Global investment markets continued their volatile roller-coaster ride in the second quarter of 2023, as markets remained focused on inflation and looked to rising interest rates for direction.
Higher inflation results in higher interest rates, which leads to slower economic growth resulting in lower company profits and lower share prices. The challenge lies in predicting the likely outcome of these changes, which often leads to extreme uncertainty and volatility.
The good news is that the inflation rate has started to decline and the global and local rise in interest rates appears near an end. This is positive for investment markets and especially for emerging markets and South Africa where valuations are at near 20-year lows. Peaking interest rates and low valuations create a favourable environment for strong investment returns.
Investment market roller-coaster continues
The JSE All Share Index (Rands) and MSCI World Index (Dollars) were up 5.9% and 13.9% in the first six months of the year respectively, but this followed hefty declines last year as interest rates spiked.
The volatility was driven by markets second guessing the outlook for an end to this steep inflation cycle and the resultant effects on interest rates and economic growth. Although we believe we are close to global interest rates peaking, markets are likely to remain volatile until there is more certainty around when inflation will reset into a historic 2% to 3% range.
2Q was all about Tech again
The US market (S&P 500) was up 11% to June, as it recovered off a 20% decline in 2022. The rebound was driven entirely by the big tech stocks and fuelled mostly by the new fad AI (artificial Intelligence). The graph below Illustrates that when stripping out the seven big tech. related shares, the remaining 493 shares were in aggregate flat for the period.
In our view, participating in this increase required some luck, as the tech sector was not attractively positioned at the beginning of the year due to the negative outlook for rising interest rates.
Global Markets are still being driven by inflation expectations
Global and local inflation rates peaked at the end of 2022 and have started to decline steadily but are still well above ideal levels of around 2% to 3% in developed economies. Core inflation (excluding food and energy) in the US declined to 4.8% in June, the lowest since 2021.
Global and developed country inflation
The key question is, how long will it take for inflation in developed countries to decline to 2% – 3%, which will ensure interest rate cuts.
Currently markets expect the US and European central banks to increase interest rates a further 25 basis points this month with a view that rate cuts will start in 2024. But the issue is, what is the effect of these sharply higher interest rates on the economy?
For now, the US market is pricing in a “soft-landing”, meaning a recession (a decline in economic growth) will be avoided. But, based on previous interest rate cycles, it’s highly likely a US recession will take place. June exports declined and consumer demand is weakening further.
However, despite this, even with a probable mild recession, we believe the market will look through this and start pricing in the positive effects of future interest rate cuts.
China’ s recovery still holds much weight for global markets
China’s economic recovery post the Covid lock down has been disappointing as consumer spending has been weaker than expected. Second quarter GDP was up 6.3% yoy (off a low base), below consensus forecasts of 7.1% yoy.
The government recently announced a scheme to boost private investment in the transport, energy and manufacturing sectors, as private investment has contracted this year. It has vowed to make the economy “bigger, better and stronger”.
With Chinese inflation near zero, it has monetary leverage to stimulate the economy, which should boost consumer spending quickly.
SA economy is still limping along
SA’s economic outlook is still weak as reflected in the Treasury’s forecasts below:
SA GDP year on year % change
The SA Treasury increased its 2023 GDP forecast to 0.4% in June from 0.3% in May. But it did previously point out that loadshedding and logistical constraints will take 2% growth out of the economy this year.
The risk is that we sink into a recession as the sharply higher interest rates bite deeper. Since November 2021, rates have increased by a total of 475bps, taking the Repo rate to its highest level since April 2009 – effectively the highest interest rates in 14 years.
SA inflation and interest rates
Higher government debt a concern
Government debt levels remain a key focus point for markets as SA potentially starts borrowing more money abroad. The revised debt to GDP level of 71% with a stable outlook was very positive at the last budget. However, government has bowed to increased wage demands and diesel costs to keep the lights on, and the impact has been significant.
It is likely that debt will be higher than budgeted, which will dent investor confidence in government’s commitment to manage finances more responsibly.
Embarrassing Lady-R debacle
The “Lady-R” debacle is another embarrassment that should not have happened as the ANC places its own ideologies and interests with Russia ahead of the country’s well-being. Giving direct support to Russia during this fragile time of conflict is just incomprehensible. The knock-on effect for the country was a further loss in confidence by foreign investors, reflected in the Rand spiking out to 19.8 to the US dollar and bonds declining to historical lows.
The positive: Government privatising by “Stealth”
With the economy unable to grow meaningfully mainly due to a crumbling infrastructure, the government has been forced to privatise more, which is taking place in electricity (uncapped private generation), Transnet (key ports and rail lines), SAA, Telkom, and likely more to come.
This is all potentially very positive for SA with its strong private and banking sectors. All hope is not lost!
The SA investment market is very attractive
As SA interest rates have likely peaked, and a more positive economic cycle is ahead, this should boost investor confidence to buy into the historically cheap SA equity market.
JSE All share index P/E
Foreigners remain a major driver of our markets, with our weak markets reflecting their investment outflows. The chart below shows the persistent majority monthly outflows, which need to reverse to bolster meaningful investment market appreciation. It is difficult to predict this change in sentiment, but any hints of an improving economic outlook could turn the tide quickly and significantly.
Foreign investment flows in SA equities and bonds
The Rand is consistently volatile – but now near fair value
The Rand/Dollar spiked to 19.8 in June on the back of the “Lady-R” saga and the potential economic consequences, which has been an over-reaction. The Rand has subsequentially retraced to 17.6, which we believe is near fair value based on our fundamental model. See graph below:
The Prosperity Fund continues to produce good steady returns
The fund is conservatively managed with an emphasis on capital preservation. It is well suited for investors who want offshore exposure and a steady investment return.
Investment market outlook
Overall, global investment markets are attractive as interest rates appear close to pivoting downwards. But the US market is least favoured as its economic and earnings’ outlooks are too positive. Better value lies in Europe and the UK, but most attractive are Emerging Markets and SA where extreme negativity is included in the price.
Despite all the woes of the SA economy, SA equities are cheap and provide an attractive entry point at the top of the interest rate cycle. Now is not the time to lock into 5-year fixed deposits at 10%, which are still fully taxed, resulting in a net 6% to 8% return, depending on one’s tax rate.
SA equities and bonds should well exceed cash returns over the next 5 years, and therefore we recommend investing in multi-asset (a mix of equity, bonds, offshore, property and cash) funds to derive the full benefit of cheap SA equities and bonds.
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