Market Overview:
Sometimes investing seems easy. Not the business of actually making money—that is always hard. But there are times when the market makes it easy to have a strong view and decide where to put money.
Last year was one of those times but, for both bulls and bears, the certainties are gone.
Stocks started 2022 overvalued thanks to the overconfidence of the bulls, providing the simplest of signals to the bears. Bonds started last year having wilfully ignored runaway inflation and the necessity of the Federal Reserve’s belated reaction. When both bonds and stocks went into a strong (downward) trend, it was easy for traders, too, as markets switched from paying no attention to inflation to focusing on it to the exclusion of all else. Good news on the economy was bad news for stocks and bonds, because it meant more inflation and higher interest rates.
Investing is hard again, because the simple signals are gone. Stock valuations as measured by price to 12-month-forward earnings are back down close to their long-run average. Bond yields are up from stupidly low levels, but the 10-year yield remains well below the 4%. The moves in both have been big, but neither one is cheap by historical standards. Bubbles in speculative technology, clean energy and cannabis stocks as well as cryptocurrencies have deflated.
Let us take a look at this past year quarter by quarter:
Q1: Paradigm Shift
The year started with central banks raising interest rates as global inflation that was running at 40-year highs. The war in Ukraine triggered a massive negative supply shock to the global economy – which at the time was already struggling with supply-side shortages due to the pandemic – reducing growth and further increasing inflation.
The MSCI World Index fell 5.2% in US dollar terms largely as a result of tech stocks losing 11%. Emerging market equities were hit the hardest, losing 7% of their value in Q1.
South African equities were resilient, with the FTSE/JSE All Share Index (ALSI) returning 3.8% for the quarter. Resources and financials gained 19% respectively, on the back of higher commodity prices and banks profit margins that typically expand with higher interest rates. Domestic fixed income lagged local equities with bonds rising 1.9%. The rand gained 8.3% against the dollar for the quarter.
Q2: Sell Season
In June, the US Federal Reserve announced its biggest interest rate hike in almost 30 years, followed by the fifth straight rate increase by the Bank of England (BoE) and the first in 15 years in Switzerland. The SARB raised its benchmark repo rate by 50bps to 4.75% at its May 2022 meeting. The May increase was the fourth consecutive hike and the biggest in more than six years due to heightened inflation risks stemming from geopolitical tensions. Global stocks and government bonds extended a bruising sell-off as investors feared that while the rate increases were needed, they could halt economic growth if the tightening was too aggressive.
Overall, the MSCI World Index lost 16.2% in US dollar terms. Growth concerns around China’s Covid Zero policies and a lack of concrete measures from the Chinese authorities to support the tech sector triggered further selling, resulting in the MSCI Emerging Market Index losing 11.4%.
The JSE also suffered, as the ALSI lost 11.7% due to the the resources sector reversing most of its Q1 gains, falling 20.7%. The FTSE JSE All Bond Index (ALBI) lost 3.7%
Q3: Clouds of Recession Loom
The weather warning sirens started. Most of the world’s central banks started to raise interest rates at a rate that caught investors off guard.
The Fed raised rates 0.75% at its September meeting and the European Central Bank (ECB) intensified its battle against record inflation by hiking interest rates by a historic 0.75%. Following six months of war in Ukraine, natural gas prices hit a record high, adding to an inflation pulse that was driving more painful policy tightening and exacerbating the risk of recession. In SA, the repo rate was hiked another 75 basis points in September, which brought the rate to 6.25%. The interest rate hike followed a painful inflation number that peaked at a 13-year high of 7.8% in July, before moderating to 7.6% in August.
Global stocks remained under pressure during Q3. News about sky-high global inflation, the energy crisis in Europe, ongoing war in Ukraine and currency volatility all contributed to the uncertainty in financial markets. The MSCI World Index dropped another 6.2% in US dollar terms – dragged down by ‘tech heavy’ index stocks. The MSCI Emerging Markets Index lost 11.6% with the CSI 300 Index in China down 15% in the quarter as investors continued grappling with stringent Covid curbs, a deepening property crisis and the risk of the potential delisting of dozens of local firms from the US. The Bloomberg Multiverse Bond Index lost a further 6.9%.
