A confluence of malign reinforcements
The modest rebound in risk appetite in March proved mere respite as April brought broad-based market weakness. Investors’ concern shifted from stagflation to recession as headwinds intensified.
Tightening financial conditions leading to alternatives
The Fed turned more hawkish in its rhetoric, leading the market to price in some prospect of 75bp increments at the near-term FOMC meetings. In addition, pending quantitative tightening and a decline in liquidity further boosted US yields and the dollar.
High US yields and a strong dollar have historically led to a more trying time for risk assets. While this is usually ascribed to a higher discount rate and resulting lower valuations, the bottom line is that defensive asset classes, such as DM bonds, are becoming investable again. In short, it is now longer a case of TINA (there is no alternative).
The war in Ukraine has proven to be more durable, in contrast to earlier expectations that this would be a quick victory for Putin. Sanctions have broadened, and many countries have begun the process of weaning their economies off Russian energy. While this may ensure supply that is more reliable in the long run, short-term provision remains tricky.
Cyclical slowdown exacerbated by China lockdown
Many argue that if were not for the lockdowns in China, the oil price would be much higher. On the flip side, China’s zero-Covid policy is again contributing to various supply chain constraints at a time when demand, particularly in the US, remains resilient.
The Chinese renminbi weakened sharply in the second half of April, sparking fears of a devaluation to limit downside to China’s growth. However, the weaker yuan reflects market fundamentals to a large degree, as the narrowing yield differential between China and the US has prompted portfolio outflows.
Central banks playing catch up
The shift in the inflation outlook from the start of the year has resulted in many central banks, particularly in developed markets, having to play catch-up. Yet even though normalisation has begun, policy rates remain low in nominal terms and deeply negative in real terms. Thankfully, many emerging markets, particularly in LatAm, are well into their hiking cycles, with forward-looking real rates stabilising or even moving into positive territory.
Some may argue that the SARB is a laggard, but it is not a case of being behind the domestic inflation curve. Rather, the Bank needs to be cognisant of global liquidity dynamics to prevent exchange rate weakness that could exacerbate cost-push inflation.
Hoping for a soft landing to balance demand with supply
The slowdown in global liquidity growth has already translated into moderating asset price momentum and should lead to weaker activity levels. Tempering global growth is required to better align demand (which is sensitive to monetary policy) with supply (which remains constrained) to put a break on the rate of inflation.
Until this happens, earnings expectations may not fully reflect the headwinds of the strong dollar, rising borrowing costs, high input costs (energy and wages), and lower liquidity. The question now is whether policy makers can achieve the historic feat of a soft landing.
During April, inflation-linked bonds (1.9%) was the only asset class to beat cash (0.4%), while listed property (-1.4%), fixed-rate bonds (-1.8%), and equities (-3.9%) ended in the red. The rand lost 7.3% against the US dollar, which would have been accretive to offshore returns.
Dollar a stronger headwind for EM FX
Hawkish Fed pricing and rising risk aversion triggered broad based dollar strength. The DXY Index gained 4.7% in April, taking it to the highs of March 2020 (Covid) and December 2016 (Trump). EM FX lost 3.1% against the dollar, on average, but this was flattered by the 13.2% recovery in the Russian rouble.
At 7.3%, the rand’s performance was on the weak end of the range, with the unit being hit by lower commodity prices, rising risk aversion, and market concern that the SARB may be lagging the global monetary policy cycle. At close to 16.00, USD/ZAR is trading modestly cheap versus its fundamental fair value, with excess risk premium reflecting heightened global uncertainty.
Higher yields on pending QT
Surging inflation and the pending Fed balance sheet run-off pushed US bond yields sharply higher in April. A position in the safe-haven 10-year US Treasury bond would have lost 3.6% for the month. The 60bp sell-off in the nominal yield, to almost 3.00%, was driven largely by real yields (+50bp) with break-even inflation only modestly higher (+10bp).
Higher US yields and the stronger dollar made for a more challenging EM backdrop. Local currency bond yields sold off by 50bp, on average, with a relatively wide range from 5bp for China and 130bp for Peru. The SA market was in the middle of the pack, with the 10-year yield up by 40bp, to 10.36%. While the market screens cheap relative to our fair-value metrics, the excess risk premium is warranted based on elevated global uncertainty.
According to the headline portfolio flow data, non-resident investors sold R13.2bn worth of SA government fixed-rate bonds in April, bringing total net outflows for the year-to-date to R90bn. This is in sharp contrast to the official National Treasury data that shows net buying of R21.5bn year-to-date, with marginal net selling of R0.5bn in April.
Equities fret about rising recession risks
A confluence of malign reinforcements left global equities as the worst performers during April. A more hawkish Fed, surging real yields, mounting inflation fears, the ongoing war in Ukraine, and the lockdowns in China triggered sharp broad-based losses after the short-lived recovery in March. The S&P500 lost 8.8% while the Eurostoxx was down by a more moderate 2.1%. Falling industrials metals prices hit EM exporters relatively hard.
The MSCI World Index declined by 8.3%, underperforming the 5.6% loss on the MSCI Emerging Market Index. The only country indices that ended the month in the black were Turkey, Indonesia, and the UK. CEE and LatAm bourses underperformed sharply – the former due to the Russia/Ukraine war and ongoing catch-up hikes, the latter due to lower commodity prices.
The MSCI South Africa Index was a relative underperformer, losing 12.8% in April, in large part due to rand depreciation. The ALSI fell by 3.7% and the SWIX by 3.9%. The underlying sub-sector performance showed only a few pockets of relative resilience. Chemicals (9.6%), beverages (3.2%), general industrials (2.6%), and personal care retail (0.7%) were the standout industries. At a sector level, consumer staples (2.3%) and industrials (1.3%) posted gains, while consumer discretionary (-0.5%) and technology (-2.9%) beat the headline performance. Financials (-5.5%), basic materials (-5.5%), health care (-7.7%), and telcos (-8.7%) underperformed sharply.
The April sell-off rendered SA equities outright cheap, with a 20% discount versus EM and a 25% discount relative to the 5-year history of the forward PE ratio. Despite negative earnings revisions (except for energy), the forward PE declined to close towards the Covid low, at around nine times.