Roiled by Russia
Russia’s invasion of Ukraine has resulted in a humanitarian crisis, with an estimated 2.8 million refugees according to the United Nations Human Rights Council (as at 13 March 2022). Moreover, those that have remained in Ukraine face the risk of not having access to electricity, food, or water. The direct impact is severe.
We also cannot ignore the risk of a broader humanitarian spillover due to surging fuel and food prices. With Russia and Ukraine accounting for a substantial share of global grain production and exports, demand for grains has risen in a bid to build inventories. With many economies still struggling from the scarring of the Covid related lockdowns, governments will be cognisant not to repeat the conditions that led to the Arab Spring of 2011.
Stagflation fears abound
Heading into the year markets were concerned about rapidly tightening financial conditions in the US. While rising yields did contribute to the correction in equities, valuations remained elevated as underlying growth conditions were seen as robust. Importantly, the Fed was expected to hike because inflation was being driven not only by supply constraints, but also by excess demand.
During February, the inflation outlook worsened notably, but the risk to global growth shifted firmly to the downside.
Numerous spillovers add to the uncertainty
The caveat is that the situation in Ukraine remains fluid and much depends on the duration and breadth of the conflict, as well as the extent and duration of sanctions.
The immediate impact is weaker growth in the Eurozone, given that it is a major regional trading partner to both Russia and Ukraine. Weaker Eurozone growth will spill over to the rest of the world.
The second-round growth impact will be via high oil and food prices, which will erode disposable income. In addition, where governments provide subsidies, usually for fuel, the pressure to maintain social stability would see fiscal positions deteriorate on the back of higher prices.
The surge in commodity prices will be negative for net commodity importers, as it entails a transfer of wealth to net commodity exporters. This has been evident in EM FX performance.
Commodity prices a boon and a risk for South Africa
While South Africa is shielded from the direct impact, given very little trade with Russia and Ukraine, the Eurozone accounts for 20% of South Africa’s exports. A sharp growth slowdown in Europe would negatively affect net export volumes. A positive offset, however, stems from the surge in commodity prices, with the terms of trade benefiting from higher coal prices, as well as those of PGMs. These have more than offset the impact of oil prices. As a result, net export values could still improve due to the price effect, with positive implications for the rest of the economy.
Even so, the consumer will not benefit directly from higher metals prices. Rather, the outlook for domestic consumption is set to deteriorate due to higher fuel and food costs. Given the weak labour market, higher basic good prices will lessen weaken disposable income for discretionary spend.
SARB stuck between a rock and a hard place
The prospect of stagflation in South Africa will make monetary policy decisions even more difficult. Mounting exogenous inflationary pressures risk de-anchoring inflation expectations that would lead to second-round price effects and higher wage demands. At the same time, the growth outlook has become more fragile due to the potential for a weaker consumer – household consumption expenditure accounts for two thirds of South Africa’s GDP.
Historically, a stagflationary backdrop would tip the South African Reserve Bank (SARB) to the hawkish side. The hawkish tilt this time round will be exacerbated by the fact that the US Fed is set to embark on policy normalisation – not only via interest rate hikes, but also by running down the balance sheet. Given that South Africa is a small open economy, in terms of both trade and financial markets, the SARB will be cognisant of rising US rates. To be sure, the interest rate hikes since November were at least partly informed by pending Fed hikes.
The combination of the hawkish Fed and high oil prices will very likely ensure that the SARB hikes sequentially to limit second round effects and to buttress the exchange rate. If oil prices remain at current levels, then inflation is set to breach the 6.0% target upper limit for two to three quarters. If we factor in the likely renewed acceleration in food price inflation, then headline CPI could average over 6.0% in 2022. This would make the SARB uncomfortable relative to its implicit 4.5% target.
Be careful what you wish for
Front-loaded hikes and the potential for a more rapid growth slowdown in 2H22 could lead to the Fed and SARB pausing by year-end, as excessively high prices lead to demand destruction. Yet uncertainty is pervasive and point forecasting in this environment is futile.
