Market commentary

DEFYING THEORY

Over the past few years, three key events have completely changed the political and economic landscape, opening the door to a world of unknowns: Donald Trump’s presidential victory, Brexit, and now the Covid-19 pandemic.

And in times of uncertainty, investors commonly refer to past events, and economic and financial theory in an attempt to make sense of the world and anticipate potential market movements. In recent months, the terms “risk-on” and “risk-off” in particular have been bandied about.

To understand the market’s behaviour, we first need to understand the difference between these two environments. A risk-on environment is often driven by a sense of certainty and optimism. The current easing of global lockdowns is a prime example: economies are operational again, employees are returning to their desks, and many assumed that we would now see a recovery. A risk-off environment is the opposite – it is usually triggered by an unexpected shock which is followed by uncertainty, such as seen at the onset of the pandemic earlier this year.

Yet one market trend has seemingly at first glance defied economic theory. Economics 101 teaches us that when monetary stimulus is deployed, the underlying currency devalues. However, the dollar has remained resilient throughout a large part of the pandemic.

To explain this, it’s important to note that in uncertain times, investors tend to sacrifice potential yield in an effort to preserve capital, or “de-risk”. This in turn sees investors sell riskier, high-yielding assets such as equities and commodity-driven currencies, and crowd into safe haven assets such as the US dollar and gold. The dollar’s status as a safe haven asset means that it then attracts additional demand in uncertain times, resulting in a stronger dollar, and thereby defying the monetary policy-currency rule.

US FED SHATTERS MARKET OPTIMISM

The US Federal Reserve took centre stage on Wednesday, providing insight into interest rates, bond purchases and economic forecasts. While markets largely anticipated that interest rates would remain unchanged, and that a degree of bond purchases would continue throughout 2020, the central bank’s sombre tone gave markets a harsh reality check following three weeks of over-optimism.

The economic outlook highlighted the economic devastation suffered across the US, with the economy expected to contract by 6.5% this year, and unemployment expected to settle at 9.3% by the end of the year. In contrast to the widespread belief that the globe will see a V-shaped recession and recovery, and false hopes over the amount of stimulus provided, markets are now coming to grips with the fact that the economic recovery may take much longer, as the Fed currently expects a recovery to take at least three years.

The Fed’s reality check quickly shattered the superficial optimism that fuelled the recent risk rally, and by Thursday morning, we found ourselves back in a risk-off environment. The peripheral risks that were placed on the backburner during the rally (such as geopolitical tensions) are all drawing increasing focus again, as investors attempt to quantify how these risks will filter in to the economic narrative, and particularly whether political decisions ahead of the US election could prolong the climb towards a recovery.

Meanwhile, China is well ahead the rest of the world in terms of restarting economic activity, but is struggling to achieve a rapid recovery, as global trade remains subdued. Faced with similar economic woes to the rest of the world, China opted for a different approach to stimulating its economy, as conventional practices often end up sending additional cheap money into financial markets rather than into the pockets of the man on the street. China’s approach has then made use of special lending vehicles to provide aid to mostly small businesses, ensuring business continuation and economic relief at a grassroots level.

Shifting focus to the UK, the British government came under fire this week, as International Trade Secretary Liz Truss received a pre-action protocol letter (that normally precedes a high court challenge) aimed at suspending the sale of riot gear to the US by UK companies. This letter comes after violent riots erupted across the US following the death of George Floyd, seeing numerous clashes between law enforcement and citizens. While US riots have subsided over the past few days, UK ministers now stand accused of aiding the US police force in its show of “flagrant racism.”

Economic data from around the world this week included:

US:
• JOLTs job opening outperformed expectations
• Year-on-year CPI for May declined to 0.1%
• Initial jobless claims dropped to 1.5m

CN:
• Exports fared better than expected, but remain negative at -3.3% year-on-year in May
• Imports undershot the mark, contracting 16.7% year-on-year in May
• CPI eased to 2.4% year-on-year in May

EU:
• GDP contracted in line with expectations, shedding 3.1% year-on-year during the first quarter

UK:
• BRC retail sales improved, gaining 7.9% year-on-year in May
• GDP due today is expected to contract by 22.3% year-on-year

SA LOCKDOWNS CONTINUE DESPITE LEGAL CHALLENGES

While South Africans had hoped to see further lockdown relaxations, there has been nothing but silence from the National Command Council (NCC) as it tries to navigate the way forward in light of recent legal challenges, leaving citizens uncertain as to what the coming months may hold.

While the political landscape has remained calm for the most part, the EFF took to the streets of Sandton on Monday, joining the worldwide Black Lives Matter (BLM) movement. EFF party leader Julius Malema remained true to form, accusing President Ramaphosa of being a sell-out, in addition to several other controversial statements.

Meanwhile, President Ramaphosa has referred the controversial Secrecy Bill back to parliament, citing concerns regarding its compliance with the Constitution. The Secrecy Bill, which was originally passed by the National Assembly in 2011, seeks to replace the current Protection of State Information Bill. However, critics have warned that in its current form, the bill will explicitly infringe on the right to the access of information, the rights of whistle-blowers, and press freedom. Somewhat ironically, this action comes as numerous calls for government to release the data being used to guide regulatory decisions made during the state of disaster continue to fall on deaf ears.

The unemployment rate that was due for release this week was postponed to later in June, as Stats SA plays catch-up in the post-lockdown period. There were, however, a few local releases that highlighted the extent to which the lockdown has hit the economy. While business confidence has been on the decline for some time, this week saw it tumble to the worst levels seen since inception of the index, as many businesses face financial devastation after lockdown regulations forced them to halt operations. Gold production tumbled 59.6% year-on-year in April, total mining output plunged 47.3% year-on-year in April, and manufacturing production for March contracted 1.2% month-on-month.

Emerging markets came under pressure on Thursday, with the rand tumbling 3.6% against the greenback by close of local trade, breaking above R17.00/$ yet again as hopes of a V-shaped global economic recovery were shattered by the Fed. While traders and economists agreed that its recent strength would not be sustainable, the speed of the selloff on Thursday shocked even the biggest of rand bears.

LOOKING AHEAD

The switch to a risk-off environment is expected to continue into next week. Following the Fed’s reality check, we can expect data to regain its relevance in market movements, as markets will look to these releases for guidance in navigating the global recession and recovery.

Monday:
• CN unemployment, industrial production, and retail sales

Tuesday:
• Local public holiday – Youth Day
• UK unemployment
• US retail sales, and industrial and manufacturing production

Wednesday:
• UK CPI and PPI
• EU CPI
• Local retail sales

Thursday:
• EU ECB economic bulletin
• UK BOE interest rate announcement
• US jobless claims

Friday:
• UK retail sales

UK GDP is due for release today, as well as UK and EU industrial production numbers. We will also keep an eye on the outcome of today’s meeting between the EU finance ministers.

The rand’s selloff continued overnight, and the local currency started today at R17.22/$, R19.42/€ and R21.65/£.

 

CTA

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