This year’s Budget Speech occurred against the backdrop of a deep and sustained global equity sell-off as investors reacted to the rapid spread of the COVID-19 coronavirus worldwide. While generally well received, the market impact of the Budget was overshadowed by these global developments. It is a reminder that global matters more than local when it comes to investments.
Rapid spread, rapid selling
Losses on major global equity indices reached double digits in the space of only a few days, indicative of panicked selling, not reasoned portfolio repositioning. While the spread of the virus inside China appears to be slowing down, it is accelerating elsewhere in the world. The sharp rise in risk aversion is centred on fears on the spread of the coronavirus to many countries around the world – including Korea, Italy, Iran, Brazil and the US – and that the same draconian measures to contain the outbreak adopted in China will be applied elsewhere. These have been deeply disruptive to economic activity, impacting both demand and supply.
In other words, although the virus is deadly for around 3% of people infected (with most experiencing only relatively mild symptoms and making a full recovery), the economic shock is a result of the steps taken to halt its spread. It remains to be seen whether other countries will follow China’s lead and adopt large scale quarantines, business closures and travel bans. Imagine for instance the negative impact of cancelling the upcoming Tokyo Olympic Games.
Chart 1: Global equity indices rebased to 100
Source: Refinitiv Datastream
While each death is tragic, we tend to have a very skewed perception of risk during events such as these. Almost 3 000 deaths have been reported worldwide so far, mostly in China. It is worth noting that more than 3 000 people die every day from vehicle accidents. The World Health Organisation estimates around 650 000 annual deaths (1 700 per day on average) from seasonal flu. This is as tragic, but perceived as normal.
There is likely to be severe underreporting of cases in poorer countries where accurate diagnosis is difficult. We have to assume therefore that COVID-19 will continue spreading until a vaccine is developed. Does this mean the market is complacent or overly concerned? Only time will tell, but four things need to be borne in mind.
Firstly, markets tend to overreact both on the upside and the downside. Secondly, the sell-off follows a strong rally late last year and into January. Thirdly, while the world economy will suffer a blow, possibly a sharp blow, it should be temporary. Once the outbreak runs its course, economic activity can resume. The price of a share reflects the discounted present value of its future profits, not just profits over the next two or three quarters. Fourthly, policymakers stand ready to act to cushion the blow (more on this below).
As investors rushed out of equities and other risk assets, they sought the safety of the US dollar which weakened the rand and other emerging markets. Again, this completely overshadowed the Budget. The weaker currency has somewhat cushioned the impact of global equity declines for local investors. Investors also piled into bonds, driving down global bond yields. The global benchmark US 10-year yield slumped to a record low of 1.2% (bond prices and yields move in opposite directions). In a climate like this, global investors are not keen on relatively risky South African bonds, but these ultra-low yields do place a lid on how high local government bond yields can rise even in the event of downgrades or other nasty surprises.
Chart 2: Global 10-year government bond yields
Source: Refinitiv Datastream
Budget bit the bullet
Which brings us to the Budget. Most South Africans tune into the Budget simply to find out if their taxes will go up or down. Some taxes, like the fuel levies and ‘sin’ taxes on tobacco and alcohol, always rise since they are not percentage-based. They have to be adjusted for inflation. However, this year the news for taxpayers was pretty good. Faced with a massive tax revenue shortfall (due to a weak economy) and rising spending pressures (SOE bailouts), government decided not to attempt milking taxpayers more with major tax rate increases. In fact, there is some relief (R2 billion) for bracket creep. Put simply, the weak economy cannot stomach higher taxes at the moment.
Instead, government bit the bullet and cut projected non-interest, non-bailout spending. In particular, the big announcement was a R160 billion reduction in the wage bill over the next three years. This does not mean civil servants will see salary cuts. It simply means that the growth in salaries and benefits will slow relative to what was projected at last year’s Budget. The wage bill will still grow, but slower than inflation over the next three years if things go according to plan. Crucially, though, this will depend on negotiations with public sector unions that have already expressed their hostility to the idea.
