Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me |
The notion of a polycrisis – various systemic crisis occurring simultaneously and interacting with one another – has been around for a while but has gained renewed traction for obvious reasons.
Columbia University economic historian Adam Tooze brought it to the fore again recently. As he notes, there is one slight comfort: ‘we are in it together. If you are feeling confused and overwhelmed, you aren’t on your own’.
COVID-19 crisis calming down
Another source of comfort is that one key element of this polycrisis, the COVID-19 pandemic, is fading from a public health point of view, even if the economic impact lingers.
To be sure, the coronavirus has not gone away and is constantly mutating. Infection rates continue to rise and fall in various countries. But the risk of dying from COVID-19 seems to have diminished thanks to vaccination, prior infection, and less serious variants. Few governments are imposing restrictions and most people seem to just want to get on with life. In the end it is not biology, but psychology that ends a pandemic. People just stop being frightened.
A notable exception is China, where the government maintains a zero-COVID-19 policy that results in quick and hard lockdowns whenever an infection is reported. But for the time being, most of these lockdowns have been lifted.
As the pandemic fades from public consciousness, some of the economic distortions it caused should similarly recede. This is good news, particularly since the inflation crisis the world is experiencing has its roots in pandemic-related disruptions.
There is evidence of consumer demand for goods easing and with it, the supply chain bottlenecks that saw the prices of goods surging. The problem is that as spending rotates back to services, it could place sustained upward pressure on service costs.
These are much more closely linked to housing markets – also supercharged by the pandemic – and wage growth. One of the more unexpected consequences of the pandemic is the labour shortages that plague developed market economies. The recent chaos at airports in Europe and North America are an example of both the shortage of workers and people’s renewed appetite for travel services. Central banks will therefore remain on guard. The problem is that they might maintain an obsessive focus on inflation even as economic growth weakens. That seems to be what bond markets are starting to price in.
Energy crisis
Russia’s invasion of Ukraine saw a geopolitical crisis compounding an economic crisis as surging energy and food prices put further upward pressure on inflation.
But an energy crisis is not just one where gas, oil and coal is expensive. It is also where there are realistic fears of supply interruptions. Energy is a basic but vital ingredient to economic life. Without it, as we are experiencing in South Africa (and discussed below), economic activity can grind to a halt. Europe is in a particularly precarious position, given its reliance on piped natural gas flows that Russia can turn off at any stage.
Russia and Ukraine are also major food producers and suppliers of inputs for fertilizers. The resulting global food crisis – a crisis of both cost and availability – is most acute in poorer countries and among lower income groups in richer countries.
Therefore, there is good news and bad news in the fact that food, energy and metals’ prices have pulled back in recent weeks. The good news is relief on the inflation front, and hopefully on the interest rate front too. The bad news is that the lower prices reflect worries about slowing economic growth.
Chart 1: S&P GSCI Commodity Indices over the past year ($)
Source: Refinitiv Datastream
Climate crisis
The interaction of political, economic and environmental systems also took a turn for the worse with the Russian invasion.
With gas supplies tight and fears of interruptions looming, many utilities in Europe and elsewhere have turned to burning coal in greater quantities. This benefits South Africa, as the fifth largest coal exporter by volume, though Transnet inefficiencies limit the extent of the bounty. This is clearly a major setback for the green energy transition, but not necessarily all bad news.
Economists have long argued that a carbon tax is the best mechanism to address greenhouse gas emissions. If carbon is expensive to emit, companies will try harder to reduce emissions and the incentive for innovation and adoption of alternatives increases.
Thanks to Russia, a global carbon tax has now effectively been imposed. The only problem is that its revenues are flowing to the Kremlin. Policymakers should seriously consider increasing carbon taxes as energy prices fall. The problem is that high prices are painful for consumers and by implication, for politicians. Leaders in many countries, who until recently were strongly anti-fossil fuels, are now calling for increased oil production to ease the pain at the petrol pump.
Even worse are petrol price subsidies that, however well-intentioned, ultimately encourage excessive use.
It will take a concerted effort, and some sacrifice, to ensure that the transition from dirty to clean energy is smooth and even then, it might still be bumpy. It was widely assumed that fossil fuel prices would fall as they are phased out. However, given tight supplies and lack of investment in new capacity, we might end up with very high prices or at least very volatile prices as the transition takes place. People need to be prepared for this, otherwise resistance to the transition will grow.
Financial risks
Global markets have been under pressure in 2022. The market narrative shifted very quickly from ‘inflation is transitory’ to ‘inflation is out of control and will require aggressive central bank hikes’ to where we are more or less today, namely ‘recession is becoming more likely, and inflation and interest rates should therefore decline eventually’. If a recession does occur, it is likely to be relatively mild in the main developed countries.
Household and company balance sheets are generally in good shape. There were few signs of excessive leverage and irrational exuberance.
