CHRIS EDDY: As US hangover sets in, SA can be glad it missed the party

Amid early signs of a correction in markets that boomed in the past decade (an apparent decoupling from global reality), there are signs that parts of world markets that did not benefit from the euphoria, including SA’s equity and bond markets, will escape the worst of it.

Since February 24, when Russia invaded Ukraine, waves of volatility have hit global markets, and many entered correction territory. The headlines point to global conflict as the cause, but the reality is that this event is set against an already fragile market environment.

In February, US inflation had its highest reading in 40 years, at 7.9%. Inflationary pressure was already forcing the hands of central banks, with many (including the US Fed) signalling their intention to hike interest rates multiple times in 2022. Lifting rates would remove the “drug” of free money that fuelled US markets to record highs over the past decade.  

Inflationary pressures have been building since the global economic engine reignited as countries came out of early hard lockdowns. Supply chain disruptions caused commodities to rally. It soon became evident that underinvestment in “dirty” commodities in a world focused on climate change made it difficult to bring additional supply online.

Sanctions imposed on Russia, a major commodity exporter, in response to the Ukraine invasion completed the trifecta of supply constraints that turbocharged commodity prices. This added fuel to the fire of broader inflationary pressures building in the system.

Lower growth

Price increases driven by supply side inflation, as seen globally, creates a tighter environment not too dissimilar to interest-rate hikes. Consumers are left with less money in their pockets, which ripples through the economy, affecting growth and corporate earnings.

The US Fed is caught between a rock and a hard place. The commodity price shock is creating an environment of lower growth and higher inflation. Hiking rates will further constrain economic growth and pull the plug on the stimulus that propelled US equity markets. Not hiking would lead to a loss of credibility and inflation becoming further entrenched in future expectations.

The drug of free money has created enormous instability, with nearly 20% of listed companies in the US now classified as “zombie” firms, according to Deutsche Bank research. This is five times as many as in 2008, when the zero interest rate policy experiment began. These companies depend on zero rates because the cost of servicing debt is higher than profits made. This raises the question: what happens when interest rates rise?

Simultaneously, the decade-long bear market in commodities magnified the effect of the broad JSE lagging technology-heavy US markets. And, as the rand depreciated significantly (with many other commodity-producing economies), there was much speculation about SA, with the most cynical describing the country as “uninvestable”. The stars (and stripes) in their eyes might have caused them to forget that markets are cyclical. Financial gravity has been a truism of the markets for more than a century.

Defy gravity

Considering 10-year annualised real (after-inflation) returns of US and SA equity markets over the past century, average real returns have been remarkably similar but, depending on where we are in the cycle they can be vastly different. As at the end of 2021, the 19% annualised return in rand to US equities represented an eye-watering 469% cumulative return above inflation over the past 10 years, compared with only 92% for SA equities.

While SA equity has made back a dramatic 15% in the two-and-a-half months to March 14 this year, the question arises: are returns to US equity markets set for reversion closer to long-term averages, or will they continue to defy gravity in future? Clearly investors should reset their expectations, based not only on the post-Covid “everything bubble” but also on whether what worked in the past decade can continue to work indefinitely.

SA has not had the luxury of extraordinarily supportive monetary policy, as have developed markets. The primary reason has been the historic vulnerability of our currency to depreciate. However, SA government bonds offer attractive real yields. These, in part, reflect the fiscal risks present in SA, but for investors in a yield-starved, inflation-ravaged world they are attractive. We are fortunate that investing in government bonds is still a feasible approach to accessing conservative, inflation-beating returns. This is a luxury for which most worldwide can only wish.

The best way to protect your wealth against inflation in the long term is to hold a well-diversified portfolio of growth assets, though this won’t shelter you from the storm in the near term. We are seeing signs — including record-high inflation, booming commodity prices and central banks talking of aggressive interest rate hikes — that warn loudly of a step-change in the cycle.

As we face withdrawal from the drug-like stimulus that fuelled markets over the past decade, it is the beneficiaries of that stimulus that have the most to lose. The long-neglected SA equity and bonds markets, whose poor outlooks and negative expectations are reflected in prices, look set to provide shelter from the storm.

• Eddy is head of investments at 10X Investments.