Much depends on when and how quickly commodity prices unwind. While a notably lower oil price would ease the SARB’s near-term inflation headache, a slump in the terms of trade could mean trouble for the rand and potential exchange rate driven inflationary pressures down the line.
2022 is turning out to be tougher than many had expected.
Market developments
During February, equities (2.7%) and inflation-linked bonds (2.1%) outperformed the other asset classes by a wide margin, while fixed-rate bonds (0.5%) marginally outperformed cash (0.3%). Listed property (-3.3%) underperformed during the month. The rand lost only 0.3% against the dollar, which would have been broadly neutral for offshore returns.
Dollar up, rouble roiled, rand resilient
The dollar index rallied by only 0.2% in February, but this belies notable intra-month volatility. Hawkish ECB rhetoric in early-February shifted relative monetary policy expectations in favour of the euro to put downward pressure on the US dollar. This was, however, short-lived with Fed comments reinforcing the focus on inflation. US CPI hit a near 40-year high of 7.5%, leading the market to price in more aggressive tightening. The final stretch of the month saw the dollar gain on safe-haven demand amid the escalating Russia/Ukraine crisis.
The Russian rouble was the key EM focus, having lost 21% against the dollar in February, with the bulk of the move coming through on the last day of the month. Contagion to Ukraine’s neighbours was evident in the FX market, as the Hungarian forint and Polish zloty notably underperformed the EM average. At the other end of the spectrum commodity currencies gained against the dollar, led by the Brazilian real (3.1%) and the Peruvian sol (1.7%), while Asian currencies held their ground. The rand lost 0.3% against the dollar, but gained 0.4% on a trade-weighted basis, reflecting the depreciation pressure on the euro.
That the rand lagged other commodity producers, notably in LatAm, could reflect that investors were overweight the rand, or rather not as underweight as in other EM currencies. Moreover, we think there is a valuation argument in that the rand has been well behaved, trading in line with its fair-value range, whereas LatAm currencies had cheapened over the course of 2021 amid domestic political risks and sharply higher inflation.
The rand is trading in line with our 14.50 – 15.50 fair-value range for USD/ZAR. Tightening global financial conditions pose a risk to the unit, but fundamentals are currently more supportive than during the previous Fed hiking cycle. Importantly, the current account remains in surplus with renewed impetus from surging commodity prices, while macro policy has been reinforced by the prudent budget, as well as the conservative- and hawkish – central bank. That said, the rand will remain vulnerable to extreme risk aversion, but the extent of any sell-off would be limited by the more robust balance of payments.
A tale of two halves for DM bonds
DM bond yields sold off in the first half of February amid hawkish central bank rhetoric and accelerating inflation. The US 10-year yield breached 2.0%, while the 2-year broke through 1.5% to flatten the yield curve. However, the escalating geopolitical tensions and Russia’s invasion of Ukraine caused the market to consolidate as hiking expectations were partially priced out. With the Fed’s firm focus on inflation, particularly in light of surging energy prices, the curve renewed its flattening trend in the second half of the month.
Breakeven inflation widened into the end of the month, driven by plummeting real yields. Not only did demand for inflation protection rise, but growth expectations moderated due to the combination of tightening monetary policy and the elevated oil price. Breakeven inflation on a 5-year horizon again breached 3.0%, reaching similar levels to November last year.
EM bond yields were relatively resilient in early-February, withstanding more hawkish DM monetary policy expectations. However, the Russia/Ukraine/NATO tensions started percolating mid-month, putting upward pressure on EM bond yields. With the invasion of Ukraine, Russia’s 10-year yield sold off by 650bp to 16.00%. The various sanctions imposed on Russia have effectively closed down trade in Russian assets. Turkey’s 10-year yield rose by only 60bp, but at 23% the yield reflects elevated Turkey-specific risk premium and rampant inflation. Turkey’s CPI reached 54.4% in February – the highest rate since early 2002.
