March 2021 Update
Making the News
It has been just over a year since most countries went into hard lockdown. In both developed and emerging markets, the recovery of economic activity and asset prices from the March 2020 low levels has positively surprised market participants. To quantify this, the FTSE/JSE All Share Index (a proxy for SA equities for example) has delivered a return of +54% over the last year (01 April 2020 to 31 March 2021).
South Africa’s inflation came in below the consensus forecast at 2.9% year-on-year in February (one month lag) bringing it below the target range of between 3% and 6%. Despite this, the South African Reserve Bank (SARB) left the repo rate unchanged at 3.5%. SARB last adjusted interest rates on 23 July 2020, when it cut the repo rate by 0.25%.
In contrast, the Federal Reserve in the US reaffirmed that rates would remain constant over the short to medium term, and that inflation is not a problem, but the market is concerned about an upside surprise (higher than c.3%) in the current inflation cycle. Stimulus packages implemented by global central banks and the U.S. Government ($0.9trn in December, $1.9trn in March and a further proposed $2trn later this year) has given rise to the concern that stimulus packages will be the catalyst causing inflation to be higher going forward.
Turkey’s President Recep Tayyip Erdogan had fired his central bank governor after only four months in office, following the latter instituting a surprise interest rate hike of 2%. The resultant effect was the Turkish lira losing about 15% of its value before clawing back some of these losses. Fortunately, little spill-over effects trickled down to the Rand, which remains stronger than it was at the beginning of March.
The ongoing positive commodity backdrop was supportive for the Rand as it appreciated slightly against the US dollar during March. The MSCI World Index increased 2.9% in dollar terms (+0.7% in Rands) during March while the Emerging Markets Index declined 1.5% (-4.0% in Rands).
In the SA equity market, the FTSE/JSE All Share Index returned +1.6% for the month, while the Capped SWIX did even better, returning 3.7%. These returns were boosted by continued strength in the Platinum Group Metal (PGM) basket and gold shares, select industrials like MTN and British American Tobacco, and financial shares. However, index returns were held back by specific weakness in Prosus (and to a much lesser extent Naspers) as Tencent (amongst other Chinese tech stocks) came under short term price pressure.
Globally, investors are concerned about inflation picking up. An increase in inflation has the effect of increasing bond yields (which is the reason why the US 10-year Treasury yield rose to c.1.8% during March, the highest point since January 2020).
The volatility in the SA bond market was driven by the weaker bond market globally, exacerbated by a weak local SA sovereign bond auction and ongoing political infighting and tension within the ruling ANC. Inflationary pressures have picked up in several emerging market peer countries arising from a rise in food prices as well as the rebound in oil. This prompted a pre-emptive start to the interest rate normalisation cycle in countries such as Turkey (+2%), Russia and Brazil (+0.75%). Rising long bond yields in the US & SA coupled with interest rate increases from peer group emerging markets resulted in the SA bond index ending the month down -2.5%.
Impact on Our Portfolios
The CWM model portfolios were up reasonably during March on the back of good equity and property returns. Pleasingly, our model portfolios have rewarded investors with robust performance over the last year. To quantify this, returns across the risk spectrum (excluding CWM Income) ranges from +20.3% (CWM Defensive) to +38.2% (CWM Flexible). When measured on a relative basis, the model portfolios with high growth asset exposure have outperformed their ASISA categories on average by +4.5% over the last year.
The risk on environment during Q4 2020 up until end of Q1 2021 has been supportive for the CWM model portfolios. As a result, we are observing a pick-up in the five-year performance in the graph above and expect returns to be strong going forward, with the inevitable element of volatility.
To conclude, we attempt to answer three key questions that influence the future economic and market outlook:
- What will be the effect of a third wave of Covid-19 (or even a fourth, if vaccine rollouts continue to be so slow)?
The graph above shows that the Covid-19 vaccine rollout was implemented swiftly in Israel, the United States, and the United Kingdom. South Africa and Europe are notable laggards in this regard. Infection rates are climbing in certain countries (i.e., France and Germany) given the ineffective implementation of their lockdowns. The vaccine rollout will not be smooth, and some countries are better placed than others.
Overall, the distribution of Covid-19 vaccines is expected to remain low in many areas, contributing to the expected uneven pace of the global economic recovery. On the positive side, South African scientists suggest that antibodies generated in response to infections from the coronavirus variant first found in the country can protect against other strains of the virus and may allow for more effective vaccines. Therefore, vaccines with this variant might provide cross-protection against other variants. Public health authorities in SA continue to caution a third wave of Covid-19 virus infections to be probable in coming months which remains a key risk to the expected recovery path.
2. What are the implications for inflation and for interest rates given the unprecedented fiscal and monetary stimulus?
US inflation appears to be well contained but the base will start to become more challenging in the months ahead. The inclusive employment and average inflation targeting policy should support the lower-for-longer rates argument, despite the rise in inflation which could surprise the market.
On the domestic front, under current circumstances, the implied policy rate path of SARB’s Quarterly Projection Model (QPM) indicates two increases of 0.25% in the second and fourth quarters of 2021. The QPM model’s projections appear to confirm that we have reached the bottom of the interest rate cycle unless there is a much more meaningful change in the country’s inflation and/or growth dynamics.
While SA consumer inflation remains well contained and subdued, there are three key areas of concern that can explain SARB’s most recent policy decision; namely: petrol price increases, electricity tariff hikes and low capital inflows from foreigners. Thus, SA’s inflation rate is expected to rise to around 5% through to the middle of 2021, averaging 4.3% during 2021, before rising modestly to an average of 4.5% in 2022.
3. Lastly, what outcomes have been priced into the valuation of equities and bonds?
Projected earnings growth for SA equities is robust and well supported by strong cyclical growth drivers from resources and domestically focused shares coupled with a structural growth component from the technology sector. Earnings growth is expected to be the key driver of shareholder returns from current levels, which have already enjoyed a strong re-rating on these expected earnings levels. Therefore, we expect very strong returns from equities going forward, albeit at a high level of volatility.
SA bond yields rose from 9.2% to 9.7% while US bond yields rose from 1.4% to 1.7%, resulting in a wide spread of 8.0%. This implies that South African bonds became riskier at the end of March than they had been at the beginning of that month. This is not the case as South Africa’s fiscal position is slightly better, progress is being made to curb corruption, improvements have been made in the energy supply situation, and the better-than-expected income collection by SARS resulting in lower weekly bond issues will result in a better demand/supply balance. Historically, bonds have delivered returns at lower levels of risk compared to equities. Based on current yield levels, we consider South African bonds to offer good risk-adjusted value.