The Russian invasion of the Ukraine late in February started against a backdrop that was already proving to be a challenge for some regional equity markets, specifically in the US. As 2022 dawned, market participants turned their collective focus to the looming benchmark policy interest rate hikes by the US Federal Reserve in response to surging consumer price inflation. From a low of 0.1% in the second quarter of 2020, US Urban CPI had surged to a rate of 7.9% by the end of February this year. While it was well known throughout the latter half of 2021 that the US Fed was under increasing pressure to raise interest rates, the US equity markets seemed unperturbed by this. In the final quarter of 2021, certain areas of the bond yield curve in the US also seemed to be oblivious to signals that benchmark interest rates would be moving up aggressively in 2022.
By the time Russia invaded the Ukraine, US equity markets were already falling, and US bond yields were rising sharply. The pressure these two asset classes were feeling was not totally unexpected since both were very richly valued following the recovery from the bottom of the pandemic-driven market responses in March 2020. By the end of 2021, US equity markets had run away from the earnings outlook and real bond yields were deeply negative.
While bond yields continue to climb in the US, equity markets in that country are now reflecting valuations that are looking much more reasonable. In fact, the US S&P 500 Index is now trading at fundamental valuations that are very close to fair value, something that was last observed early in 2020. US equity markets are now valuing future earnings at a much more appealing level, in spite of the expectation of at least another 200 basis points interest rate hike this year by the US Fed. The earnings outlook for companies in the S&P 500 Index is proving to be very resilient, even as the rate hike cycle in the US kicks into gear. The negative impact of the Russian invasion of Ukraine on the US equity markets has already been reversed.
The resilience of the earnings outlook for companies listed in the US seems to be based on a fairly widely shared view that growth in the US will remain solid and steady, even as interest rates rise. Key US economic indicators show that although the economy is coming off the boil, it is still in solid shape, being supported by resilient manufacturing purchasing manager indices. Furthermore, sound momentum and a large pool of savings are expected to provide a wide buffer to the economy to absorb these policy rate hikes.
Our investment committee’s research partner, Macro Research Board (MRB), suggests the US economy will continue to grow faster than its potential/expected rate until the US Fed hikes interest rates to a truly restrictive level, which they estimate to be near 3.5%, and not 2.5% as many investors believe.
Lastly, the above commentary focusses on the US, the stronger of the three legs of the MRB barstool. However, we believe this should provide an underpin to global equities as China continues to stimulate and not hike rates, while Europe lags both the US and the UK with policy rate hikes.
“We’re not seeing that this rate hike, and the others to come, will be enough to put the economy into a recession. Consumers have the ability to weather the storm.”
– James Ragan, DA Davidson director of wealth management research
- The US central bank must move “expeditiously” to bring high inflation into check, according to Federal Reserve chair Jerome Powell. He added that the Fed could use bigger-than-usual interest rate hikes if required and that “the labour market is very strong, and inflation is much too high”.
- Meanwhile, the Bloomberg Global Aggregate Index, a benchmark for government and corporate debt total returns, has fallen 11% from a high in January 2021. That’s the biggest decline from a peak in data stretching back to 1990, surpassing a 10.8% drawdown during the financial crisis in 2008. It equates to a drop in the index market value of about $2.6 trillion, worse than about $2 trillion in 2008! (Dynasty’s proprietary offshore funds have zero exposure to ten year treasuries).
- The threat of stagnant growth and accelerating inflation adds to the upside risk for yields, according to Australia & New Zealand Banking Group. The bank predicts we are likely to continue seeing upward pressure on yields and expects monetary tightening in several Asian economies to start in the second half of the year.
- Ghana’s central bank has announced the biggest interest rate hike in a generation as it seeks to slow rampant inflation that threatens to create a debt crisis in one of West Africa’s largest economies. The Bank of Ghana raised its main lending rate by 250 basis points to 17%, signalling an aggressive stance against the rocketing price of goods from flour to sugar and fuel, and against a depreciating local currency that has dented investor confidence.
- At the time of writing, the S&P 500 week-to-date was up 0.85% in US dollars while the MSCI World Index climbed 1.04%.
