2022 started with optimism for a more stable investment environment “after COVID”, but then to the markets’ surprise, Russia invaded Ukraine. This is the second black swan event within two years, which is unprecedented. Previously, these “surprise” events have generally taken place once a decade, triggering large market declines – COVID in 2020 (-35%), the Great Financial Crisis in 2008 (-57%) and the IT bubble in 1999 (-49%).
These complete surprises or unforecastable events lead to shock and massive uncertainty as the outlook suddenly becomes obscured and worrying. Despite this, history has shown that the world and investment markets have recovered each time. We believe history will repeat itself, but we don’t know how long this recovery will take.
Year to date, the JSE All Share Index is flat, but the sector divergence has been significant: Resources +17%, Industrials -18%, Financials +15%, Rand/Dollar -8%. This is all mainly due to the consequences of the strict sanctions being imposed on Russia.
We have been recommending a global conservative strategy for the last 2 years as market growth has been fuelled by central bank stimulus. Now, with probable higher and more persistent inflation (added to by the Russian / Ukraine conflict) a sharper rise in interest rates is starting to be feared by markets.
However, despite a rising interest rate environment, equity markets are generally not expensive, and offer some very distinct areas of value – such as South Africa, Emerging Markets and Value-orientated shares.
Global equity P/E valuations below 25-year average
Global factors remain the biggest challenge to markets
Global factors are a major driver of SA equities as approximately 70% of the JSE All Share Index earnings are being generated offshore.
Global inflation – Global inflation has spiked up due to central bank monetary stimulus, supply chain disruptions and commodity shortages from sanctions imposed on Russia. The major risk for global markets is maintaining economic growth, whilst suppressing inflation through raising interest rates. Although developed world economies are strong with low unemployment, their debt levels are high. This makes them sensitive to high interest rates. Therefore, central banks have a delicate balancing act of quelling inflation by raising interest rates, but not supressing growth.
Inflation is up across the globe
The Ukraine war – This heinous invasion took markets by surprise and the outcome is difficult to predict. We don’t believe this is the start of a new world order (East vs West) as China is not directly supporting Russia’s war and they are appearing sympathetic to Ukraine. China needs the West as a trading partner. However, this war does highlight the geopolitical risks of authoritarian countries where autocratic decisions govern. An upside is the strengthening in Western nation relations, but Europe has learned a hard lesson of becoming too dependent on Russia for oil and gas.
Other commodity shortages (such as sunflower oil, fertilizers and wheat) will propel more inflation.
Ukraine, Russia, and Belarus share of global supply (%)
China is down but not out – China comprises 15% of the global economy and its prosperity is essential for global growth. With its stock market (Hang Seng Index) tumbling 30% over the last year and being back to the same level of 15 years ago, numerous concerns have arisen: slowing economic growth, certain industry restrictions to promote a narrowing of their wealth gap, a perceived rejection of western capital and a failing COVID containment strategy.
China’s phenomenal growth over the last two decades (average 8.3% GDP) has had global markets sceptical of its longevity. With growth slowing to 5%, but still well above developed countries of 2.6%, per the IMF, concerns are rising over the accuracy of its economic data. Politically, China needs to maintain a prosperous economy, but with a more even wealth distribution. Hence its new Prosperity rules for a sustainable social fabric. However, China is in a favourable position to be able to start lowering interest rates to stimulate the economy. And with its sharp market correction, China is looking like an attractive investment market.
Living with COVID – Globally 4.5bn people have been fully vaccinated and barring Africa and Russian associates, most countries have administrated more than 1 dose per person. The vaccination strategy is appearing successful as we’ve seen Western countries getting back to normal and COVID-related deaths declining significantly.
Value vs Growth Investment Sectors – These are two distinctively different types of investments. Simplistically, Value companies are seen as traditional and boring versus Growth companies being innovative and exciting. Over time, Value investing has outperformed Growth investing. But there have been long cycles where each style has outperformed the other. Over the past 20 years, Growth has outperformed Value largely due to a long period of low interest rates. Now with interest rates starting to rise, this will diminish Growth valuations and the Value sector should start a new cycle of outperformance. The graph below shows that on numerous valuation metrics, the Value sector’s relative valuations are at a 20-year low and have recently started to turn upwards.
