After a turbulent start to the year global equity markets gathered some composure to finish the quarter down -5% in USD terms and -2.5% in GBP, with energy the only sector to close the period in positive territory, surging over +20% as oil prices broke through $120 per barrel. Initially, equity market valuations adjusted to the change in the outlook for interest rates, but this was soon followed by fears of a possible invasion of Ukraine by Russian forces, which sadly became a reality and has resulted in one of the worst humanitarian crises in recent history. Equity markets did however behave exactly in line with previous episodes of heightened geopolitical tension and have rebounded strongly from their lows after the initial shock and further angst around the potential long-term implications of such an event on world stability and commodity prices. Although still very early days, history has taught us that the increase in volatility from geopolitical events tends to be short lived.

Central Banks Dilemma

The combination of strong underlying demand, in part due to highly accommodative monetary policy (low interest rates) and reduced supply, which has been amplified by Russia’s invasion of Ukraine, has resulted in inflation reaching multi-decade highs in the developed world. Until recently, western world central banks have been patient in the face of an inflation spike that was viewed to be transitory. However, this has changed as the broadening of price pressures and labour shortages have increased inflation concerns. During the past three decades the global economy was regularly buffeted from geopolitical events that limited commodity supply and caused price spikes, but the current cycle is different as prolonged and broad based COVID-19 led supply disruptions, and now the Russia/Ukraine conflict, have also created more widespread core price pressures in labour and basic food stuffs.

High and sustained inflation results in reduced disposable incomes, elevated interest rates, lower asset prices, and in turn decreased economic growth. As a result, both the US Federal Reserve and the Bank of England are guiding the market to sharper and quicker interest rate increases and at the same time quantitative tightening, which involves the shrinking of central banks’ balance sheets as they dispose of government and corporate bonds. Some of the effects of the withdrawal of easy monetary conditions are already evident in the US housing market where a significant (31%) increase in the cost of servicing mortgages has been a major contributor to moving the property affordability index back to levels last seen during 2007. In other words, a period of subpar growth might be required to contain inflation if it continues to overshoot.

The mining sector and companies supplying into the industry have benefited hugely from high commodity prices, which has been a function of supply chain disruptions during the crisis and more recently the war in Ukraine. Although the current profitability levels may not be sustained as commodity prices normalise and cost pressures intensify, the decline in aggregate earnings (and tax revenue) should be offset by the recovery in other sectors as company profits return to levels achieved prior to COVID-19. In general, financial results for listed companies have been surprisingly positive this year and have played an important role in underpinning share prices of undervalued South African stocks. Whether the positive momentum (relative to our peers) is going to be sustainable remains to be seen, but while the sun is shining on SA, policy makers have a golden opportunity to make hay, by distinguishing ourselves from the rest of the EM universe by implementing sound and credible growth and fiscal reforms.

The South African Reserve Bank has unsurprisingly become more concerned about the outlook for inflation since the outbreak of the war and has revised its forecasts higher. Headline inflation for 2022 is now expected to reach 5.8% (4.9%), before reverting to 4.6% on average for the subsequent two years. Core inflation is expected to gradually increase this year and to remain above the targeted midpoint of 4.5% by the end of 2024, with risks firmly tilted to the upside. The rhetoric from the MPC (Monetary Policy Committee) has turned decisively hawkish with two of the five members opting for a 50 basis point increase during their meeting in March. The majority vote resulted in a 25-basis point hike in the repo rate. The MPC is serious about anchoring inflation expectations at the midpoint of the 3-6% range and has sent a strong message to market participants and consumers - interest rate increases will likely be frontloaded in this cycle should inflationary pressures not subside. Not the greatest news (in the near term) for an economy trying to get off its knees, but the sooner the MPC reacts to contain inflation (expectations), the greater the chance of preventing interest rates from becoming too restrictive over the medium term. Anchored inflation expectations, together with prudent fiscal discipline and the successful implementation of growth reforms will in the future open the door to lower sustainable interest rates and ultimately higher trend growth which is desperately needed to alleviate some of the country’s socio-economic challenges such as unemployment and poverty.

The update from the presidency showed progress, especially within the electricity and the telecommunication sectors with the recent spectrum auction. Bureaucratic hurdles still need to be overcome and challenges remain, but the upshot is that the foundations are slowly being put in place for a more sustained and improved growth outlook in the economy.

