MAMOKETE LIJANE: Dreams of an elegant transition in financial markets that did not happen

We are halfway through 2022, which started on a somewhat chilled note, but  what a time it has been in financial markets.

I was worrying  about monetary policy tightening, but expected that growth momentum would hold up, supported by economic activity going back to normal operation.

In my imagined world we would have this elegant transition, where the underpin for financial asset valuations would change from interest rates to economic activity in a smooth handover. While not expecting further material acceleration, I still thought risky asset prices would bumble along until maybe in 2023. I was wrong.

I, like others in Team Transitory, underestimated the extent of overheating in rich countries. Demand recovered far faster than supply, hence the supply chain snarls post the Covid-19 crisis. Add to that food and fuel supply shocks in response to the war in Ukraine, and inflation got another boost. The zero Covid lockdowns in China, the manufacturing capital of the world, have not helped.

I started the year thinking developed economy monetary authorities would have to slow demand growth to prevent inflation getting out of hand. Now I think the authorities might have to destroy demand to get runaway inflation under control. The change in narrative from we need “slow demand growth” to we might need to “shrink demand” explains much of the financial markets turmoil of the first half of this year.

Globally easy monetary policy settings, rising inflation and rising inflation risk premiums killed developed economy bond returns, and have probably spooked bond traders for a generation. Valuations peaked in 2020, but the deepest losses materialised in the first half of 2022. The 14.5% (27% annualised) loss in safe assets like developed market bonds is unprecedented and has come as a shock to many.

Global equities have also had a torrid time. Along with other risky assets, equities enjoyed a strong period as markets gorged on freely available and essentially free liquidity provided by central banks. Valuations skyrocketed and earnings came back strongly from their crisis slump. The party ended in 2022. The MSCI World Index was down 20.5% (37% annualised) in the first half of 2022. This is official bear market territory, and the jury is still out on whether we have seen the bottom.

Credit is also under pressure, with rates and spreads to safe assets on the ascent. Commodity prices came late to the gallows, but even they cannot withstand global recession fears. Copper and other cyclically sensitive commodities led the descent, but even oil and food prices, subject to war and other idiosyncratic risks, are sagging. The less said about crypto and meme stocks, the better.

SA financial assets have also been punished, albeit slightly less than those in developed economies. Bonds had a tough time after Russia’s invasion of Ukraine, but their 1.9% loss does not even compare with the US Treasury’s 9.1%. Equities held up in the first quarter but tanked in the second. Listed property fared worse than the other asset classes. CPI-linked bonds benefited from terrible inflation dynamics and made their holders some money over the period. Cash was princely, but not king. 

At the beginning of the year the global economy outlook narrative was caught between “transitory inflation” and “stagflation”. It then moved to “recession” with a side of “stagflation”, and this transition was highly destructive for financial asset valuations. These narratives are never static, so we can expect that a dominant narrative will emerge in the next six months which will drive prices.

Most now expect that growth will slow. The tension is between Team Stagflation, who expect high inflation will persist even as growth softens, and Team Deflation, who think inflation will moderate. Deflation will create room for the authorities to become less hawkish and would be a better outcome for growth. I tend to be in Team Deflation. That said, I have an optimistic bias, so take this prediction from whence it comes.  

• Lijane works in fixed-income sales and strategy at Absa Corporate & Investment Banking.