SA is offering value but the economic outlook remains dismal
SA equity P/E valuations near 20-year lows
SA equities have been out of favour with foreign investors for the last two years with constant net foreign outflows taking place. But now there appears to be some renewed interest in SA by foreigners, as SA has avoided a short-term debt crisis, which has been supported by rating agencies Moody’s and Fitch upgrading SA to Stable from Negative, although these ratings remain as Junk status. In addition, with Russia and Turkey being un-investable, Emerging market choices have narrowed.
Unemployment is the major problem
SA unemployment surged to 35.3% at the end of 2021, with the number of unemployed rising by 688,000 over the past year. The expanded definition of unemployment, which includes people not seeking employment, is now at 46.2%.
Number of people officially employed in South Africa
In 2008, the population was 49m. Today, it’s 61m. Since 2008, SA GDP average growth is 1.2% p.a. versus the global average growth of 2.6% per annum.
High unemployment is capping SA’s growth rate, which is in dire need of improvement. However, only private sector investment will provide sustainable economic growth, which will only take place with more flexible labour rules and business-friendly structural reforms. Sadly, government is still not making these important changes.
Government promoting a positive stance
The budget speech in February was investment market friendly but failed to deliver structural reforms needed.
Ramaphosa announced he has received 95% of his targeted R1.2T investment pledges and importantly the Radio-Frequency Spectrum was eventually auctioned off for R14.4bn, which should open SA’s internet capacity.
The potential introduction of private investment into the electricity, rail and port sectors is positive, but the true extent and timing is likely to be far off. But again, the key issue is the lack of capacity and skills to implement these initiatives.
Debt crisis has been averted in the short term, but the economic outlook is anaemic
The debt crisis has been averted in the short term by fortuitous higher commodity prices post COVID. Debt to GDP is expected to peak at 75% from 85% as excess revenues of R230bn were realised in 2021 from surging commodity prices. However, these high commodity prices are unsustainable and will not support higher revenues for long.
World Commodity Index
With higher commodity prices, Treasury has increased SA’s GDP forecast for 2022 to 2% (from 1.7%), but 2023 and 2024’s low forecasts of 1.9% and 1.8% are a major concern. Only real growth of +4% will prevent a long-term debt crisis.
Inflation and interest rates rising moderately
In March, the Reserve Bank raised interest rates 25bps to 4.25% as inflation rose to 5.7% in February. The market outlook is for a further 1.0% increase this year, but with inflation slowing in 2023. We believe there is an upside risk to inflation rising higher than expected, due to higher fuel and food prices stemming from the Russian / Ukraine war.
SA’s vaccination rate is low
Only 30% of South African’s are fully vaccinated against COVID, well below Western country averages above 70%. This could lead to further infection waves and new variant risk, which would result in more restrictions and further negative economic consequences.
The political landscape remains precarious
Despite Ramaphosa appearing to gain ascendancy in the ANC, the party’s demise continues as support wanes and infighting persists. A potential cabinet reshuffle will hopefully inject more competent and proactive Ministers.
Following on from the municipal election where the ANC obtained 47.9% of the vote, it is appearing more likely the ANC will not obtain a 50% majority in the 2024 national elections, which in our opinion, will be very negative. Municipality coalitions have contributed to more disruptions, which is likely to be replicated at the National level, thus making crucial policy changes even more unlikely and making government even more dysfunctional.
Government’s abstention on voting against Russia at the UN is a reprehensible and raises more suspicions of its dubious ties with the Kremlin.
The Rand has been surprisingly strong
This year, the Rand has been the second strongest Emerging Market currency, after the Brazilian Real. The Rand/Dollar has strengthened from 15.9 to 14.6, mainly due to another spike in commodity prices, which has resulted in an abnormally high positive trade surplus.
SA Trade Surplus
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 Rand/Dollar 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.
Review your Investment Strategy
With the negative effects of the global fallout with Russia’s war on Ukraine and rising interest rates, more volatile investment returns in 2022 are likely. But the nature of investment returns will also vary as sector rotations are likely between geographies and Growth to Value sectors.
As discussed, Value as opposed to Growth sectors and Emerging Markets incorporating SA equities are offering far better value opportunities.
SA interest rates should continue to rise slowly but real interest rates should remain low over the next year, which will still favour equities but will be negative for interest earners. Therefore, including a measured portion of equity risk into your portfolio is essential to achieving after-tax returns above inflation.
In this uncertain time, a balanced (local/offshore) and diversified position is important to mitigate the risks of a potential weakening of the Rand and rising interest rates.