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Local and global investment markets continue to test investors’ patience as extreme short-term fluctuations reflect the market’s uncertainty over major economic and geopolitical outcomes over the next year.
Year-to-date, the MSCI World Index is down 22% (in US Dollars) and the JSE All Share Index is down 10% (in Rands). Why these big declines and how much lower will equity markets go?
JSE All Share Index (R)
MSCI World Index ($)
Leading up to 2022, global markets had become complacent over inflation risks after central banks pumped an enormous amount of stimulus into developed economies over the last 14 years. Now that this stimulus is being withdrawn (as interest rates are increased and bond buying is reduced) there is panic, which is highlighted by the US Dollar’s surge, Sterling’s collapse, and global equity markets being down 20+%.
In our opinion, global equity markets in 2021 and 2022 were overvalued, which we wrote about many times, and the current declines form part of a normal market cycle correction. However, it’s impossible to say how much lower markets could go, as markets are irrational in the short-term.
The best market gauge is valuation levels. Currently, global and local equity markets are trading well below their 20-year P/E averages, which would indicate that further downside is limited. South African equities are extremely cheap as they price in a weak economic outlook.
South Africa JSE All Share Index P/E
World MSCI Index P/E
Rising Inflation is the biggest headwind
The biggest investment issue remains rising inflation and its persistence. Global markets have not seen inflation at these levels (US 8.3%, Europe 10.1%) for the last 40 years. Hence the markets’ shock and irrational volatile behaviour
US Inflation
Contributors to US Inflation
Energy – in orange, and Services – in blue, are the two biggest contributors to inflation. Core inflation excludes energy and is the key measurement used when Central Banks adjust interest rates. Hence, the recent spike up in core inflation drove the US Federal Reserve to indicate that it will forcefully increase interest rates until inflation is subdued, which sparked the current equity market decline.
In September, US interest rates were raised another 75 basis points to 3%, with an indication that a probable further 100 basis points could still follow this year. The market is currently pricing in US interest rates to peak at 4.75%. Although this is very likely to slow the US economy into a possible recession, this should be short lived, unless inflation persists at a higher level. Sustainable higher inflation is the biggest risk to markets, which the market is not pricing in, and we believe it is unlikely given the Federal Reserve’s determination to quell inflation.
Ukraine war outcome is unpredictable
It’s impossible to forecast the outcome of the Ukraine war as Putin hangs on for political survival in Russia. The war is costing the global economy an estimated $2.2T, which is 2% of global GDP.
Europe’s energy crisis
Gas prices have doubled this year as Russia chokes its supply to Europe by reducing supplies by 50%. This brings Russian gas supplies down to 10% of European demand. Surging energy prices are a major contributor to Europe’s spike in inflation to 10% and it is most likely that an economic recession will follow. A harsh winter will make the situation worse.
China’s slowdown is a further drag on a global recovery
China contributes 15% to the global economy. The World Bank has slashed China’s 2022 GDP growth forecast to 2.8% from 5% earlier in the year. However, the rest of East Asia is expected to grow 5.3%. The main reason for China’s slowdown is its property market meltdown and the effects of its zero-Covid policy, which is a major failure and is largely a consequence of China not having a reliable vaccine.
Although growth is predicted to rebound above 5% in 2023, which will be assisted by monetary stimulus (the opposite to the rest of the world), China’s outlook appears precarious as its leader Xi Jinping should be reappointed for an unprecedented third term.
SA’s economic outlook remains a major concern
Unemployment is our biggest problem
Despite the economy contracting 0.7% (quarter on quarter) in the second quarter, unemployment declined to 33.9% from 34.5%, or on the expanded basis, 44.1% from 45.5%. Of the 40.2m workforce (aged 15 to 64), 15.6m people are formally employed.
SA unemployment %
With our very low economic growth rate forecast (1.4% and 1.7% for 2023 and 2024), the unemployment rate will only continue to increase, leading to further socioeconomic strains. The SA economy needs to grow at 4%+ to reduce unemployment.