The willingness to tackle the wage bill, which had become unsustainably large, is the main reason why commentators and investors gave the Budget the thumbs-up. However, these measures are really only scratching the surface as the budget deficit will still average more than 6% of GDP per year over the medium term, with the total debt to GDP ratio set to rise above 70%.
This is not high by global standards, but the International Monetary Fund has flagged it as uncomfortably high for an emerging market since it means there is almost no buffer to a future shock (such as the global pandemic). The debt ratio continues to rise rapidly and since government pays a high interest rate to borrow, interest payments are eating a larger and larger portion of each rand. It is the fastest growing single item in government expenditure. With no major new announcements on raising economic growth, the Budget arithmetic remains extremely challenging.
The biggest internal obstacle to economic growth is simply excessive government intervention in the economy, which while mostly well-meaning, is ineffective at best and harmful at worst. Eskom is a case in point: a monopoly electricity provider that cannot provide enough electricity, despite the tripling of tariffs and the surge in borrowing. But there are many mini-Eskoms scattered through the towns and cities of South Africa. Minister Mboweni has been beating the drum on this topic for a while, but he has yet to convince his colleagues in Cabinet. If there is a sustained global slowdown because of the coronavirus, it will weigh on South African growth too, and ultimately put more pressure on government’s finances.
The dreaded downgrade
What are the ratings implications? Ratings agencies provide an opinion on the creditworthiness of a borrower. They each have a scale running from AAA to D which indicates how likely a borrower is to service and ultimately repay its loans. In a weak economy, with tax revenues under pressure and spending demands high, the government’s ability to service its debt is somewhat lower. Hence, Fitch and S&P have assigned a sub-investment grade (junk) rating, and Moody’s is likely to do so too. However, there is no real danger of the South African government defaulting on its debt, as Argentina seems set to do (for the seventh time in the past 100 years). Most borrowing is in rand and there is a large savings pool available to fund the government if the price is right. And that’s the key question we all need to ask: does the price of South African bonds, equities and the currency reflect the risks? By and large, it does.
CHART 3: Actual and projected Gross Government Debt-To-GDP Ratio, %
Source: Refinitiv Datastream
Time for a fiscal rethink
There is another relevant global context, namely that the role of fiscal policy is being reconsidered. When the dust had settled after the Global Financial Crisis, many politicians and commentators were suddenly gripped by fear over the surge in government debt across the developed world. Never mind that government gearing was simply offsetting private deleveraging and that interest rates were extremely low (they’ve since declined even further). Rather than focus on nursing their economies back to health, there was a vicious turn to austerity (cutting spending and raising taxes).
But now there is a growing realisation that fiscal stimulus has a role to play given that we have achieved the limits of where monetary policy can push us. Zero, even negative, interest rates cannot lead to an economic boom if private borrowers don’t want to borrow. But it does mean that governments can borrow to make productive investments that will raise growth and pay for themselves over time. One person who has taken this lesson to heart, or the first part of it at least, is Donald Trump. The US president has increased the federal budget deficit to 5% of GDP, the largest increase in debt outside a war or recession, mostly in the form of company tax cuts. There has been no investment boom though, so it ultimately represents a missed opportunity. It also leaves the government with less room to manoeuvre should a recession hit one day.
COVID-19 might finally be the trigger that unleashes global fiscal spending. The realisation that we need to rebuild much of the global energy infrastructure to avoid further catastrophic climate change might be another.
Value of diversification
We are not making any substantial changes to the strategies we manage at Old Mutual Multi-Managers. They remain appropriately diversified for the return targets. We are overweight fixed income, and this has been defensive, while the weaker rand has offset lower global equities. We remain underweight South African equities, but the asset class is offering value and we will consider increasing the weight. Diversification remains the best defence to unpredictable events and means one doesn’t have to make panicked responses.
In summary, much of the recent selling is clearly fear-driven, and we should avoid falling into the same trap. Very weak economic numbers for the first few months of the year can be expected from many countries, so this shouldn’t cause a surprise. But the weakness is highly likely to be temporary. If you have a long-term horizon, consider that the outbreak is not going to be raging five, ten, twenty years from now. However, in the current uncertain environment, market volatility will probably be high so investors should exercise caution. As always investment decisions should be based on your financial plan and not on what other investors are doing.