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11 Mar 2020

Current Market Volatility and Implications for Foord Investors

Panic reverberated across world markets on Monday, 9 March, fuelled by the spread outside of China of the Covid-19 virus, and the slump in oil prices following the all-out oil price war between Saudi Arabia and Russia. The oil price (Brent Crude) had already slumped from $69/bbl to $50/bbl before the surprise OPEC disagreement which saw it cratering to a low of $32/bbl, before bouncing back to $37 on 10 March.

There is high uncertainty of future infection rates of the virus and its severity. The potential implications for global business and household demand for goods and services (which affect global supply chains) have already caused serious angst amongst global investors. World equity markets, emerging market currencies and high-yield / “junk bond” credit assets have fallen meaningfully as investors rushed to safe-haven assets, mainly US treasuries and gold. 

The Federal Reserve lost its nerve and cut the Fed Funds Rate by 0.5% during an unscheduled meeting in an attempt to stave off a pandemic driven broad-based economic contraction. The 1% lower bound of the Fed Funds Rate is well above the yields on all US Treasury bonds except the 30-year bond (as at 9 March 2020), leading to market speculation that the Fed may further reduce short-term rates end March, to 0.5% - 0.75%. Unscheduled and unexpectedly large rate reductions by central banks generally do not instil market participants with confidence. In addition, monetary policy stimulus will likely be of little use to counteract the economic consequences of the outbreak.

Times of panic in financial markets are characterised by a fall in liquidity and a broad-based selling of assets as investors rush for the exit doors. The increase in leverage in the global financial system over the last decade has increased the risk of loss in the current cycle. While the focus currently is on the US high-yield debt markets (with its relatively large weight in energy companies) risk of contagion is likely to spread to businesses outside of this sector. The general slowdown in economic activity and loss of earnings due to disruptions in the global supply chain will affect free cash flow and bring many businesses to their knees.

Whilst many companies will likely suffer some degree of permanent capital loss, given the likely pressure on earnings and balance sheets, there are also many companies that are relatively well positioned to withstand the short-term economic headwinds. However, when markets are gripped in a sentiment/fear driven sell off, even the better quality and better positioned companies get sold off too. This provides long-term investors, who have the liquidity available in portfolios, to buy into these companies at attractive price levels. The good news is that there are many examples of these businesses in our research universe, and we have for some time maintained elevated levels of portfolio liquidity (cash and cash proxies) across the Foord funds, in anticipation of precisely these kinds of opportunities. Whilst nearly impossible to have forecast the specific market correction catalyst in this case, we have been positioned for such an event which is so typical of late-stage market rallies.

While there is much uncertainty in the short term which is likely to keep volatility high and markets under pressure, there are also increasing opportunities that will likely be unaffected in the long term, and this is where we are focusing.

The Foord portfolios are well positioned for the unfolding environment: 

  • Full allocation to foreign assets (where mandate and regulation allows) and non-resource rand hedges in the domestic equity component has protected investors to some extent
  • Market hedges on the S&P500, in place since early January and extended in the early days of the virus outbreak in China, have meaningfully protected investor capital in the foreign component of funds
  • No allocation to lower quality, high yielding debt securities, which are most vulnerable in the current environment
  • Allocation to physical gold (via ETFs) has proved its diversification worth every time volatility has spiked, providing further investor protection
  • Significant allocation to high coupon, short duration SA government bonds has anchored the portfolios well
  • Equity allocation focused on high quality companies that are well positioned to weather the short-term volatility (the only meaningful performance detractor through this period has been Sasol, which has been caught in a perfect storm)

Volatile markets provide investors with significant long-term investment opportunities. We have been preparing for such for the last three years. 
 

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