Since February 24, when Russia invaded Ukraine, waves of volatility have hit global markets and many have entered correction territory. The headlines point to global conflict as the cause, but the reality is that this event is set against an already very fragile market environment.
In February, US inflation recorded its highest reading in 40 years, at 7.9%. Inflationary pressure was already forcing the hands of central banks, with many (including the US Fed) signaling their intention to hike interest rates multiple times during 2022. Lifting rates would remove the ‘drug’ of free money that has fueled US markets to record highs over the last decade.
Inflationary pressures have been building since the global economic engine reignited as countries came out of early hard lockdowns. First, supply chain disruptions saw commodities rally. It soon became evident that under-investment in “dirty” commodities in a world focused on climate change made it difficult to bring additional supply online.
The sanctions imposed on Russia, a major commodity exporter, in response to the Ukraine invasion have completed a trifecta of supply constraints that have turbo-charged commodity prices. This has added fuel to the fire of broader inflationary pressures building in the system.
Price increases driven by supply-side inflation, as we see across the globe, creates a tighter environment not too dissimilar to interest rate hikes. Consumers are left with less money in their pockets, which ripples through the economy, impacting growth and corporate earnings.
The US Fed is caught between a rock and a hard place, with the commodity price shock creating an environment of lower growth and higher inflation. Hiking rates will further constrain economic growth and pull the plug on the stimulus that has propelled US equity markets. Not hiking would lead to a loss of credibility and inflation becoming further entrenched in future expectations.
The drug of free money has created massive instability, with nearly 20% of listed companies in the US now classified as “zombie” firms, according to research by Deutsche Bank. This is five times as many as in 2008, when the zero interest rate policy experiment began. These companies are dependent on zero rates because the cost of servicing debt is higher than profits made. Which begs the question: What happens when interest rates rise?
At the same time, the decade-long bear market in commodities magnified the effect of the broad JSE lagging the technology-heavy US markets. And, as the Rand depreciated significantly (along with many other commodity-producing economies), there was much speculation about South Africa, with the most cynical describing the country as “un-investable”.
The stars (and stripes) in their eyes might have caused them to forget that markets are cyclical. Financial gravity has been a truism of the markets for more than a century.
Looking at 10-year annualised real (after-inflation) returns of US and SA equity markets over the last century, we can see that the average real returns have been remarkably similar but, depending on where we are in the cycle, they are vastly different. As at the end of 2021, the 19% annualised return in Rands to US equities represents an eye-watering 469% cumulative return above inflation over the last 10 years, compared to just 92% for SA equities.
Whilst SA equity made back a dramatic 15% in two and a half months to 14 March this year, the chart below poses the question: Are returns to US equity markets set for reversion closer to long-term averages, or will they continue to defy gravity going forward?
What is clear is that investors need to reset their expectations, not only based off the post-Covid ‘everything bubble’, but on whether what has worked over the last decade can continue to work indefinitely.
South Africa has not had the luxury of extraordinarily supportive monetary policy, as have developed markets. The primary reason has been the historic vulnerability of our currency to depreciate.
However, South African government bonds offer attractive real yields. These, in part, reflect the fiscal risks present in South Africa but, for investors in a yield-starved, inflation-ravaged world, these are relatively attractive, nonetheless. We are fortunate that investing in government bonds is still a feasible approach to accessing conservative, inflation-beating returns. This is a luxury that most around the world can only wish for.
That said, the best way to protect your wealth against inflation in the long-term is to hold a well-diversified portfolio of growth assets, although this won’t shelter you from the storm in the near term.
We are seeing signs – including record high inflation, booming commodity prices and central banks talking of aggressive interest rate hikes – that warn loudly of a step-change in the cycle.
As we face withdrawal from the drug-like stimulus that has fueled markets over the last decade, it is the beneficiaries of that stimulus that have the most to lose. On a relative basis, the long-neglected South African equity and bonds markets, whose poor outlooks and negative expectations are reflected in prices, look set to provide shelter from the storm.
Chris Eddy is Head of Investments at 10X Investments
The content herein is provided as general information. It is not intended as nor does it constitute financial, tax, legal, investment, or other advice. 10X Investments is an authorised FSP (number 28250).