The ALSI dropped 1.9%, declining for the second quarter in a row. Resources suffered as most commodity prices fell. Domestic fixed income, however, showed more resilience in Q3 and gained 0.6%.
Q4: The winds have changed, but the storm still approaches
The FED increased interest rates by a further 75bps in November and 50bps in December – a downshift in line with market expectations. The Federal Funds target interest rate has increased 425 bps since the start of 2022. The ECB and the BoE followed the US Fed, raising rates 50bps in December. This raising the country rates to their highest since 2008.
In South Africa, the SARB increased the repo rate 75bps in November to 7%, a level last seen more than five years ago. The sharp hike in interest rates is likely to heap more ‘pain’ on the embattled SA economy and consumers, who are already struggling with sky-high fuel and food prices, and record levels of load shedding, not to mention the ongoing instability at Eskom and the resignation of its CEO in December.
So where does this leave us? Well, it might be time for investors to return to the old thinking. After three years of everything being extreme, things are finally returning to normal. We’ve been conditioned by recent events to expect gigantic swings in government policy, demand, supply, inflation and interest rates, bringing clear indicators for the direction of asset prices. Now we have to get used to moderation again and the continual uncertainty it brings to investing.
Sure, it matters especially to this year’s earnings whether or not there is a recession. Sure, whether the Fed starts cutting rates in late summer or waits until next year matters. And sure, whether inflation turns out to be sticky or not matters. But we don’t have to worry about missing out on a bubble or about a bubble bursting, a pandemic or the danger of a depression. Things are getting back to normal, and that is good.
Going forward into 2023
Uncertainty across financial markets is higher than it has been over the last few decades. This is due to the world moving into several new paradigms.
In this environment, we don’t believe there is one asset allocation call you need to get right. There will be multiple decisions to make, and you need to be nimble in making them.
A buy-and-hold asset allocation strategy is unlikely to deliver optimal outcomes, largely because US equity markets and developed bond markets are not yet offering enough value. The risk of inflation being structurally higher and mean reversion of profitability levels have not being fully priced in. We are not convinced that equity (share) prices truly reflect this erosion in earnings.
The first half 2023 will be particularly challenging with the direction of global inflation and interest rates front and center. Sticky (higher) inflation and higher interest rates for longer will impact the profitability of businesses and consequently affect investment (returns). The material and consistent easing of inflation will be key.
Most market valuations are also not pricing for the potential of increased geopolitical risks.
Commodities may benefit from these impacts as has been evident post the start of the Russia/Ukraine conflict. They will help to provide diversification away from financial assets that may come under pressure as global tensions increase.
The high and rising sovereign debt levels in developed markets and China are also a new consideration. Determining what constitutes a concerning level of sovereign debt has always been unclear. But with a return of inflation, higher interest rates and significantly higher spend related to Covid and energy costs, markets are likely to start worrying more about high sovereign debt levels.
This was made clear as the UK bond market went into freefall in response to a reckless budget that had to be subsequently reversed.
However, we don’t believe you can rely on the outcomes of these uncertain events for relative performance contribution, because we can’t predict them.
South African assets are attractively priced and that this pricing justifies a healthy allocation in a South African investor’s portfolio. That said, South Africa is prone to engaging in behaviour that negatively affect investor perceptions and asset market returns.
Factors like dollar strength, how much to take offshore, and when and where to deploy cash holdings also must be considered. The news flow around global inflation, interest rates and the factors discussed above will also create significant price volatility and over reaction.
It is for this reason that we try to avoid undiversified exposure to South Africa. So, on top of asset allocation decisions we believe it’s very important, especially considering the volatile macroeconomic environment, to be mitigating risks so that we are not dependent on a particular outcome to generate returns.
We believe that having many independent good ideas in your portfolio is the surest way to outperform over the long term.
Keeping a cool head and being able to step back from the short-term news flow will be critical in taking advantage of over and undervalued investment opportunities to make profitable allocation decisions.
We trust this communication will provide you an overview of current market conditions, what to expect, how this is likely to influence and impact your investments. Rest assured, despite the volatility, despite the noise, we always keep you informed, we are on top of it, and we understand you!