- The big story on the local front this week is the continued surge in the rand, which has gained almost 10% against the US dollar in 2022! Our local news, therefore, focusses on this subject, with an explanation for the phenomenon in a “risk-off” environment supplied by our research partner, Analytics FX Solutions:
- The Russia-Ukraine conflict has resulted in a very sharp divergence in the performances of Emerging Market currencies. This divergence can be divided in three baskets of currencies. The first basket includes Russia and Ukraine, and other countries severely impacted by the crisis or continue to be crippled by poor economic/political policy, such as Argentina and Turkey. Egypt would also be included in this group, partly because that country is the world’s largest importer of wheat and might require IMF support.
- The second basket of currencies includes a broad selection of countries that are net importers of commodities and either rely heavily on manufactured exports and/or are located in the broader eastern European region. This includes South Korea, Taiwan and other Asian economies as well as east European countries such as Poland and Hungary.
- The third basket is a relatively small selection of five countries that are net commodity exporters, including South Africa, Brazil, Chile, Colombia and Peru. These currencies have all strengthened meaningfully during the first three months of 2022. However, the rand and Brazilian real have two additional benefits, namely higher interest rates and the fact that both currencies were significantly over-sold (and undervalued) at the end of 2021.
- Another factor supporting the rand is that the SA Reserve Bank discussed increasing interest rates this week by 50 basis points instead of 25. This admission added further support to the value of the rand, which suggests the rand is currently in an especially favourable position.
- Support for the rand can change very quickly should commodity prices start to decline as a result of a peace deal in Russian and Ukraine – even though Russian sanctions are likely to persist beyond this event.
- Support for the rand would also likely change should the Russia-Ukraine crisis escalate significantly. Under these circumstances, there could emerge a clamour for safe haven assets such as the dollar and/or gold – despite persistently high commodity prices. The Analytics Currency Decoder by Dr Lance Vogel now has fair value at R15.91/USD, showing that current market levels around R14.55/USD represent exceptionally good value for externalising funds.
- On Thursday, the South African Reserve Bank hiked interest rates 25 basis points on the basis that there were upside inflationary risks. The bank did not hike more, despite supply pressure caused by the Russia-Ukraine war. The central bank has moved by 25 basis points in each of the past three meetings as it unwound emergency rates that came after the Covid-19 outbreak.
- While South Africa’s overall tax base is growing – and fared better during the pandemic than many had feared – the small pool of high net worth taxpayers has stagnated over time, which suggests SA is haemorrhaging wealth and talent and raises questions over the country’s long-run fiscal sustainability. Globally, the number of ultra-high-net-worth individuals increased by more than 9% from 2020 to 2021, adding 52 000 very wealthy people. However, in South Africa, the number of individuals worth in excess of US$30 million declined by 7% from 603 to 561 over the same period. In the ten years to 2022, SA added almost one million taxpayers (above the tax threshold), with the total tax base growing from 6.57 million to 7.44 million people. About 300 000 is due to the threshold falling by about 10% in real terms since 2012. Read more here.
- In company news, the Competition Commission has found that there is a prima facie case of “abuse of dominance” against WhatsApp and its parent, Meta Platforms. It has referred them to the Competition Tribunal “for prosecution” and has proposed a hefty fine of “10% of [the] collective turnover” of Meta (and its Facebook and WhatsApp subsidiaries) in South Africa.
- Murray & Roberts’ subsidiary, Clough (part of the Regionerate Rail consortium), has been selected as the preferred tenderer to advance the R16.5 billion Inland Rail project in Australia. The section of the project comprises 128km of new and upgraded rail track and includes a 6.2km tunnel which will be the largest diameter freight tunnel in the southern hemisphere.
- At the time of writing, the JSE ALSI week-to-date was down 1.7% in rand terms while the rand continued to strengthen, gaining 2.58% against the US dollar.
Sources: Dynasty, BusinessLive, Reuters, News24, Fin24, Bloomberg, Moneyweb, Analytics FX Solutions, Fortune, etc.