Eskom sees no improvement
Loadshedding has unfortunately become a normal part of our lives in 2022 and it’s likely to continue to at least the end of 2024.
It’s estimated that economic growth has been hampered by 8% to 10% over the last five years due to loadshedding.
To reduce blackouts, Eskom has spent R4.1bn this year on diesel to power its backup generators. That’s an average of R23m per day.
Andre De Ruyter, Eskom’s CEO, says it needs to spend R1.2T by 2030 to meet demand. The problem remains sourcing finance. Eskom is asking for another massive 30%+ tariff increase to fund operations.
The government is suddenly desperately looking to the private sector, which it had previously rejected, to contribute meaningfully to new capacity. Despite this, unfortunately much needed new capacity will only come online by the end of 2024, if the government gives its full support. Therefore, loadshedding is likely to continue until then.
Challenges to Ramaphosa at the ANC year-end elective conference
The demise of the ANC continues with more infighting and limited accountability. This constant conflict fuels more opportunity to change leadership, which will be staged at the ANC year-end conference in December. Our view is that the biggest challenge comes from Dr Zweli Mkhize, the former disgraced Health Minister, who has been endorsed by KwaZulu Natal, the ANC’s biggest voting province. We believe it is unlikely Ramaphosa will be toppled this time, but the anti-Ramaphosa faction appears alive and well with numerous other candidates gunning for his job. His farm scandal does not help matters, but we believe this will be dealt with internally in the ANC.
Given that there is no major party alternative to the ANC, a weak ANC will likely lead to a coalition government post-2024, which in our view, would result in an even more dysfunctional government.
SA economy a recession risk
The economy grew by a meagre 0.2% year-on-year in Q2 2022, well below market estimates of 0.6%. The Reserve Bank has lowered its 2022 GDP forecast to 1.9% from 2%, which appears optimistic, with 2023 and 2024 forecast at 1.4% and 1.7% respectively.
SA interest rates were raised 75 basis points to 6.25% in September and could go up a further 100 basis points before peaking in 2023.
On the positive side, inflation in August declined to 7.6% from 7.8%, hopefully signalling a peak in inflation.
SA inflation and interest rate expectations
The Rand is vulnerable to a strong dollar and weaker commodity prices
The Rand/Dollar has spiked out to 18.1, which is above our fair value of 17.5. The R/$ weakening has partly been driven by a strong US Dollar, which has strengthened 18% this year relative to other global currencies.
US Dollar Index (weighted against other global currencies)
The Rand has been vulnerable to the decline in trade flows, which have recently swung negative as commodity prices have weakened.
SA Current Account (Trade of goods and services)
We’ve warned that this positive trade flow was unsustainable and would reverse, pressurising a weaker Rand.
Our view is that the Rand will weaken over the long term due to the SA’s weak economic outlook and its rising debt. However, in the shorter term, we expect that the R/$ has peaked and is more likely to strengthen towards our fair value of 17.5, which includes a 25% premium to its current purchasing power parity (PPP) of 14.0.
Prosperity continues to produce solid returns
Over the last 12 months, the Prosperity Worldwide Flexible Fund of Funds (managed by Investonline director, Nick Brummer) has returned 9.2%, despite the MSCI World Index being down -1.4% and the JSE All Share Index up 3.5%. Since inception (Sep 2014) the fund has returned an average 8.4% (net of fees) per annum. The fund is conservatively managed with an emphasis on capital preservation. It is well suited for investors that want offshore exposure and a steady investment return.
Investment Outlook
We maintain that this market decline is a normal market cycle correction. We believe that most of the correction has taken place based on the market’s current low historical valuation levels.
Markets are forward looking and are therefore pricing in further global interest rate increases. Once there are signs that inflation has peaked, market stability is likely to return, which we believe will resume in 2023.
Until then, equity selection remains important with Value-orientated sectors favoured. Local SA equities are attractively valued, despite the country’s dismal economic outlook.
Although it’s difficult to predict when markets will start recovering, 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. Ensure that your financial plan is up to date. It is critical to ensure that the risk you take in your investment portfolio matches your financial plan, especially when nearing or during retirement.