Surviving the volatility
The second quarter was challenging for global financial markets. Upside inflation surprises spurred even more hawkish central bank rhetoric and a substantial tightening in financial conditions. Looking at the Goldman Sachs Financial Conditions Index for the US, the level might be in line with the long-run average (since 1990) but the delta has been large over a short period.
Out-hawk, out-hike, and fast
Developed market central banks continue attempts to “out-hawk” the Fed, but this largely failed in June. The FOMC delivered a 75bp hike, with the dollar surging on the combination of tightening US monetary policy and global recession fears. Front-loaded tightening has led the market to price in rate cuts in the US, starting by mid-2023.
Negative economic surprises in G10 countries spurred the recession narrative. While a slowdown should dampen price pressures, the moderation in the inflation surprise indices has been notably less pronounced. This may reflect the fact that inflation forecasts have been forced to catch up to reality.
Nascent cooling in input costs
The global PMI data revealed a recovery in activity and orders amid the selective reopening in China. Easing supply constraints are evident in lower backlogs and improving delivery times, even if these measures remain off their pre-Covid levels. Input and output prices have moderated, but only modestly.
Lower commodity prices, notably oil and grains, should allow inflation to moderate in the coming months. However, it is not obvious that the peak is behind us, as we could have a sticky inflation profile, both here and abroad, due to the lagged impact of high input costs, tight DM labour markets, and potential second-round effects.
Are unions making a comeback?
There is mounting concern about a wage-price spiral given numerous headlines that unions are making a comeback, particularly in the US – union power has always been stronger in Europe and the UK. However, to give some perspective, unionisation rates have fallen since the 1960s and 1970s.
The US peaked at around 30% and declined to 10% (in 2020); while in the UK, it peaked at 50% and fell to 23%. Concern may be warranted, but unionisation is coming off a low base.
The Covid lockdowns, work flexibility, the great resignation, rising inflation, and inequality are contributing to the demand for better pay and renewed picketing for labour unions. An improvement in income, alongside excess savings, could support growth in the longer-run, assuming rising labour input costs are not readily passed on to customers to protect firms’ margins.
Savings will not necessarily provide immunity
The shorter-term outlook suggests caution. Saving rates have fallen – from a flow perspective households are able to save less out of income due to rising prices – even as the stock of savings could buttress spending in a downturn. Yet based on the slump in consumer sentiment measures, rising uncertainty could lead to precautionary saving and hence lower spending than would otherwise have been the case.
We have much to worry about
South Africa has not been immune to the precarious economic outlook. The BER Business Confidence Index declined from 46 to 42 in Q2 and the BER Consumer Confidence Index slumped from -13 to -25, in keeping with recessionary levels. Despite the large upside surprise in Q1 GDP, rising inflation, rate hikes, and intense load shedding are weighing on the outlook.
Political uncertainty could also be a contributing factor, particularly given that much of the news flow in recent weeks has been directed at the president. The political mudslinging is set to worsen as we near the ANC elective conference in December.
25, 50, 75…100?
Market focus is on how the SARB will respond to what is set to be a meaningful target breach in CPI inflation. The upside surprise in the May CPI release was the largest standardised miss in the post-GFC period. The problem for policy makers is that this was entirely due to exogenous factors – fuel and food prices. Core inflation has remained remarkably well behaved, reflecting the fragile domestic economy and high unemployment.
Yet we cannot ignore the fact that the risks cited by the MPC in recent meetings have started to come to fruition. The rand has been under pressure, which could contribute to higher imported inflation. In addition, unit labour costs will be scrutinised given above-target wage settlements across the mining and SOE sectors.
Many challenges await the SARB, and investors, in 2H22
As long as DM central banks, particularly the Fed, keep fighting the inflation fires, the SARB will be under pressure to turn more aggressive. The May inflation report and anticipated breach of 7% should cement a 50bp hike at the July MPC meeting. However, rand weakness and the potential de-anchoring of inflation expectations could tip the SARB to follow the Fed with a 75bp increase in the repo rate.
The challenge for investors is that much of the front-loaded monetary policy tightening is already in the price, but recession conditions and lower earnings are not.
All of the major asset classes underperformed cash (0.4%) in June. Losses in inflation-linked bonds (-0.9%) were relatively modest, with more notable declines in fixed-rate bonds (-3.1%), equities (-7.5%) and listed property (-10.3%). The rand depreciated by 4.2% against the US dollar, which would have been accretive to offshore returns.
For 2Q22, only inflation-linked bonds (3.0%) beat cash (1.2%), with fixed-rate bonds (-3.7%), equities (-10.7%), and listed property (-12.7%) posting outright losses. The rand lost 10.0% versus the US dollar, which would have enhanced offshore returns.
The dollar wins, again
The DXY dollar index gained 2.9% in June, taking the quarterly appreciation to 6.5% and the year-to-date rally to 9.4%. The dollar benefited from a more hawkish Fed, with the FOMC delivering a 75bp hike, as well as heightened recession fears.
The dollar’s rally was broad-based against the majors, with only the Swiss franc appreciating as the Swiss National Bank delivered a surprise 50bp hike.
EM FX lost 2.9% against the greenback, on average, with the bulk of the weakness reflected in LatAm currencies amid broadening commodity price weakness. The Chinese yuan was broadly stable, while the Russian rouble continued to recover, gaining 15.4%.
Rand down, but not out
The rand underperformed the average somewhat, depreciating by 4.2%. This reflected the decline in growth-linked commodity prices, such as copper, iron ore, and even oil. In addition, there may be renewed concerns about the SARB being behind the curve given potential inflationary pressures, as well as risks to the fiscal position from sharper declines in South Africa’s terms of trade.