Standard Bank Research department has in a recent note to clients provided a useful summary of the key reforms that have been implemented thus far.

Asset Allocation

Chief Investment Officer
Bernard Drotschie

Domestic Equity – Overweight

Economic momentum has surprised positively this year in South Africa as the recovery takes hold. The same holds true for earnings growth, which for the MSCI SA Index is now expected to increase by 19% in 2022 (from a depressed base), against an expectation of 9% at the start of the year. The positive revisions have been broad based across sectors and has resulted in a derating in equity valuations as the positive revisions to earnings growth outpaced price returns this year. We remain constructive on domestic equity given that valuations are attractive compared to history and earnings growth momentum remains supportive. Although this is not factored into our expected returns, any improvement in sentiment towards SA or an improved growth outlook on the back of growth reforms could drive valuations higher. Higher interest rates globally and in South Africa, do however pose a headwind to growth in the medium term and will likely result in more moderate returns. It is therefore important for investors to be selective in their approach. We remain committed to investing in good quality companies with strong balance sheets, unique offerings, and pricing power.

Global Equity – Neutral

Global equity markets have de-rated considerably this year and are trading at levels not too different from their long-term averages with returns expected to be positive for the remainder of the year. Even so, as interest rates increase and with them the discount rate (risk free rate) for long duration growth assets, valuations will remain under pressure and should de-rate further. Sustained high inflation poses an additional headwind to valuations. Earnings growth of 6%-8% over the next year is achievable and will be in line with long term averages, but operating cost pressures do pose a risk for lower profit margins in the future. Strong underlying demand has allowed companies to pass on the costs and maintain gross margins, which has more than offset the increase in operating costs, but this will become more of a challenge for companies to overcome as growth reverts to trend over the next year or two. We are monitoring the effects of the war and sanctions imposed on Russia closely and will reduce risk in portfolios should the medium-term outlook for economic growth and/or expected returns weaken materially and necessitate action.

Domestic Fixed Income – Overweight

Government’s commitment to fiscal consolidation and attractive valuations have underpinned returns from government bonds this year. Yields remain attractive for long term investors on both an absolute and inflation adjusted basis. Interest rates are expected to be increased over the next two years as monetary policy becomes less supportive, but these expectations are already reflected in prices. We do therefore not expect that bond yields will move significantly higher (lower prices) from current levels. Returns from bonds over the long term are primarily a function of their income yields, and with the 10-year SA government bond yielding almost 10%, we find bonds attractive and remain overweight the asset class.

Global Fixed Income – Underweight

The US Fed commenced the tightening cycle in the quarter, sanctioning a 25 basis point hike to 50 basis point almost immediately after ending their quantitative easing program. This marks the beginning of a raft of rate rises this year, set to be one of the most aggressive tightening cycles since the mid-2000s. We can expect another five or six hikes before year-end with moves of 50 basis points at one or more meetings a distinct possibility. In addition, the Fed currently expects a further 100 basis points of tightening in 2023 although much can change between now and then. The Fed’s dual mandate of full employment, which one could argue has been achieved with high vacancy rates helping to push the unemployment rate down to 3.9%, and an inflation target “averaging 2% over the cycle”, currently running at a headline rate of 7.9% (a forty-year high), is clearly an issue for the committee. The onset of the Eastern European war has provided more “fuel to the inflationary fire” and in response Jerome Powell and his committee have a tough job in balancing tighter monetary policy against a slowdown in economic growth. However, for now the underlying health of the US economy remains robust on a number of measures. The consumer remains healthy, but the effect of higher food and energy prices together with higher borrowing costs will no-doubt have an impact on disposable incomes, which in turn will lead to lower growth. Whilst growth will slow in the months ahead, we do not forecast a recession over the next twelve months as sufficient pillars of support remain in place to underpin growth at, or likely above, long-term averages.

Major ‘negative’ geopolitical events would ordinarily favour government bonds for their ‘safe-haven’ status, but other than a brief and temporary retracement in yields when Russia first invaded, this has not stopped ten-year US Treasury yields from rising sharply to the current 2.35% level. Currently, it is expected that the long-term neutral/terminal US interest rate will surpass 2.5% which should, by default, put yields on a path to 3% plus (barring the onset of a recession and rapid decline in inflation). Central banks credibility is at stake and they will be looking to drive down inflation expectations to regain credibility. We continue to view the asset class as unattractive and expect developed market government bond yields to continue trending higher to more normalised levels.