A year of transition
After two years in a global pandemic – with acknowledgement (rather than celebration) of the anniversary of the Wuhan lockdown on 23 January – the theme for 2022 is normalisation: the process of returning to a normal condition. Yet the impact of the pandemic, lockdowns, and policy responses has been so large and systemic that for many it is difficult to think back to what normal was.
Our worlds have moved online and it will be a challenge to get off. Even so, we cannot ignore that things have started to shift, in some instances quite rapidly.
The world is transitioning.
The beginning of the end of this pandemic
We are learning to live with Covid and this should mark the transition from Covid being a pandemic to becoming endemic. This will allow governments to ease restrictions on mobility in an attempt to normalise economic activity. South Africa has been an exception in this regard, with sequential easing leaving mobility at or above pre-Covid levels.
From dovish to hawkish
After substantial explicit and implicit easing since the onset of Covid, developed market central banks are set to move from extremely accommodative monetary policy to a tighter stance.
The key focus has been on the Fed, where there is increasing speculation that there will be a 50bp lift-off in March, as many as eight hikes by year-end, and balance sheet run-off (quantitative tightening) from June onwards. Based on the FOMC’s Summary of Economic Projections, the real Fed funds rate is predicted to rise by more than 300bp this year – a large move relative to history.
With the hawkish shift from the Fed and, more recently, the ECB, negative yields have started to rise. Whereas the entire German nominal yield curve was trading below 0% in 4Q20, the 10-year yield has now moved back into positive territory. The market capitalisation of negative yielding debt has fallen from a peak of US$18.4trillion in December 2020 to US$4.8trillion (smaller than the Fed’s balance sheet).
A concern for markets will be the transition in US TIPS yields from negative to positive, as these are the basis for financial conditions in global markets.
Oil moves from base effects to bad effects
As the world’s focus on climate change and ESG intensifies, “greenflation” has come to the fore alongside a surging oil price. Low oil prices in 2020 (recall the negative WTI price in April 2020) were a benefit to oil consumers, even if they could not fully capitalise on this in light of lockdowns. This advantage is now reversing sharply, as high oil prices are creating a transfer of wealth from oil consumers to oil producers.
The oil price is at an inflection point for global growth as the resultant inflation and second round pass-through pose downside risk to real incomes.
More uncertainty ahead
Whereas a hiking cycle usually reflects strong growth, high confidence, and low financial market volatility, this normalisation cycle might be too late in the game. Tightening policy when growth is set to roll over could introduce higher financial market volatility. Oil price risks and geo-political instability will exacerbate the uncertainty.
Thankfully, 1 February 2022 marked the Year of the Tiger. According to the Chinese Zodiac, the Tiger is known for its courage and strength. Moreover, it is the Year of the Water Tiger, to be precise. The energy associated with the water element is stillness. Yet, a tiger can have a very short fuse and the calmness of a lake masks the raging river that feeds it.
It may be the year of the tiger, but we are not out of the woods yet.
Market developments
During January, equities (2.4%) outperformed the other asset classes by a wide margin, while fixed-rate bonds (0.9%) managed to outperform cash (0.3%) marginally. Inflation-linked bonds (-1.1%) and listed property (-2.9%) underperformed during the month. The rand gained 3.6% against the dollar, which would have been dilutive for offshore returns.
Dollar on the front foot in early 2022, but ZAR resilient
Monetary policy differentials dominated G10 FX markets in January, as the hawkish Fed and the upside surprise in the December CPI release boosted the dollar – the DXY gained 0.9% m/m. However, the more hawkish Fed and sell-off in US yields did not lead to broad-based risk aversion, based on the varied EM FX performance.
Despite the surge in the oil price, the Russian ruble lost 3.5% against the greenback as tensions between Russia, Ukraine, and NATO intensified. The Chilean peso appreciated by 6.4% as the unit recovered following the Q4 blowout amid domestic political uncertainties. A rebound in the terms of trade, seemingly stronger economic activity, and hawkish monetary policy expectations in the lead up to the January MPC meeting supported the rand, which rallied 3.5% against the dollar.
