Fight or flight?
6 Jul, 2022

Global markets came under severe pressure over the past few days. The inflation genie is not getting back in the bottle voluntarily and will have to be forced in by central banks. Investors therefore must adjust their expectations for interest rates, company profits and the margin of safety that is appropriate in the current environment. Nonetheless, when there is a big correction, the first question serious investors should ask is not “should I sell?” but rather “should I buy?”

Basic instinct

This goes against the fight or flight instinct. We still perceive threats very instinctively with the part of our brains that evolved at a time when lions or snakes were common and deadly risks. Financial risks are not life-threatening, but our brain can still perceive them as such, until the more rational part kicks in and takes over. The great behavioural scientist and Nobel laureate Daniel Kahneman refers to these two cognitive responses as System 1 and System 2 thinking. System 1 operates intuitively, automatically and rapidly, relying on past information to make snap decisions about the current situation. Its ability to make decisions in microseconds saves countless lives in tight situations but also often leads to the wrong conclusions when there is nuance and complexity. System 2 is analytical and calculating but requires effort and time to get going. It can still make cognitive mistakes, but when investing, we should rely on the more deliberate System 2, rather than default to System 1 when the adrenaline starts pumping. In simple terms, System 1 will tell you to get out of the markets when you should be buying or vice versa. So, let’s give System 2 a chance to rationally assess the situation and conclude. This means looking at the macro-outlook, and then the valuations for each asset class.

Hawks in full flight

First of all, the big macro headwind is clearly inflation and central bank response. Inflation hit 8.6% in May in the US. Coming from an emerging market environment where inflation can be volatile, this might not sound so terrible (SA inflation briefly hit 7% in early 2016 and was above 8% in early 2009). But it is hard to overstate how much of a shock this is to people used to low and steady inflation. Inflation was last this high during the early 1980s in Europe and North America.

While US inflation was initially driven by rising prices of fuel and a handful of lockdown-impacted items, it has now broadened out considerably. Moreover, it is not as if energy prices have eased noticeably. No matter how it is sliced and diced, inflation seems to be becoming entrenched. Consumer surveys shows that ordinary folk now expect relatively high inflation to persist. This is not what any central banker wants to see.

In response, the US Federal Reserve hiked its policy interest rate by 75 basis points last week, the biggest rate increase since 1994. The previous meeting delivered a 50 basis point hike and the one before, 25 basis points. The increased increments point to a deeply worried central bank that believes the time for playing nice is over. It is time to fight back against inflation, even if it hurts markets and results in rising unemployment.

Every quarter, the forecasts of senior officials at the Federal Reserve and its regional banks are plotted anonymously. This “dot plot” gives a strong indication of what the collective mind of the central bank expects of the future. It shows how rapidly the Fed – and markets – have had to ratchet up interest rate expectations. In December, the dot plot pointed to short rates peaking at 2.1% by end 2023. In March, it rose to 3%. The latest estimate was boosted to almost 4%. Bearing in mind that the actual rate was 0% at the start of the year, this is a mighty quick dose of tightening.

But it must happen since the Fed now expects inflation to only return to the 2% target by 2024, even with all these rate hikes. Supply improvements will help, but ultimately the US economy has to cool substantially on the demand side to bring inflation back to acceptable levels. If it tips into recession, it appears the Fed will view it as unfortunate but necessary collateral damage. The Fed cannot bail out the markets and the economy until there is “clear and convincing” evidence (Fed Chair Jerome Powell’s phrase) that inflation is heading back to target.

In the same week, the Bank of England hiked its policy rate by 25 basis points, as expected, while warning that inflation could hit double digits soon. On the other hand, the Swiss National Bank surprised markets by increasing rates for the first time since 2007. In other words, the Fed is far from the only central bank in full hawkish flight.


A well-known Irish joke refers to a traveller asking for directions to Dublin. The local shakes his head, “If I were going to Dublin, I wouldn’t start from here.” Where you start matters. The better the starting point, the easier to get to your destination.

In investing, the best starting point is when an asset class is cheap relative to estimates of the cash flows it can be expected to deliver over time. When it is cheap, you don’t have to make heroic assumptions about those cash flows. When it is expensive, the cash flows will need to outperform to deliver any kind of return. In other words, you can buy a fantastic company with a strong brand and loyal customers. But if you pay too much for it – if there is too much good news priced in – returns are likely to disappoint. The technology shares come to mind here. Fantastic transformative companies they might be, but investors just expected too much from them and now their share prices have fallen a lot. Usually, assets are expensive after a period of strong growth. Often, it is precisely when growth starts to settle down towards more normal levels that people jump in to buy at elevated valuations – this is System 1 at work.

So, let’s look at the major asset classes at a high level.

