Why listed firms are out of kilter with postlockdown economy

• Equity markets are forward-looking and government s GDP numbers are backward-looking

The SA economy had never faced such an abrupt cessation of trade and economic activity as with the start of the nationwide lockdown on March 27. The same can be said for other economies around the globe.

As economies begin to reopen, many investors have been left scratching their heads

the rebound in financial mar

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kets paints a very different picture from the economic outlook. How is it possible for financial markets to rise in value, when the economy is shrinking?

It is not surprising that markets experienced some of the sharpest falls in asset prices during the first quarter of 2020. The JSE all share index lost more than 30% from the start of the year untilMarch 23. Also apparent is the speed of the recovery thereafter from March 23 (the

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bottom of the sell-off) the market gained more than 40% to July 31, making Covid-19 seem like a mere short-term disruption.

However, the economy tells a different story. A 30% contraction is predicted in second quarter GDP (on an annualised basis) and unemployment has surged to 42%. But let s have a look at

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financial markets in more detail, specifically the equity market.

The equity market is forward-looking and prices of stocks, shares, bonds (any listed liquid instrument) are determined by the supply and demand of investors. Investors who are buying these instruments are expecting positive outcomes in the future. Sellers, on the other hand, expect the price of the stocks, shares, bonds to decrease in value.

So how do you know if you should be buying or selling? Ultimately, you need to consider value. The intrinsic value of a company can be estimated by taking its future expected earnings and discounting the future cash flow, with an appropriate discount rate to ascertain what the value of those future earnings are worth now (or at the time one buys the listed equity).

The factor that has changed most notably in the above equation is the significant drop in interest rates, not only in SA but globally. With interest rates decreasing three percentage points since the start of the year, the discount rate being used to calculate the worth of future earnings is now significantly lower. This will result in future earnings being worth more today than before the rate cuts.

When the economy is slowing, the SA Reserve Bank cuts interest rates to stimulate financial activity. This benefits businesses in that they enjoy the ability to finance operations, acquisitions and expansions at a cheaper rate, thereby increasing their future earnings potential, which also leads to higher share prices. The reduced financing cost also increases future earnings figures.

Companies also have control over aspects that contribute to the current value of the company. They can use times of uncertainty as justification to cut their cost base and in doing so increase their bottom line and earnings. In other words, the leaner operational costs will result in higher expected future earnings.

In short, market crashes reset valuations of listed companies and provide investors with the chance to invest in opportunities that might not have been available, or a previous option due to prices being too high. This opportunity buy

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ing cycle subsequently drives up market prices.

The last factor that cannot be ignored, which is especially important in the SA landscape, is that listed companies selling products offshore do not rely on the SA economy s performance.

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These shares are more broadly known as rand hedges (with the weaker rand also working in their favour).

In contrast with forwardlooking equity markets, government GDP numbers are backward-looking. GDP is the value of goods and services produced-rendered in a country during a certain period. It provides a snapshot of a country s

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economy and is used to estimate its size and growth rate.

Due to stringent lockdown rules in SA, several sectors came to a complete standstill and therefore did not contribute to growing our GDP rate. As an example, in SA GDP numbers are highly dependent on mining, agriculture, manufacturing and construction (to name but a few)

most of which had to halt — operations for quite some time. In addition, many of the companies that contribute to our GDP numbers are not listed entities but rather privately held and/or small businesses.

Unemployment is another number that has a different effect on economies when compared to listed companies. When a company retrenches employees it immediately lowers the expenses of the business and can potentially grow earnings (if income is unchanged) but the opposite is true for an economy.

When someone is retrenched and they cannot find an alternative job, they move from being paid by a company to being paid by the economy, thus increasing the expenses of the government.

The sustainability of the equity market rally remains to be seen. For investors, it would be prudent to look beyond the overconfidence and optimism of the current equity rally as well as the pessimism of the secondquarter economic data.

The most relevant indicators are to be found in company operations, specifically earnings from listed companies. In the end, that s far more insightful

’ than equity market exuberance.

MARKET CRASHES RESET VALUATIONS OF LISTED FIRMS AND PROVIDE INVESTORS WITH INVESTMENT OPPORTUNITIES

LISTED COMPANIES SELLING PRODUCTS OFFSHORE DO NOT RELY ON THE SA ECONOMY S ’ PERFORMANCE