At current levels, the rand is undervalued relative to our core 15.00 – 16.00 fair-value range.
Recession risks roil raw prices
The Bloomberg Commodity Index lost 9.2% in June, taking it back to early-March levels. Outside of coal, cattle, and coffee, prices were lower. Gold was hampered by rising TIPS yields, despite elevated risk aversion and inflation fears.
Growth-linked metals prices, such as platinum (-7.0%) and copper (-13.5%), reflected growth concerns, alongside iron ore (-8.4%) and even oil (-6.4%). Grain prices have declined somewhat on improving exports, while palm oil prices continued to unwind sharply as Indonesia ramped up exports following a short-lived ban.
Tug of war in bonds
US bond yields again faced a tug of war as high inflation and the hawkish FOMC competed with the strengthening recession narrative. The former pushed the 10-year yield to almost 3.5% by mid-June, while the latter reversed the trend with the benchmark falling back to 3.0% by month-end. TIPS yields were stickier, trading above 0.5%, which compressed breakeven inflation towards 2.3% – levels last seen in 3Q21.
Quantitative tightening – the Fed’s balance sheet run-off – commenced in June. Given the outsized impact that quantitative easing had on real yields, the reversal could have a similar impact on the TIPS market. This would partly explain a more technical reason for the compression in breakeven inflation.
While the German ILB curve remains deeply negative, the nominal curve beyond one year has moved into positive territory. The dynamics in the Eurozone during Q2 were similar to the US, with hawkish central bank rhetoric resulting in lower breakeven inflation. The standout has been Japan where the BOJ has upped the ante on capping the yield curve, albeit at the expense of the yen.
Keeping the Eurozone tribe together
The Eurozone bond markets showed increasing fragmentation fears amid more hawkish policy guidance, inflation concerns, mounting recession fears, and country-specific political uncertainty. The Italian/German 10-year spread rose to almost 250bp, the highest since the Covid turmoil. In an emergency meeting, the ECB signalled the deployment of an anti-fragmentation toolkit via the pandemic emergency purchase programme, which successfully compressed the spread.
EM bonds on the chopping block
The reversal in US yields did little to aid EM bonds. Upside inflation risks and persistently hawkish central banks were exacerbated by recession fears and falling commodity prices. Sovereign dollar bonds took more strain with the EMBI+ yield almost 100bp higher month-on-month compared to the 30bp rise in the GBI-EM yield. While the sell-off in Asian markets was relatively contained, LatAm and Ceemea took strain, evidenced in Brazilian, South African, and Hungarian rates rising by more than 50bp.
High yields could not keeping foreigners on-side
The sell-off pushed the SA 10-year yield towards 11%, the highest level since the Covid dislocations. Despite higher yields, the market was broadly fairly valued by the end of Q2 in the context of higher TIPS yields, inflation uncertainty, and potential fiscal risks associated with lower commodity prices and a global growth slump.
SA breakeven inflation reached 7.0%, the highest level since 4Q16, when inflation last breached the 6% upper limit. The upside surprise in the May inflation release and persistent inflation fears were not enough to cap ILB yields, with the generic 10-year around 30bp higher in sympathy with the sell-off in nominal bonds and higher TIPS yields.
While lower commodity prices pose a risk to the fiscal position, previous revenue overruns, successful switch auctions, and the announcement of the government’s floating-rate note could create space for lower weekly auctions from 4Q22, which could favour ILBs over nominals.
According to the official National Treasury statistics, non-resident investors sold R15.9bn worth of fixed rate bonds. Unit trusts (R20.7bn), banks (R13.5bn), and long-term insurers (R7.1bn) took up the implied net supply to domestic investors of R35bn. Foreign ownership of SA government bonds declined to 27.4%, which is the lowest level since June 2011.
Earnings could be blindsided
Global equity markets were hit by heightened risk aversion as upside inflation surprises prompted central banks to turn even more hawkish. The recession narrative is being reflected in prices via multiple compression, but not yet in earnings expectations.
The S&P 500 lost 8.4% in June, bringing the quarter’s decline to 16.4% and the year-to-date fall to 20.6%. While this is severe, it has been an orderly sell-off based on the behaviour of the VIX volatility index, which has not yet breached 40. Except for China’s 6.7% recovery, there was no local bourse in the black, with an average sell-off of 7.2%.
The MSCI World Index lost 8.7% in June and 16.2% in Q2, underperforming the MSCI Emerging Market Index, which lost 6.6% and 11.5%, respectively. LatAm countries were the notable laggards amid the commodity price declines with sharp losses in Colombia (-29%), Argentina (-19.9%), Brazil (-19.2%), and Chile (-19.0%).
Limited shelter in SA equities
The MSCI South Africa Index underperformed the average, losing 12.7% in June, in part due to sharp rand weakness. The ALSI and SWIX declined by 8.0% and 7.5%, respectively, with broad based weakness across sectors.
Technology (34.4%) managed to buck the trend on the back of the announcement of the Naspers/Prosus share buyback. Telco’s (-18.0%) underperformed sharply amid a pared down revenue outlook, followed by basic materials (-16.6%), which suffered from falling commodity prices, and financials (-12.9%) that were hit by downside growth risks. Industrials (-5.1%), consumer staples (-4.0%), health care (-3.6%), and consumer discretionary (-2.7%) outperformed the market but were nevertheless in the red for June.
The equity market de-rated further, trading at close to 8 times, despite the downward revision to earnings expectations. This was largely dragged down by updates to Naspers’ earnings projections, but outside of energy/chemicals, the outlook has become somewhat less optimistic.