates, low energy prices and pent-up consumer demand when lockdown measures are lifted.

The outlook for shares in developing markets, however, are less rosy.

According to Lawrenz, the damage in emerging markets will potentially be substantially greater than in developed markets.

“For now, it makes sense to reduce or avoid exposure to them,” he says. “Some of these countries may experience systemic failure.” The focus should, at this stage, be on quality stocks in regions that have the combination of the ability to respond coupled with the willingness to respond, according to him.

Some funds are gauging what the world will look like following the pandemic.

“We believe we face a ‘new normal’ in many different aspects once the Covid-19 issues are over,” says Gerrit Smit, head of equity management at Stonehage Fleming. “Our dependence on technology may continue to increase and we believe the health sector will remain a focus area of many governments and continue to offer many solid investment opportunities.”

Smit has his reservations about whether world travel will soon return to normal levels and is worried about subsequent overcapacity in this sector.

Global fixed income

On the other hand, the fixed-income markets will likely remain resilient, especially government bonds. This is evident from the monetary and fiscal stimulus packages announced in all major economies.

“Global fixed-income markets will remain well-supported by massive quantitative easing programmes,” says Absa’s Benn. “Moreover, global central banks are committed to keeping interest rates low until we are well into the global economic recovery.”

Momentum’s Adsetts expects interest rates in developed markets to be low or even negative in some countries “for as far as the eye can see”.

Will this easy cash find its way to consumers in order to spend the economy back to life, or will it, as it happened after the 2008 and 2009 financial crisis, get pumped into assets, leading to asset inflation? “Many lessons were learned post-2008, and the prospect of seeing stimulus either stuck inside banks or spent on asset purchases and buybacks is an unpleasant one,” says Sewnath. “We believe that with the enormous monetary stimulus joined by fiscal stimulus, much sooner than at the comparable point in the global financial crisis of 2008, the money should reach its intended homes much more effectively this time around.”

Fund managers are divided about the inflationary outlook, which is a key consideration in the pricing of longer-dated bonds. The underlying debt of a bond is a fixed amount which gets eroded by inflation over time. The price that investors are willing to pay for a bond is dependent on the investors’ outlook on inflation, which gets discounted into the price.

The current environment is “inherently disinflationary” and therefore there should be no concerns about inflation in the short term, says Ashburton’s Lawrenz. “Monetary policy support through interest rate cuts do not easily translate into inflation as much of the world’s consumers are in lockdown, unable to resume normal buying patterns,” he explains.

The lower interest-rate environment – although not great in terms of returns for investors – may have an added benefit to companies who borrow in the bond market.

“It will also help leveraged businesses survive by cutting the cost of capital,” says Lawrenz. “Post the crisis, one may expect businesses to begin shifting global supply chains as risk assessments may point them away from the lowest cost supplier to the lower risk supplier. This may translate into higher input costs being passed on to consumers in time.”

Sewnath reckons it is too early to comment on the inflation prospects, “but given the catastrophe in job markets and subsequent expected slump in demand, inflation may be the least of our problems”.

From an economic output perspective, the global production setup may be key to whether inflation picks up or not.

“While the global economy will get back to work, there will be significant excess capacity in major industries such as hospitality, travel, tourism and retail shopping centres,” says Benn. “The excess fiscal debt will also be a long-term drag on economic growth.”

Therefore, taxes will need to rise “systematically to repay the debt”, he says. “These are large disinflationary forces which should support fixed-income assets.”

These high government debt levels may pose future financial risks.

“We remain very negative on developed market government bonds, given sovereign debt levels,” says Coronation’s Lineveldt. “For example, the US fiscal deficit in 2020 is estimated to be the highest since the Second World War – at up to 18% of GDP – and debtto-GDP is expected to eclipse 100% by next year.”

After two decades of declining inflation, he is concerned that “all of this fiscal and monetary stimulus will ultimately be inflationary over the very long term”. ■