Two crises in two years
Two crises in two years
The pandemic is not over yet, and now investors also need to contend with the war in Ukraine.
Meanwhile, central bank policy has also taken an unfriendly turn.
Despite the uncertainty of the past few years, returns have been good.
South Africa entered hard lockdown two years ago on 28 March. At the time, many thought it would last a few weeks or maybe a few months at most. Instead, the Covid-19 pandemic is still with us, and South Africa is still technically in a state of lockdown, though most of the restrictions have been lifted.
While we are still trying to figure out the short- and long-term implications of the ongoing pandemic, we must now also consider how the brutal Russian invasion of Ukraine will change the global economic and political order.
In other words, the world has faced two profound crises in the space of two years. They will cause far-reaching change, but what exactly? Understanding the present is hard enough. Predicting the future is well neigh impossible. A lot of commentary now talks about the world splitting into two blocs, one led by America and one by China (joined by Russia and other illiberal states). Where South Africa would fit in is unclear. Local business elites and the middle class tend to look West, but many political leaders look East.
Professionals study logistics
Nonetheless, one likely consequence is an increased focus on resilience and security of supply over speed, efficiency and cost. Anybody running a business will think carefully about where crucial inputs come from, the risks of disruptions and steps needed to prevent disruption (governments are hopefully doing the same). Shortages of computer chips have hobbled auto production over the past 18 months, for instance, but more recently German manufacturers found themselves short of a much less sophisticated part that is imported from Ukraine, the humble but crucial wire harness.
General Omar Bradly, the American World War II hero, is said to have noted that “amateurs talk tactics while professionals study logistics”. Russia’s generals seem to have forgotten that in planning their invasion of Ukraine, with soldiers running out of food and ammunition and tanks getting stuck without fuel, but business leaders will not want to be caught short again.
That said, a big part of the strain on global supply chains remains the extraordinary demand for goods compared to the past. This is one consequence of the pandemic that is still with us. Demand for goods, particularly by American consumers, is still well above pre-pandemic trends. Spending on services has recovered but not back to where it would have been in the absence of the pandemic. Seen in this light, supply chains actually performed remarkably well to produce and ship record breaking amounts of goods. But not well enough to avoid shortages, huge price increases and extended lead times.
Chart 1: US consumer spending on goods and services, rebased
Source: Refinitiv Datastream
Neither of these two global crises is over. China has again resorted to hard lockdowns to limit the spread of the virus. But in most other countries it has thankfully become background noise thanks to widespread vaccination, immunity from prior infection, better treatment options, less severe strains and frankly, people simply wanting to get on with their lives. Whether we are really at the end of the pandemic remains to be seen, but there is reason to be optimistic.
China’s hard lockdowns of major cities including Shanghai and Shenzhen will add further pressure to supply chains. China is the world’s factory and will remain so for a long time even if companies start diversifying away from a country where policy has become less predictable and geopolitics more uncertain.
The war in Ukraine also rages on with no immediate end in sight even if Russia seems to have given up some of its original war aims. The market reaction – with equities up since the first days of the invasion – seems to suggest that investors believe the worst-case scenarios are less likely.
The Fed shifts
However, in the background another important shift is underway. Central banks, led by the US Federal Reserve, have turned hawkish, meaning they want to act to tame high inflation. The Fed’s preferred inflation gauge hit a four-decade high of 6.4% in February. While fuel prices are part of the story, core inflation excluding food and fuel was at 5.4%. In the Eurozone, inflation hit 7.5% in March, the highest since the creation of the single currency in 1999. The energy price spike has played a bigger role in Eurozone inflation than in the US, but core inflation nonetheless hit a record 2.9%.
Faced with historically high inflation and historically low unemployment rates, central banks are set to continue tightening policy despite the increasingly uncertain growth outlook. For most of the past 14 years, central banks, particularly the Fed, had been seen as investors’ friends. This was particularly true two years ago when they unleashed unimagined stimulus in response to the Covid shock.
No more. What lies ahead will increasingly be a trade-off between sustaining growth and lowering inflation. All indications are that the Fed and company will now focus on the latter.
No quarter given
Despite interest rate risk, most major global equity benchmarks were positive in March, with China being a notable exception. However, the first quarter return from global equities was decidedly negative. Apart from the shock of war, equity markets have had to discount rising interest rates.
The first quarter was even worse for bonds. Rising interest rate expectations saw yields jump. The benchmark US 10-year Treasury yield rose to 2.32% at the end of March having started the year at 1.4%. Shorter-term yields increased faster, leading to a flattening yield curve. The US two-year Treasury yield still ended the quarter at 2.28% having started at 0.7%. Yields rose in other developed countries too, and the share of bonds with negative yields has shrunk rapidly from a peak of $18 trillion dollars to low single digits.