A week ago, world markets were discounting a rapid recovery from the COVID-19 pandemic. Then the number of cases in America began to spike up. Until the middle of June there had been a steady downward trend and then suddenly the number of cases began to rise with 31 000 on the 20^th of June, 33 000 on the 23^rd, almost 39 000 on the 25^th and 44700 on the 27^th. Investor perceptions that the pandemic was under control evaporated and the S&P fell in response. From an intermediate high of 3117 on 22^nd June, the market fell 3,5% to 3009 at the close on Friday 26^th. It is now 6,9% below its cycle high of 3232 made on 8^th June 2020 and 11% below its all-time record high of 3386 made on 19^th February 2020. Consider the chart:

Here you can see the anatomy of the recovery on the S&P500 index. Since the recovery began on 23^rd March 2020, technical analysts have been forced to keep adjusting the steepness of their trendline, making it progressively shallower and shallower as investor perceptions of the recovery became less optimistic. The cycle high made on 8^th June 2020 at 3232 was just 4,5% below the all-time record high of 3386 made on 19^th February 2020 – indicating that the rally was not the “B” wave in an ABC bear trend. Following that cycle high, investors have discounted their fear of a second wave of the pandemic resulting in a correction in the S&P. Technically, we see the current correction encountering support at around 2970 (the level at which the S&P encountered resistance in April and May this year). You will also notice that on Friday last week, it broke back down through the 200-day moving average.

We have always said that the market would follow investors’ perceptions of the progress of the virus - and that is what we believe it is doing. Investors now fear that major parts of the US economy may have to return to some form of lockdown - and that is being discounted into the S&P.

Before the panic of the last few days, there was a growing gap between what the media was presenting and how investors were behaving. The media and various economists were painting a dire picture of collapsing economies, shrinking GDP and a second wave of coronavirus infections. They were emphasising how long it would take to recover from the pandemic. And until the last few days, investors were busy pushing up the S&P500 index and markets all around the world (including the JSE) towards the record highs that they made immediately before COVID-19 struck. So, the media story and investor perceptions were in direct opposition. Of course, doom and gloom scenarios always make for the best attention-grabbing headlines and they are always the preference of the media. In our experience, economists usually tend to simply extend the current economic trends and suggest that they will persist into the future – but they have limited expertise in the behaviour of markets.

It is also true to say that economists and journalists do not suffer financially when they are wrong. The same cannot be said for investors. They have billions, if not trillions, of US dollars on the line. Their mistakes translate into an immediate and significant loss. This means that investors are highly motivated to do their homework and to be as sure as possible about what the future holds. Furthermore, they make their investment decisions based upon their perceptions of where the economy will be at least a year in the future, not where it is now.

The problem is that no one can really know the full effects of the disjointed and clumsy mismanagement of the virus in America. At the moment, some sort of second lockdown, with a consequent impact on the economy, appears inevitable. But at the same time there are very encouraging indications that a vaccine is imminent. It seems probable to us, that in a year from now a massive campaign to vaccinate all adults in America (and elsewhere) will be underway.

As a private investor you need to try to balance the consequences of this recent spike in American cases against the distinct possibility of an effective vaccine by early next year. What seems to be clear whatever happens is that sooner or later, probably by the middle of next year, perceptions of the pandemic will cease to have the impact on markets which they currently do. Investors across the world are adjusting their positions to reflect what they see as the reality. Most of them had thought that the pandemic was declining in significance until the bad news of the last few days.

So how can you assess the situation? It seems clear to us that in the short term the spike in cases in America is likely to continue and perhaps get worse. But unlike the initial spread of the virus in March this year we now know what to do, to mitigate infection. We wear masks, practice social distancing and sanitise at every opportunity. These practises have been shown to reduce the rate of infection by 50% or more, which results in a far slower spread of the virus. So, we believe that this resurgence of the virus will not have the impact on markets that its first appearance had. Various states and cities in America will implement stricter measures, but it seems unlikely that the US economy will go into anything resembling a full lockdown. At the same time, we believe that the probability of a viable vaccine will steadily increase and be factored into investors’ decisions.

For these reasons we regard the current downtrend, once again, as a buying opportunity – but you must try to make your own assessment and decide how you want to respond.