The deepest recessions are usually associated with banking crises that follow a build-up of bad loans, typically linked to a property bubble. While there have been property booms in most developed countries, generally borrowers and lenders have been well behaved. To use the US as an example, most mortgages have been of a high quality in contrast to the sub-prime borrowing binge (of the previous housing boom). Banks, under the eagle eyes of regulators and still scarred by the near-death experience of the 2008 crisis, have maintained sufficient capital buffers.
Where there has been excessive optimism and outright speculation has been in crypto and various other emergent technology sectors. New and unprofitable technology companies could trade on multi-billion-dollar valuations until the start of the year. Most of these investments have already lost anywhere between 40% and 80% of their value. The froth has settled.
For emerging markets, the big culprit is usually a balance of payments crisis where the country runs out of the hard currency needed to make foreign debt payments, sustain imports, and manage the exchange rate.
Sri Lanka has already suffered such a crisis this year, and Argentina and Turkey could be headed that way. Few of the other major emerging markets seem at risk, and South Africa, for all our problems, certainly is not. While the rand slumped over the past few days as load shedding fears interacted with a rising dollar and global risk aversion, this is not a currency crisis.
The freely floating Rand is a shock-absorber and adjustment mechanism for the local economy by discouraging imports and raising global asset values and export revenues. Its volatility also discourages the kind of offshore borrowing binges that get developing countries into trouble in the first place. Moreover, South Africa is still running a trade surplus at this stage.
Chart 2: Rand-Dollar exchange rate and dollar index
Source: Refinitiv Datastream
Electricity crisis
Apart from the global energy crisis, South Africa also has a homegrown electricity emergency.
The government, which until recently largely monopolised the supply of energy, failed over many years to build sufficient generation capacity. In fact, Eskom now generates less electricity than it did in 2005.
The bulk of Eskom’s fleet of coal-fired power stations are reaching the end of their lifespans. They are old and require constant maintenance, but this means taking them offline. Add in a cold winter that pushes up demand and an illegal strike that hampers supply, and the ingredients are there for Stage 4 and Stage 6 load shedding.
The worst appears to be over for now as unions have agreed to a 7% wage increase, but the reality is that we will constantly be skirting the fine line between demand and available supply until substantial new generation capacity comes on stream in the years ahead.
Chart 3: Eskom electricity production
Source: StatsSA
Eskom itself has noted that between 4,000MW and 5,000MW of new capacity is urgently needed, with more required over the coming decade as it decommissions its older plants.
The foot-dragging from government’s side has been astonishing. Bid Window 5 of the government’s renewable energy independent power producer programme (REIPPP, to use the clumsy acronym) was closed in April last year but input costs have increased so dramatically between now and then, that none of the firms have managed to convert their winning bids into on-the-go projects. This should have brought 2,500MW online.
The 2,000MW ’emergency’ REIPPP was gazetted in mid-2020 with winning bids announced a year later. So far only 150MW of new projects have been confirmed. So much for emergency.
The one good thing about crises is that they often force tough decisions and spur action from reluctant politicians. If there is no action, then the crisis is not big enough and a worse crisis will occur. This is where we are now. The bigger crisis has occurred, and more urgency is now likely.
The one bright spot – the light at the end of the tunnel to use an overused pun – is that private companies can now produce up to 100MW for own use without lengthy regulatory approvals. The better-managed municipalities will also be able to source from independent producers. Solar and wind power plants can be set up relatively quickly. The Mineral Council estimates its members in the mining industry will generate around 2,300MW for own use by 2025.
South Africa is at the early stages of transitioning from a monopoly model of electricity supply to one where private producers and suppliers will be much more prominent. This will require hundreds of billions of Rands to be spent over several years on production, storage and transmission. It is probably the single biggest investment opportunity in the country, if not the continent. And that is excluding the promising emergence of green hydrogen as an energy source of which South Africa is well placed to become a leading producer and exporter.
The local economy is much less energy intensive than it used to be, and businesses have over the years learned to live with blackouts, but there is no doubt that sustained load shedding at Stage 6 and above is extremely disruptive, especially given the current cost of running a diesel generator. The near-term growth outlook has therefore taken a knock.
Polycrisis, polyopportunities
US President John F Kennedy popularised the notion that the Chinese word for ‘crisis’ (weiji) is comprised of the characters for ‘danger’ and ‘opportunity’. That turns out to not be true. The more accurate translation, apparently, is closer to combining ‘precarious’ and ‘turning point’.
This makes sense. Many of the great turning points in history have come from times of crisis. In particular, big policy turning points usually only happen when there is a crisis of some sorts. Politicians will usually only do something that requires sacrifice if doing nothing is worse.
Moreover, crises do present opportunities. From an investing point of view, we should not just stand back and analyse the various interacting crises, but also look for where too much bad news has been priced in.
The one thing most crises share is that there are some investors who are prepared to sell at rock-bottom prices to cut their risk. In such a situation, you want to be a buyer, provided it fits in with your long-term strategy. Therefore, recent declines in bonds and equities make them more attractive to long-term investors, not less.
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