For a long time, South African investors could safely ignore global fixed income. Until recently, up to $17 trillion of dollars of bonds traded at negative yields, mostly in Europe and Japan. Elsewhere, yields weren’t much better. Moreover, under Regulation 28 available foreign capacity was limited and the preference was for equities. This picture has now changed. Now Regulation 28 has been relaxed, and global yields are becoming more compelling, especially if you believe a global slowdown is underway and that inflation will ultimately decline. The US 10-year government bond yield is pushing 3.5%, the highest level since 2018 and corporate bond yields are even higher.

Chart 1: Global 10-year government bond yields, %

Source: Refinitiv Datastream

For global equities it is worth splitting the universe between the US and the rest. Amazingly, the US counts for more than half of major global benchmarks. This is partly because of the size and strength of its economy and markets, and partly because US equities have outperformed the rest by 400% since the end of the global financial crisis. A strong dollar also helps.

US forward price: earnings ratio is trading near a long-term average of 15. This suggests the market is no longer overvalued, but not necessarily cheap. The big question is if the expectations of future earnings are not too optimistic. Company margins are close to record highs. This is great if you are a shareholder, but it has the effect of propagating inflation. It is a sign that companies are passing on high input costs to consumers in the form of higher selling prices. Something has to give. Either margins (i.e. pricing power) has to come down by itself, or the Fed has to push it down. Therefore, if you take a more pessimistic view of earnings over the next year or two, the US market doesn’t look like a buy just yet.

As for non-US equities (MSCI All Country World ex US), the valuation is now below the longer-term average. This would be an attractive entry point if you had similar confidence that the earning would hold up. However, while non-US equities are not at record margins and earnings base is not elevated by historic standards, the outlook for top-line growth is hardly exciting. Europe is at an even greater risk of recession given its dependency on Russian energy imports, while China’s zero-Covid policy means it can lock down again at any moment. The Japanese yen has plunged due to it having one of the few central banks not actively battling inflation. For outside investors, this is a huge blow to the value of their holdings, but it might be a good entry point for new investors.

Chart 2: Forward price: earnings multiples

Source: Refinitiv Datastream

All in all, the outlook for global equities is not particularly compelling yet, but the longer your investment horizon, the more attractive current valuations are starting to look.

Local can be lekker

Local bonds also sold off in the last week. Long-bond yields rose to the highest level since March 2020. However, while there has been capital volatility, the default risk remains small and has in fact decreased as structural economic reforms are gradually implemented. The SA government continues to make interest income payments and should continue doing so. Therefore, any investor who can ignore short-term fluctuations in bond prices should consider this an extremely attractive asset class.

While the Fed and other central banks are hiking rates, the SA Reserve Bank will not sit on its hands. Therefore, expect it to frontload repo rate increases in the next few months. However, the longer-term inflation outlook in South Africa is not worrying even though fuel prices will push headline inflation up in the next few months. There is little pass-through from fuel prices to other items since demand is not strong enough to absorb it. Unlike the US, core inflation is still below the Reserve Bank’s target.

Chart 3: South African fixed income yields

Source: Refinitiv Datastream

Finally, while local equities have not escaped global market volatility, the asset class has held up much better. In dollar terms, the FTSE/JSE All Share is down 9% since the start of the year, while the MSCI World Index is down 22% (and technically in a bear market). Renewed selling globally will affect the local market, but it has the benefit of being cheaper to start with. Even when the JSE hit a record level in February, it was not based on excessive optimism but simply catching up with rising company earnings, mostly, but not exclusively, from mining. The All Share Index trades on a single-digit price: earnings multiple, with levels last seen after the March 2020 crash. Amid tremendous uncertainty about the global economic outlook, and by extension the local outlook, there appears to be a significant margin of safety in South African bond and equity valuations.


What to do given all the uncertainty? One of the ironies of investing is that the worse things are, the better they are getting. In other words, as markets sell off, valuations improve raising future return prospects. Dumping equities after they’ve fallen is therefore counterproductive. For someone making a monthly contribution to building retirement capital, the latest market turmoil should not be of too much concern. The main thing is to keep System 2 in control and stick to the strategy.

It is a lot more difficult for investors in retirement already. Volatility is much more vicious if you are making regular withdrawals, as opposed to regular contributions. Most retirees still require equity exposure (even at 65 your investment horizon is still 20 years according to average life expectancies) but this needs to be balanced with other asset classes that can dampen volatility and provide income. Ideally, retirement income portfolios should also be structured in a way that minimises the need to sell at regular intervals.

The one bit of good news here is that rising interest rates will boost returns from money market and income funds. The other important thing to remember is that while the market value of each share has fallen – this is always volatile – you still own the same number of shares and are still entitled to the same share in profits paid out as dividends. But it is clear that the environment is extremely challenging with overall returns under pressure at the same time as the cost of living is rising.

As always, the key is to approach things as calmly and rationally as possible. Neither fight nor flight is what is needed now.



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