We continue to believe that the pandemic is essentially a completely unpredictable “black swan” event within the greater long-term bull trend which began in March 2009. We believe that by the middle of next year that bull trend will once again be the dominant factor in markets - but that in the meantime, we will experience some quite sharp volatility.

Our Economy

In past Confidential Reports we have spoken of the three areas of reform which the government needed to address:

(1) The selling off of state-owned enterprises (SOE’s).

(2) The reduction in the size of the civil service.

(3) A shift in labour legislation to make it more employer-friendly.

All 3 reforms will bring the government into conflict with the unions. One of the effects of COVID-19 has been to bring these reforms sharply into focus as the government tries desperately to balance the budget without resorting to quantitative easing (Q/E). The easiest reform is to sell off or shut down some of the SOE’s. This will reduce the government’s need to be constantly bailing them out and provide some much-needed cash for the fiscus.

Tito Mboweni tabled his “adjustments” budget on 24^th June 2020. This was an almost impossible balancing act because of the parlous state of government finances before the massive hit of COVID-19. SARS is expected to collect R304bn less than was projected in the February 2020 budget and then there is the plan to cut spending by R230bn over the next 4 years – on top of the R160bn reduction of the civil service wage bill tabled in February. There is R40bn in tax increases planned for the next 4 years, but no detail on these. The government has raised $7bn from the IMF, World Bank and other international sources. All these factors will together leave us with a budget deficit of 15,7% - more than double what was expected in February 2020 budget. What is clear from this budget is that the direct cost of managing the pandemic itself was always far less than the cost to the economy of the lockdown – and that cost will only really be felt as the year progresses and into next year. Surprisingly, the treasury still believes that GDP will only shrink by 7,2% this year. At the moment, a major point in our favour is the fact that only 10% of the government’s debt is in hard currencies - the rest is rand-denominated. The only easy solution to the government’s funding shortfall would appear to be some sort of quantitative easing (Q/E) – but that is strongly opposed by the Governor of the Reserve Bank.

Both Tito Mboweni (Minister of Finance) and Lesetja Kganyago (Governor of the Reserve Bank) have warned that South Africa’s national debt is too high and unsustainable. There is a danger of the government falling into a “debt trap” where it will not even be able to pay even the interest on the debt. Kganyago says that South Africa is in danger of following in Argentina’s footsteps where they recently defaulted on some of its $65bn of international debt. The Governor warned that South Africa was potentially entering an era of much lower growth and lower incomes as it struggles to repay debt. At the same time Mboweni warned of a sovereign debt crisis over the next 4 years which would necessitate IMF funding.

To meet the requirements of Tito Mboweni’s adjusted budget, he says that structural economic reform is required, by which he probably means a significant cut in the size of the civil service and the rationalisation of state-owned enterprises (SOE). Mboweni is calling for “zero-based budgeting” which means not using the previous year’s budget allocations as a starting point and re-thinking allocations for everything in the light of current realities. This involves a great deal of additional work, but it is necessary in order to find the savings which he envisages. Every line item in the budget needs to be re-thought from the ground up. So, as usual, the question will come down to whether the government can actually implement what it has said it will. Theoretically, the budget has been approved by parliament and so should be put into practice, but often the reality ends up being substantially watered down. Implementation has never been the ANC’s strong point.

The ANC will have to re-think many of its “holy cows” and try to decide whether they are still relevant in the post-lockdown era. Those holy cows include the retention of hundreds of pointless and often unprofitable state-owned enterprises that have been, and promise to continue to be, a drain on the fiscus. It means thinking again about the balance between labour and employers to balance the legal framework more in favour of the employer. It means the acceptance of the idea that the government cannot and should not try to solve the unemployment problem by employing more people. Rather it should do everything it can to encourage the private sector to grow and create jobs. The imminent showdown with the civil service unions should reveal much about how the ANC will be able to reinvent itself.

The civil service unions have already rejected Tito Mboweni’s R160bn unilateral adjustment of the government agreed 3-year wage deal with them and are engaged in legal action. The lockdown temporarily postponed this matter and now Mboweni has delegated Titus Mchunu, Minister of Public Service and Administration, to handle the court actions and arbitration which have arisen as a result. Mboweni’s problem is that a reduction of the civil service wage bill is the only practical way to balance the budget without resorting to Q/E.

