Kevin Cousins | Head | Research | PSG Asset Management | mail me |
Significant uncertainty, marked by rampant inflation, fears of a looming recession and growing geopolitical risk, clouds the near-term global outlook. The knee-jerk reaction is to retreat to safe assets and preserve capital until the storm has blown over.
However, we believe that investors should look past the noise of the simple narratives and take a longer-term view based on more enduring factors.
Some assets that historically acted as safe havens could in fact amplify risk over the next few years, but investors that maintain and build exposure to carefully selected equities are likely to be well rewarded for weathering near-term volatility.
Elevated inflation
Inflation in the US, UK and Europe is back at levels last seen in the early 1980s and 1970s. SA is also experiencing elevated inflation, although our rate is below that of the US, UK and Western Europe, a rare event last seen in 2003/4 and before that the 1970s.
However, there is a world of difference between how markets are pricing the future inflation risk in different economies. Even if inflation stays elevated, a holder of SA government bonds will still make attractive real returns – inflation is priced to get worse in SA. By contrast, in developed markets, bond pricing assumes inflation will be rapidly brought to heel.
The combination of the Federal Reserve’s rate hikes restraining demand and base effects will no doubt temporarily lower inflation, but will not alleviate long-term price pressures. While the consensus narrative has been to blame the COVID-19 demand bump and Russian invasion for high commodity prices, they were mostly catalysts that exposed tight markets, and not the root cause.
Sustained long-term price pressure stem from many years of under investment in real economy sectors (e.g. energy, materials and shipping), a tightening US labour market, massive resource requirements for the looming energy transition, and the onshoring of global supply chains.
Addressing these will require substantial new investment and it would take many years to make an impact.
What this means for SA investors
As a large commodity exporter with ample labour, SA is likely to be a resilient market in this environment. Comparable historic periods (2001 to 2011, 1970s) show our own inflation rate tends to be curtailed by a strong currency.
The obvious equity beneficiaries are ‘real asset’ sectors such as materials, energy, shipping and capital equipment. However significant foreign capital flows are likely, meaning lower yields and ‘SA Inc’. domestic companies also perform well. This could make selected SA mid-caps the pick of the bunch.
Global recession fears
The likelihood and timing of a US recession has dominated financial media recently. The rapid increase in rates in the US has already had an impact on the economy, leading economic indicators have shown a sharp slowdown in activity, and yield curves have just inverted. These may indicate an approaching recession.
Financial markets are now explicitly pricing in an imminent recession and a pivot from tightening to easing by policymakers, with the Fed Fund futures curve pricing in nearly 75 basis points of rate cuts starting as soon as early 2023.
Most investors’ experience of a recession involves the global lockdown of 2020 and prior to that the GFC in 2008/9. The GFC was an unusually severe event, where the slowdown in demand triggered severe negative feedback loops from the over-leveraged private sector balance sheets.
The aftermath of ‘balance sheet’ recessions like the GFC, is a long period of economic stagnation as the private sector reduces leverage and rebuilds capital. That process took the best part of a decade in the US, but is now complete. The banking sector currently has ample capital and clean lending books and US households are also in a strong financial position. The US economy is likely to be surprisingly resilient in the face of lower demand.
What this means for SA investors
The significant probability that the next recession is mild (more like 2001 than 2008) is not appreciated by the market consensus, and economically sensitive sectors have been aggressively sold off.
Locally, SA equities are attractively valued and remaining invested makes sense. Assets like developed market bonds are likely to be sources of risk rather than safe havens, given a stagflationary environment.
A new cold war?
The past 20 years can be characterised as a ‘honeymoon period’ of steadily increased globalisation and few geopolitical confrontations. This came to an end with the Russian invasion of Ukraine and resultant sanctions.
Even more worrying has been Chinese alignment with Russia and escalating tensions with the US and other democracies.
To our mind, China has thrived under leadership best described as smart, pragmatic technocrats. This appears to be over in the Xi Jinping era and his election for a third term at the Party Congress later this year is likely to be just a formality. This raises a significant risk that we are moving into a ‘new cold war’ era.
While the direct impact on a South Africa-domiciled investor may be limited, the Russian crisis has shown that even if SA did not participate, the impact of future sanctions could be devastating to the share prices of China-exposed businesses.
What this means for SA investors
China, as the second largest global economy, is deeply entwined with global businesses. Any cold-war like escalation could be extremely painful. While we would not regard China as ‘uninvestable’, it is appropriate to have a high bar when evaluating opportunities.
We believe it is necessary to ensure your portfolios could weather a China crisis, stress-testing both direct impacts from companies with Chinese operations and indirect via upstream supply chains or downstream customers.
Financial markets battle to conflate time horizons, with the consensus invariably focusing on the near-term prospects to the exclusion of more nuanced longer-term ones. Navigating the storm requires us to look through the noise and focus on more enduring factors such as supply-side constraints and household balance sheets, and doing so can create attractive opportunities for astute investors.
