Global outlook tempered by economic headwinds
What were some of the key themes shaping this quarter?
Although concerns about the COVID-19 pandemic have been declining, the third quarter of 2022 will be noted for the broad acceptance of the end of the pandemic for most countries. China has, however, maintained its zero-COVID-19 policy which continues to result in lockdowns in certain regions. As the world tackled higher inflation and increasing short-term interest rates over the quarter, global markets have continued to sell-off with the concern of a global recession being considered. In South Africa (SA), loadshedding remains a major hurdle to productivity and the political machinations of the upcoming ANC elective conference weighs on the collective conscience. South African consumers are feeling the pinch of sharp price increases in the costs of food and petrol amid the threat of a significant hike to the price of electricity in 2023.
Little respite in markets
The third quarter saw a continuation of the negative trend in market returns. The FTSE/JSE Capped SWIX, which is a representation of the SA market, saw a further 2.4% decline, due to financials (-4.6%), resources (-2.1%) and industrials (-1.5%), highlighting the broad-based nature of the negative sentiment. SA property declined by 3.5% while the fixed interest asset classes of nominal bonds and cash experienced a modest uptick of 0.6% and 1.3%, respectively. Inflation-linked bonds, which have provided protection from the recent increases in inflation, delivered a return of -1.0% as inflation expectations moderated somewhat towards quarter end.
The US dollar strengthened by 9.7% against the rand for the quarter, as global investors chose the safe-haven status of the reserve currency, as yields increased in the US. The rand depreciation was a tailwind for SA investors with offshore exposure, as foreign equities increased by 2.2% in rand with developed markets up 2.9% and emerging markets down by 3.0%. Global listed property continued to decline (-3.1%), while global bonds, measured by the World Government Bond Index, was up 1.4%. Although these returns were positive in rand terms, the negative market sentiment is apparent from the weak returns when measured in US dollars.
Are the three R’s still the major global economic concerns?
The three R’s referring to rates, Russia and risk of recession remain significant points of contention among market commentators and are driving the direction of global markets. “Rates” not only refers to short-term interest rates but, by implication, to inflation and the effect the pace of inflation is having on the action of central bankers across the world. The Russian invasion of Ukraine is a geopolitical crisis which has a macroeconomic impact and appears to be a long way from concluding. The debate about recession continues, seeming to ebb and flow between a deep slowdown to a soft landing and even the possibility of averting one with the impact of each outcome analysed. Even though these factors are considered individually, there is an interaction that links these effects in markets
The impact of high inflation remains prevalent across the world, with developed markets experiencing levels of inflation unseen for decades. In the past quarter there has been a mild slowdown in the growth of inflation in the US. US CPI peaked at 9.1% in June and printed at 8.5% in July and 8.3% in August. Similarly in SA, the CPI print for July was 7.8% and August was slightly slower at 7.6%. In the UK and Germany however, inflation was at 10% as these economies have been more susceptible to the increase in energy prices. Central banks have continued to sharply raise short-term interest rates during the quarter raising the question of whether inflation, particularly in the US, may moderate quicker than previously expected.
The Russian invasion of Ukraine has had a direct effect on energy prices, as sanctions have reduced the supply of Russian energy and increased oil and gas prices. There have been reports of sabotage on the Nord Stream 1 gas pipeline from Russia to Europe which has further slowed supply to about 20% of capacity. In addition, hiring costs for gas tanker ships have increased by more than 60% since the drop in pipeline supply. These supply shortages continue to be inflationary and is likely to have a larger effect in Europe due to the dependency on Russian energy.
Consensus expectations of a US recession appear to be changing as new data points are made available. The US has entered a technical recession as the GDP growth for the first two quarters of the year saw declines of 1.6% and 0.6%, respectively but this has not been ratified by the National Bureau of Economic Research that uses several factors to determine whether the US is in fact in recession. The implications are potentially significant as growth assets have experienced material drawdowns in previous recessions. During the quarter, consensus moved from expecting a mild recession to the possibility of the US averting a recession, albeit possibly for the short term only, as the labour market remains strong. In Europe, however, the outcome appears more concerning as the expectation of a recession in the region remains highly probable.
Apart from the three R’s, the zero-COVID-19 policy in China has continued. This has had a dampening effect on GDP growth as production and exports have slowed with the continued lockdowns. The most recent GDP growth showed a decline of 2.6% for the quarter, which was the first decline since the first quarter of 2020 when COVID-19 lockdowns initially started, and is well below the 6.0% and above levels experienced in China pre-COVID-19 lockdowns. This has the potential to have a negative effect on commodity prices should demand for resources slow in China which would be detrimental to SA.
In SA, GDP declined by 0.7% for the second quarter with the expectation of further declines in the third quarter. Both business confidence (39) and consumer confidence (-20) disappointed in the third quarter as the country continues to experience prolonged periods of loadshedding. With inflation remaining stubbornly above the target band, the South African Reserve Bank (SARB) followed the precedent set by the US Federal Reserve and increased short-term interest rates by 75 basis points twice during the quarter. Even though the SARB has acted timeously, the SA macroeconomic conditions will be influenced by global trends, particularly from the US and China.
How are the portfolios positioned?
There has been no change to the houseview during the quarter as medium-term risks are still to the downside even though there may be evidence that short-term news flow could surprise to the upside. This is premised on the possibility that forthcoming US inflation prints may be lower than market expectations due to the pace of recent interest rate hikes. While this does tempt an increase from the current underweight global equity allocation, the consensus view of no recession being priced in leaves no margin of error.
US interest rate expectations are realistically pricing in a continuation of the hawkish stance of the Federal Reserve which could influence a recession should this result in a greater slowdown to demand than planned for. While this may provide an opportunity to further increase the global bond allocation for the current underweight, the risk to yields continuing to rise was deemed too high to implement this change during the past quarter.
In multi-asset portfolios, the SA equity allocation remains overweight primarily as a result of the valuation of the asset class. Forward price-to-earnings (P/E) ratio is about 8 at quarter end and while price volatility, especially in sympathy to global markets, may materialize, strong long-term returns have historically manifested from these starting valuation levels. The steep yield curve and double-digit yields on offer in the SA bond market results in the overweight exposure to SA bonds being maintained. Even at the current high inflation level, the SA 10-year government bond is offering a real return of more than 3%.
Global and local listed real estate exposures remain underweight as macroeconomic conditions, particularly increasing interest rates and the risk of recession, do not favour the asset class. Portfolios continue to maintain a neutral exposure to both global and local cash, even though the real yields are negative. The diversification benefit of holding cash has proved advantageous over a volatile quarter and, with continued market uncertainty, it remains a buffer to potential volatility.
Asset allocation decisions that are not too different from long-term strategic levels become more appropriate when market uncertainty is heightened. This allows for material adjustments when a directional view is taken without compromising the risk-return profile of a portfolio over the shorter term. In addition, as a multi-manager, there is a diversification benefit of the underlying managers who, as a blended solution, we believe will deliver competitive returns regardless of the market outcome.