It doesn’t take much more than looking at the daily news headlines to conclude that most of the risks that lie ahead this year will be related to the ongoing global pandemic.
The recent economic recovery has been driven by an increase in business and consumer sentiment. This confidence could prove premature, and if it does turn out to be wishful thinking, South Africa could experience a boom and bust cycle, during which periods of economic expansion and contraction alternate – and ultimately add to the exceptionally bumpy ride we’ve experienced since COVID-19 made its presence felt.
This recent positive turn in sentiment largely rests on the expectations of a highly efficient vaccine bringing with it the light at the end of the tunnel. To us, any potential setbacks to this good news would pose the most risks to economic and financial performance in 2021. Questions to contemplate when considering vaccine-associated risks include: We know now that COVID-19 continues to mutate, but could this eventually render the vaccine ineffective? Is the South African government failing to procure enough COVID-19 vaccines, thereby opening the door for further waves of infections and more hard lockdowns? Will serious side effects emerge after being vaccinated?
Alongside these most immediate risks, are the second-round effects of the pandemic. The first that comes to mind is the highly problematic increase in South Africa’s debt-to-GDP ratio. We had already been speaking about a fiscal cliff and a debt trap before this pandemic hit. The renewed rise in sovereign debt as a result of measures to counter the devastating impact of lockdown has now risen to even more unsustainable levels that could easily trigger a sovereign debt crisis – which we see as the largest risk to our local bond market, as well as to our currency exchange rate.
Outside the risks posed by the Covid-19 crisis itself, the world faces a threat to financial stability. Globally, central banks are running the most expansionary monetary policy stimulus programmes in human history in conjunction with equally stimulatory, well-coordinated fiscal stimulus packages.
Capital markets have become dependent on the continued injection of money into financial markets. The consequences of removing the supply of cheap money – an unavoidable decision policymakers will have to face – could be unprecedented. We don’t foresee this risk materialising in 2021, but it is certainly something that we need to start factoring into our expectations about the future already. This is especially true in the context that we all know that global authorities’ current policy measures are unsustainable, to say the least.
The most worrying side effect of these historically unprecedented expansionary fiscal and monetary measures is that they could result in higher, or even a prolonged escalation, in inflation rates.
While we can’t see any evidence of these symptoms arising yet, we must remain vigilant and acknowledge that inflationary shocks can emerge much faster than expected for various reasons.
We do not expect a demand-driven supply shock, but what if we see a simple acceleration in the velocity of money? Once we observe a revival in the confidence-driven animal spirits that our economic system relies on globally, we could see more money being put to work than ever before. While this remains a tail risk, for now, we want to highlight that there are no long term studies into the economic ramifications of financial conditions that are as easy as they are right now. So we are in uncharted territory.
From a socio-economic perspective, our biggest concern is the growing inequality. Inequality has been an ongoing issue, and it has been one of our primary concerns for years now. The arrival of Covid-19 has propelled the problem to an entirely new level. To be clear, this does not only apply to South Africa but is a global phenomenon. With the oversupply of easy money, the wealthy are participating in a prolonged market recovery that could rally to new all-time highs. The less affluent, however, have not participated in the economic or financial rebound. The damage inflicted by lost jobs, for instance, often turns out to be permanent for them.
We are pretty sure that once the pandemic is more under control and the dust finally settles, there will be a deeper investigation globally into the source and the cause and the appropriateness of actions taken during this pandemic. A continued deterioration in the US-China relationship, perhaps even a continuation of the trade war, could all be potential outcomes. President Biden’s election may not change these risks because it is not obvious whether his stance towards China will be dramatically different from President Trump’s. If we turn the attention away from trade wars and China, Iran’s increased uranium enrichment and the nuclear program could once again stoke tensions in the Middle East.
Different risks introduce different downside scenarios. However, with so much money in the system, we think a synchronised deflation in prices across asset classes could hit market participants hardest. We saw this already partly playing out in March 2020, when correlations jumped to all-time highs, and traditional asset allocation decision making became significantly more challenging. Once asset classes move in perfect sync, it becomes difficult to find a place to hide – you have to be exposed somewhere, and cash is not an attractive long-term investment.
Risk management is going to be as crucial this year as it was in 2020. The key will be to run asset allocations through different systematic scenarios, understand the importance of deleveraging, and measure how individual asset classes contribute to overall risk exposure. Investors who understand the structuring concepts behind the creation of asymmetric payoff profiles will also gain a potential edge in a heightened risk environment. We cannot avoid risks, but we can focus on taking calculated risks that continuously optimise our funds’ risk-return profiles.
‘Forewarned is forearmed’ has never seemed as relevant as it is this year. With 2021’s many potential risks that lie ahead, surviving – and hopefully thriving – the year will require investors to stick to many of the tried and tested investment principles. Investment decisions will need to be well-considered, even more risk-conscious than usual, unemotional and still focused on the long-term objectives you aim to achieve long after this crisis has passed. DM/BM