Just when we thought it was time to “take risk”, following a phase one US-China trade deal and many factors leading to an increasingly favourable market environment, it became clear by February that COVID-19 was spreading exponentially through the Chinese mainland.

At the time we highlighted the likely impact of supply and demand shocks feeding through to the economic data and market dynamics over the next quarter. The extreme response from China to contain the virus meant we could expect a soft patch for markets, assuming that the virus would not cross borders.

We were not so fortunate. The virus has now spread to multiple countries with a significant impact on Italy. Markets took in the reality of worldwide contagion and the impact of limitations on human movement, supply chain disruption and the potential shock to what was, until then, a seemingly “bulletproof US consumer”. The market moved quickly to price in the negative feedback loop of declining growth, earnings and short-term cashflows, especially in an environment characterised by over-indebted capital structures that support rich equity prices. This price reaction stretches from the negative equity moves to an aggressive move across to “safe” sovereign bond curves and an adjustment in currency markets, most notably the yen. All of these point to significant fear and to some degree, rightly so.

In our minds the “draconian” virus containment in China, followed by the closing down of Italy, is too late, and the spread will continue. The reaction from various governments, and more importantly society, may well dictate how extreme the economic impact is.

As was the case in late 2018, the US Federal Reserve has cut rates by 50 bps in an emergency meeting (despite continued strong economic data) in an effort to shore up market confidence. The futures market is pricing in further cuts by the Fed this month. Central Bank commentaries around the world are unanimous in their statements around “standing ready to act”. We believe they have taken and will continue to take action. The virus has stirred credit markets because of the potential cashflow impacts of supply chain disruption, and stocks have begun pricing in some really poor earnings results.

Oil has sprung a leak, adding to market fragility

The announcement about the breakdown of OPEC agreements, more specifically Russia declining to join OPEC in curbing oil production, and subsequently Saudi Arabia slashing oil prices, has effectively ushered in a short- term price war between the two largest exporters of oil. Oil, which is a highly leveraged sector in US junk and high yield markets, has sprung a leak.

The market adjustment to an oil price drop has impacted global equities dramatically again, at a time where fear is already elevated. It remains to be seen if this is something that is resolved quickly or if it is a longer- term play against US shale markets. Clearly, leverage (or capital structure) is a concern when looking at a company like Sasol, whose equity was down approximately 80% between 9 and 12 March. BHP, a diversified resources company with around 25% of its EBIT coming from energy, was down approximately 20% for the same period. Both highlight the risk to equities in highly leveraged corporates. To be clear, BHP is not excessively leveraged, but it is leveraged to the cycle, despite being a so-called rand hedge!

In 2015/2016, we saw similar issues in credit markets among material companies. This time, the system and corporates are more leveraged, and we are at peak margins and elevated equity multiples. As a result, the speed of the move lower in equity and yields and, more widely, in credit spreads was eye-watering. In our minds, the combination of these two events has materially increased the risk to the constructive outlook we provided only a few weeks ago.

We believe markets move economies and right now the market is screaming for “support”. A co-ordinated fiscal response from superpowers is probably looming. Will it come quickly enough? Will it be enough? We have learnt not to “fight the Fed”, but a fear-induced demand and supply shock is creating a potential economic air-pocket. The impact on growth is hard to quantify but it will be poorer than current consensus. While the economic impact of COVID-19 is clearly negative, the extent is unknown. While we hope this does not usher in a recessionary world, the oil spat adds even further to the downside probability.

Portfolio decisions – adapting quickly

We cut risk aggressively towards the end of February and went into March very conservatively positioned, although still holding emerging market debt. We indicated in February that COVID-19 spreading outside China would be a game-changer. We therefore cut equity risk aggressively towards the end of February after our momentum, volatility and market liquidity signals began flashing negatively across multiple markets. We have no advantage in our COVID-19 information and understanding but are simply following our process and philosophy. Our first job is to protect capital and, as you would expect, we have continued to act with that objective at front of mind.

Market fear is currently feeding on itself, and given the small clustering of virus cases reported in the US, the slow widening of credit spreads and “stickiness” in volatility curves, as well as anecdotal evidence of business stoppages, we have not yet added capital into equities or SA fixed income. Our view of the rand relative to SA bonds has been borne out (with fixed income holding steady and the rand seeing significant pressure) but the call becomes much tougher from here. Staying very liquid is important and allows us – should we see opportunities – to deploy and manage risk in more volatile markets. Our broad positioning at the end of February relative to the end of January (when COVID-19 was still largely contained) shows a significantly reduced exposure to offshore equity in favour of offshore cash and SA nominal bonds. Despite our previously articulated views (pre-COVID-19), we adapt to events and manage risks as they develop. We believe we are well placed to take advantage of the opportunities that are thrown up when market volatility erupts.