Letsetja Kganyago, governor of the Reserve Bank, is of the opinion that South Africa is “not yet” in a position where it needs to resort to quantitative easing (Q/E). He notes that those countries which were currently undertaking Q/E had run out of other monetary policy solutions whereas South Africa had not yet reached that point. This statement does, however, envisage a point where Q/E will become appropriate and we believe that it is inevitable given the government’s lack of funds and our low inflation rate. Kganyago says that we will only employ Q/E if the economy is facing a deflationary cycle. But inflation has now fallen to 3% in April 2020 (the lowest level for 15 years) – so maybe Q/E will begin. The printing of money in this way obviously offers the government an easy mechanism to get around its funding problems and, with inflation falling to record lows, it seems unlikely that it will result in a major loss of purchasing power of the currency – at least in the short term.

Following the 2008 sub-prime crisis, the government was able to put together an R800bn stimulatory package to help the South African economy. In 2020, the government could only muster R500bn and R130bn of that had to be taken from the existing budgets of various government departments. Given the effects of inflation, the current R500bn package is less than half of the 2008 package – which is a clear indication of the depletion of government resources in the intervening 12 years – mostly due to the Zuma/Gupta administration.

The unemployment rate in the first quarter of 2020 rose to 30,1% - a new record high. If those who have given up looking for work are included, then the number rises to almost 40%. Obviously, these numbers do yet not reflect the impact of COVID-19. That will only become apparent in the second quarter – which will hopefully be the worst quarter. In the third and fourth quarters some recovery should be evident. At the same time, the Reserve Bank’s leading indicator fell by 5% in April month compared to March – the largest single-month fall on record. Obviously, April was a month of full lockdown when business throughout the country was brought to a virtual standstill. Again, we can expect better figures in May and June. In our view, the recovery will be relatively sharp – and that can already be seen in the JSE Fin30 index:

This chart clearly shows the “V-bottom” in the JSE’s 30 largest financial and industrial shares. It shows that investors are anticipating a very rapid recovery in the economy. This is probably because of the expected rapid take up of unutilised capacity which now exists.

The government’s plans to revive the economy post-COVID-19 will take the form of infrastructure projects. An initial list of 55 projects has been selected from 188 possible projects. These projects will be private-public partnerships which should reduce the need for government financing or guarantees. The projects are for the development of roads, housing developments, ports, and energy. Obviously, if this plan is put into effect, it will impact on the decimated construction industry – which has lost much of its skill base over the past ten years. Nonetheless, companies with the required expertise will be undoubtedly found and projects like this will certainly create rapid employment. But the plan is similar to the plans of the Minister of Economic Development, Ebrahim Patel, in 2014 to undertake about 650 infrastructure projects – most of which never got beyond the planning stage. Hopefully, the government’s current initiative will be pursued with more enthusiasm.

The internal “discussion document” prepared for the ANC on the question of funding for infrastructure projects in the post-COVID-19 economy is understandably vague. But it does talk about reducing the cost of finance through requiring asset managers, especially the public investment corporation (PIC) to invest directly in these projects – which is in effect a system of “prescribed assets”. The system of prescribed assets was introduced by the National Party when it was in power when it forced pension funds and other asset managers to invest a percentage of their funds into government bonds thus helping to finance government projects at lower rates of interest than market rates. Big institutions already invest heavily in government bonds, but they do so through the bond market at market-related yields which take into account the risk inherent in investing in South Africa. Obviously, the recent downgrade to “junk status” has pushed up the cost of financing for the government which makes it far more expensive to fund infrastructure projects. With the governor of the Reserve Bank dead set against any type of quantitative easing (Q/E), prescribed assets offer a potential solution – but are disapproved by the investment community generally because they are an interference in a free market and artificially lower interest returns.