Outside of these autocracies, the EM sell-off was relatively contained, with the GBI-EM yield rising by 20bp. Rather, the pain was more acute in EM hard currency bonds, where the EMBI+ sold off by 143bp, again reflecting Turkish woes, and geopolitics. While Turkey’s 10-year USD bond sold off by 110bp, Ukraine’s yield shot up by 1360bp to 24.2%, while Russia’s 15-year benchmark USD bond yield rose by 1580bp, to 20.4%.
SA macro anchors not enough to counter risk aversion
South Africa’s benchmark USD bond yield rose by 50bp, to breach 5.0%, but this was a contained move relative to the EM peer group. SA’s local currency 10-year yield rose by a mere 2bp month-on-month as the pre-Budget rally was reversed by the Russia/Ukraine crisis. The 10-year yield ended the month at 9.80%, which was moderately cheap versus our 9.00% – 9.50% fair-value range.
A prudent budget and unchanged issuance was not enough to steady the market, as the sell-off turned more severe since the end of February. The 10-year yield reached a high of 10.70% in early-March, rendering the market outright cheap. That said, much depends on the evolution of the Russia/Ukraine war, the inflationary consequences, and how the SARB responds.
Non-residents bought R19.6bn worth of SAGBs on a net basis in February, taking their share of holdings from 28.4% to 29.1%. For the first two months of the year, non-residents have effectively absorbed 83% of net government issuance – a vast improvement on the 12% for 2021. Banks bought a net R8.4bn in February, while unit trusts were modest sellers of R4.9bn.
The headline daily bond portfolio data showed an alarming R79bn in net foreign selling year-to-date, with R71bn coming through in March. However, this is in contrast to the monthly Treasury data, as well as the settlements data that is now being published by the JSE. On this “cleaned up” basis, non-residents sold only R8.2bn so far in March.
Confluence of inflation and geopolitics make for another tough month for DM
Developed equity markets had to contend with rampant inflation, hawkish central bank rhetoric, and the fall-out of the Ukraine invasion. It is clear that Omicron and reopening were quickly forgotten. The S&P500 lost 3.1% in February, bringing the year-to-date fall to 8.2%. Eurostoxx dropped by 5.2% amid the more direct risks to Eurozone growth from Russian sanctions. There were pockets of resilience in local currency bourses: Peru (12.5%), Colombia (8.3%), and Brazil (7.9%) posted strong gains on surging commodity prices.
The MSCI World Index lost 2.5%, marginally beating the 3.0% fall in the MSCI EM Index. The latter was drawn down by the slump in the MSCI Russia Index (-52.8%), and the contagion to Hungarian (-26.3%) and Polish (-11.9%) counters. The MSCI Peru Index (8.8%) was the outperformer for the month, while the MSCI South Africa Index (4.7%) posted a respectable gain.
Commodity prices dominate SA equities
The ALSI and SWIX gained 3.0% and 1.9% respectively, as the benefit of strong commodity prices countered the spillover of Russian sanctions on specific counters.
Basic materials (16.0%) were the star performers, led by precious metals and mining (26.7%) amid the surge in PGMs and the resilience in gold. Financials (2.7%) ended the month in the black, largely thanks to banks (6.0%), while consumer staples (-0.1%), telco’s (-0.4%), and health care (-1.1%) posted modest declines. Consumer discretionary (-4.8%) and industrials (-6.0%) underperformed due to the negative impact of surging oil prices and the attendant upside inflation risks, as well as direct Russian exposure in some instances.
The standout sector for the month was technology, which lost 30% as Naspers and Prosus unwound all of their pandemic gains on the back of direct Russian exposure, fragile China sentiment, and contagion from global food delivery peers.
Despite the February rally, the discount in the local market stabilised at around 21% compared to the long-term average rating. The price performance coupled with positive earnings revisions resulted in a slightly lower forward PE ratio to just below 11 times. The projected moderation in earnings growth for the overall market masks diverse underlying trends. While earnings growth in basic materials and banks are forecast to moderate quite sharply, consumer related sectors and health care are expected to show accelerating earnings growth in 2022.
