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Year to date, the JSE All Share Index (SA market) and MSCI World Index (global market) are down 6% and 11% (in Rands) respectively. We see this decline as a normal market correction after abnormal market growth pre-COVID: the JSE and MSCI were up 18% and 23% from Feb 2020 to end 2021.
This growth was driven by unprecedented monetary stimulus to rescue the global economic fallout brought on by COVID. However, this monetary stimulus has led to rising inflation, which is now being quelled by rising interest rates and a decline in equity markets.
In our opinion, global equity markets were expensive (which we wrote about numerous times over the past year) and are now readjusting down to more normal levels.
It’s all about inflation
Global inflation has spiked with US inflation now at a 40-year high at 9.1%. What are the effects?
Higher inflation leads to interest rates being increased to reduce inflation, but results in lowering spending power and slowing economic growth. This all leads to lower equity valuations, which are at least 12 months forward looking.
Thus, when inflation starts declining, equity markets should react more positively.
The key inflation-related issues are:
- Will inflation rise further and how long will it remain at high levels, above 3%?
- The speed with which central banks raise interests to quell inflation,
- The consequential extent of an economic slowdown or recession.
Currently, the US market is predicting that inflation will peak by year end, and the Federal Reserve will raise interest rates a further 150 basis points to 3.25% this year. The big unknown is the extent of the economic slowdown or a likely recession and the consequential negative effect on company earnings.
History has shown that earnings are mostly underestimated on the way up and way down, meaning there is still a reasonable amount of risk in global markets until inflation starts declining.
US inflation (%)
Geopolitical risks are fuelling inflation
A protracted Ukraine war is materialising, with the global economic effects of commodity shortages (mainly food and energy) likely to remain a supporter of higher global inflation. Predicting an end to the war is difficult and it appears it may continue longer than most expected.
China’s COVID shutdowns and subsequent regulation changes, have added further supply chain disruptions. This has led to a likely sharp economic slowdown to around 4.3% in 2022. However, the outlook for 2h2022 and 2023 appears positive. Contrary to the rest of the world, China has started adding monetary stimulus to boost its waning economy and certain regulations are being relaxed. This is promoting a far more attractive investment case following the 25% equity market decline over the last year.
SA’s downward slide continues
It’s difficult to find anything positive about the SA economy and its outlook.
Politically, SA is rudderless. The ANC infighting continues and it’s likely that we are heading for a coalition parliament in 2024, which will be a disaster, in our opinion. This is mainly based on current municipal coalitions that have become even more dysfunctional and the wide disparity in political party agendas.
Eskom is a major problem. It needs more capacity to stop load shedding, which will take two years to build. It desperately needs more funding, either directly from government or from the taxpayer through exorbitant proposed price increases of +30%. But its debt is spiralling higher with S&P rating its debt “super-junk” at ccc+ with a negative outlook.
Local municipalities are a mess. In the latest Auditor General Report, only 16% of 257 municipalities received clean audit reports. There was R29bn of irregular expenditure. The Treasury flagged this as a major burden to the SA economy and said it didn’t have the resources to assist them.
Inflation and interest rates are rising. Consumer price inflation (CPI) spiked to 7.4% in June, resulting in a 75-basis point rise in the repo rate to 5.5%. Rates are now up 2% since November 2021, with the prime interest rate set to increase to 9%.
Inflation is expected to peak by the end of the year, with a probable further 0.5% increase later in the year.
SA CPI and forecast (%)
SA economic outlook is dire. Although the SA Reserve Bank increased its 2022 GDP forecast to 2% from 1.7%, it slashed its 2023 and 2024 forecasts to 1.3% and 1.5% respectively from 1.9% for both years.
SA annual GDP growth rate (%)
COVID appears to have ‘disappeared’. After a small 5th wave of infections in May (peaking at 9000 per day), official COVID cases are currently at 379 per day. This is remarkable given our low vaccination rate, but hopefully the country’s herd immunity will persist, and new variants won’t spread as aggressively as they have in the past.
The Rand has suddenly weakened
True to form, the Rand remains impossible to forecast in the short-term. Over the last two months the Dollar/Rand has spiked up to 17.2 from 14.5. Over the last two years (post-COVID) the Rand has been strong largely due to the abnormal high trade surplus from high commodity prices and low local import demand.
These high commodity prices are not sustainable, and a retracement will result in a negative trade surplus, which will be negative for the Rand. We are still of the opinion that the fundamental fair value for the Dollar/Rand is 17.5, which includes a 25% premium to its current purchasing power parity (PPP) of 14.0. The premium represents the risk to SA’s weak economic outlook as a debt crisis still looms because of the absence of meaningful economic growth.
Prosperity continues to produce solid returns
The Prosperity Worldwide Flexible Fund of Funds is our proprietary unit trust fund, which is conservatively managed with an emphasis on capital preservation. Since inception (Sep 2014) the fund has returned an average 8.4% (net of fees) per annum. The fund is well suited for investors that want offshore exposure and a steady investment return.
Global Valuation Correction
The global MSCI forward P/E has dropped to 14.1, below its 25-year average. Although this is indicating broad-based cheaper equity markets, further downside risk still exists as inflation and a global economic slowdown persist.
Local Equities valuations nearing 27-year lows
SA equities remain out of favour with foreign investors, with year-to-date net foreign outflows and the gross underweight of SA equites in Emerging Market funds. The narrative is that all SA’s bad news is discounted into these historically low valuations and that anything positive will assist in driving prices higher.
Investment Outlook
Although a global recession is likely, it is not abnormal. We believe that we are going through a normal economic and associated investment cycle. Offshore markets were expensive, and a normalisation is taking place. This normalisation should lead to more volatility for the rest of the year, even though a lot of the market correction has already taken place, in our opinion.
Equity selection remains important, with local equities having attractive value, despite the country’s dismal outlook. A lot of the “bad news” is already priced into SA equities.
Markets are at least 12 months forward-looking, therefore they are pricing in the further interest rate hikes and trying to anticipate when inflation will start to recede to pave the way forward for a new economic upcycle.
Although it’s difficult to predict when equity markets will start rising again, their valuations are a lot more attractive now, especially in South Africa.
As markets correct in this ‘normal cycle’, opportunities will be presented. The Growth to Value sector rotation continues and Emerging Markets, incorporating SA, are offering far more attractive valuations.
Now is not a time to panic, but to rather ensure that your investment portfolio is properly balanced and adjusted to suit your personal risk profile to achieve your goals. Also, make sure your financial plan is up to date. It is critical to ensure that the risk you take on in your investment portfolio matches your financial plan, especially when nearing or during retirement.