The R26bn that it will take to pay off all the debts of SAA and then recapitalise it as a “new” airline in terms of the business rescue plan is ludicrous. It comes on top of the R30bn which the company had previously received in bailouts. Firstly, of course, it will not be a “new” airline in any real sense since the idea is to buy all the shares of the existing company and take on its existing staff. The net effect of this will be that SAA has cost the taxpayer more than R50b over the past 20 years. The rescue plan says that the government supports the plan because SAA is a “national flag carrier” – which shows that this action is all about ego – an ego which this country simply cannot afford at the moment. Notably, nothing was said of the R26bn rescue of SAA in Tito Mboweni’s adjusted budget on 24^th June 2020. Apparently, the Treasury and the Ministry have to produce a letter of commitment by 15^th July 2020 for an initial R10,4bn. Hopefully that won’t be forthcoming, and they will allow SAA to go into liquidation.

Vehicle sales and manufacture are a good proxy for the economy’s recovery. The last two vehicle manufacturers began production again at the beginning of June 2020 and will ramp up production in the coming months. April had almost no vehicle sales, but May was considerably better. Up to the end of May, however, exports were running 41% behind last year. At this stage it looks like vehicle sales for 2020 will be about 25% lower than last year. Local sales and sales to the rest of Africa were already depressed before the lockdown. There will probably be some pent-up demand, especially from key export markets.

The Democratic Alliance (DA) is proposing a radical shift in economic policy including selling off or closing unprofitable state-owned enterprises (SOE), opening the electricity market to free competition, abandoning the policy of land expropriation without compensation, abandoning the national health insurance (NHI) and black economic empowerment (BEE). What is interesting is that they make no mention of reforms to labour legislation in favour of employers. Obviously, South Africa, in the wake of COVID-19, cannot afford anything which is not productivity enhancing. The economy needs to be rapidly streamlined for growth. However, most of the DA’s suggestions are probably politically impossible for the ANC even in the face of COVID-19. What is clear to us is that the government needs to cease being the source of jobs in the country and focus on encouraging private enterprise to create jobs. The essence of this is the understanding that only private enterprise creates surpluses in the economy – everyone else lives off those surpluses, including the government and all its employees. The larger the government gets, the smaller private enterprise gets. Adam Smith famously stated this in his concept of a “laissez-faire” economy where the least government was the best government.

A footnote to Tito Mboweni’s budget was the fact that R3bn had been allocated to bail out the Land Bank which carries 29% of South Africa’s agricultural debt. Mboweni had no choice in this matter since the Land Bank’s defaults had triggered defaults on about R50bn of state guaranteed debt. Apparently, the bank had allowed its interest received to fall below its interest paid over a number of years. This is an example of bad banking. Every bank charges more interest on what it lends out, than it pays on money that it borrows. That is known as the “mismatch factor”. And this year is shaping up to be one of the best for agriculture with massive surplus production which can be exported to generate foreign currency. It seems to us that the Land Bank has been badly mismanaged.

The full impact of the lockdown on the economy can be seen in the National Payment System which now shows that 13% less was paid in salaries and wages in May 2020 than in May 2019. This indicates that thousands of people lost their jobs during the lockdown or drew a lower income from their employers. This comes immediately after the publication of the unemployment statistics reaching a record high above 30%. Obviously, this will reduce consumer spending in the coming months.

The Rand and the Long Bond

The rand/US dollar exchange rate and the effective yield on our government long bonds provide a good benchmark for the attitude of overseas investors towards South Africa. If the rand is falling and the yield on the long bond is rising, then that shows that overseas investors are dumping their South African assets and taking their money out of the country – and vice versa.

The yield on the long bond spiked up during the early stages of the COVID-19 pandemic as overseas investors shifted rapidly from “risk-on” to "risk-off” taking their money out of emerging markets and putting it into safer assets like US treasury bills. Since the initial spike, however the yield has come back down to more normal levels, partly because of the Reserve Banks interventions, but mostly because of a return of overseas enthusiasm for the yield to be obtained, especially after our relatively low inflation rate is taken into account. The current resurgence in corona cases in America has caused a slight return to risk-off sentiment which can be seen in the rising effective yield on the R186 in recent days. Consider the chart:

What is clear from this chart is that while the yield has certainly increased in recent days, it remains at levels which existed before the pandemic – which indicates that sentiment remains positive towards emerging markets and South Africa in particular. You should watch this yield, however, for any sign of a strong return to risk-off sentiment.

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