The rand is trading on the cheaper end of 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 supportive compared to the previous Fed hiking cycle.
Normalisation narrative hits DM bonds
Following the faster taper and higher dot plot in December, the FOMC minutes and post-meeting Q&A in January elucidated the extent of the hawkish shift. These triggered a notable repricing in US bond yields, with the UST 10-year yield rising by 27bp, driven by higher real yields. The curve flattened further, with 2s10s falling to 60bp – the lowest since October 2020. Rising US yields and accelerating Eurozone inflation have even pushed the German 10-year yield back into positive territory (for the first time since May 2019).
EM reaction muted versus mini tantrum of 1Q21
The rapid repricing in US rates did not have as big an adverse effect on EM local bond markets compared to the mini taper tantrum a year ago. Whereas the rout in 1Q21 was driven by rising risk premia, the recent sell-off resulted from tightening monetary policy expectations amid robust US GDP growth and a strong labour market. In fact, the risk premium in US bonds has declined since the start of the year. The average EM bond yield sell-off was 20bp in January, compared to 100bp in February-March last year.
Geopolitical risk was evident in the 103bp rise in Russia’s 10-year yield, while Turkey’s benchmark bond rallied by 97bp, but this is still off a very high level. SA was a relative outperformer, with the 10-year yield only 2bp higher month-on-month. Part of the reason for the relative resilience in EM bonds, so far, is that foreign positioning was light compared to the start of 2021. At that time, the 2020 US election outcome and falling US yields boosted demand for EM assets. In contrast, investors entered 2022 underweight duration relative to EM local market benchmarks.
The SA 10-year yield recovered sharply in December, but has traded broadly sideways year-to-date. At 9.75%, the market screens moderately cheap versus our 9.00% – 9.50% fair-value range. While there is substantial excess risk premium in the market, significantly higher US yields pose downside risk to bond market returns. SA bonds screen moderately overvalued versus the EM peer group on a tactical basis.
A torrid month for DM equities with selective EM outperformance
Following a strong end to 2021, developed equity markets buckled under renewed Covid uncertainty with the surging Omicron wave, disappointing earnings results from large tech names, and rising real rates. The S&P500 lost 5.3%, while the Eurostoxx fell by 3.8%.
The MSCI World Index lost 5.3%, underperforming the 1.9% decline in the MSCI EM Index. EM exchange rate resilience aided dollar returns in equities. Developed markets dominated the weak end of the scale, with New Zealand, Denmark, and Sweden posting double-digit losses. In line with FX and bonds, the MSCI Russia Index (down 8.7%) was one of the worst performing EM equity markets in January. Following a bumpy Q4, LatAm bourses recovered in January, with Brazil, Chile, Peru, and Colombia posting double-digit gains.
The MSCI South Africa Index was a relative outperformer, with the 6.8% increase in dollar terms partly aided by the rand’s recovery. The ALSI gained 0.8%, while the SWIX rose by 2.3%. The sector performance was diverse with strong gains in telco’s (10.1%) being countered by weakness in consumer discretionary (-7.1%) and health care (-6.1%). Industrials (-2.4%) and technology (-1.7%) also underperformed, while consumer staples (3.0%) and financials (2.5%) managed to marginally beat the overall market. The standout sub-sector was chemicals (28.5%) within basic materials (3.6%), where Sasol benefited from the surge in the oil price.
Following the relatively strong performance in January, the discount in the local market has lessened slightly, from around 25% to 22% compared to the long-term average rating. The price performance coupled with moderating earnings growth lifted the forward PE ratio to just above 11 times. Slowing earnings growth, from around 50% to 11%, is largely due to the very high base in basic materials. In contrast, many SA Inc. industries are expected to show improving earnings momentum on a 12-month view.
