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.
The 8% appreciation of the rand against the dollar since the start of the year has compounded the losses from global assets for South African investors.
Fortunately, South African bonds and equities were positive, so a diversified portfolio would’ve held up reasonably well.
The FTSE/JSE Capped SWIX returned 1.5% in March, 6.7% year-to-date and 20% over one year. South African bonds returned 1.8% in the first quarter despite volatility in local yields and the big global bond sell-off. The 12-month return of 12% is well ahead of cash.
Since bonds, equities and the currency have been buoyed by elevated commodity prices, they are all at risk should these prices fall sharply.
A year or three
If we look at three-year returns, covering the last of the pre-pandemic days, the Covid-crash and recovery, and the Ukraine war, an interesting picture emerges.
Chart 2: 3-year annualised asset class returns in rand, %
Source: MSCI, FTSE, JSE, Bloomberg, Refinitiv
Global equities returned 14% per year over the past three years in US dollars as measured by the MSCI All Country World Index. This is a remarkably good outcome given the turmoil the global economy faced.
In terms of global bonds, it is notable that the ballyhooed increase in the benchmark US 10-year yield pretty much takes it back to where it was three years ago. The UK equivalent is about 60 basis points higher than where it was three years ago. Germany’s now trades at 0.5%, while it was around 0% in April 2019. It spent most of the subsequent three years submerged below 0%.
While global bond returns were fantastic while yields were falling, the recent rise in yields pretty much wiped out the return of the past three years.
Chart 3: 10-year local currency government bond yields %
Source: Refinitiv Datastream
South African equities (FTSE/JSE Capped SWIX) delivered a 12% annualised return over the three years to end March. That is about 7% ahead of inflation and in line with the long-term (120 year) average real return.
However, the reality is that there are very few years where equity returns line up with the historic average. The average is made up of blockbuster years, negative years, and years when nothing much happens. But average years are rare. This implies that you need to stay invested over several years to benefit from the good years when they take place. This also implies that you need to sit through the bad years, since we cannot predict which years will be good or bad.
This is particularly true of local listed property returns. Despite gaining 26% over the past year, the three-year annual return of the FTSE/ JSE All Property Index is -4%. This compares poorly to the 30-year average real return of around 6%.
South African bonds delivered 8.5% per year, well ahead of inflation and despite the government losing its last investment grade credit rating in March 2020. The July 2021 unrest also failed to meaningfully dent bond returns. Given that the best indicator of future bond returns is simply the yield you pay today, the outlook for bond returns remains attractive, especially given improving domestic fundamentals.
Money market returns are linked to prevailing short-term interest rates. When the Reserve Bank cut rates aggressively two years ago, money market returns fell in tow. They will now follow the repo rate higher again, but at this stage still lag inflation. It is also unlikely that we will return to the pre-2020 situation where short-term interest rates were 2% to 3% above inflation, offering attractive risk-free real returns. In other words, the age-old risk-return trade-off is back.
Finally, at the end of March the rand was only slightly weaker against the dollar compared to three years ago and not far from where it was six years ago. The idea that the rand always falls and boosts global returns for South Africans is simply not true. The long-term trend is weaker, but there can be long periods of sideways movement or appreciation. This needs to be considered.
The world faced major shocks in the past two years and is undergoing economic and political changes that we don’t yet fully comprehend. Yet investment returns were quite good. Investors who ignored the noise and stuck to their strategy would have done well. It is easy to get carried away with the bad news of the moment, but with change there are always investment opportunities. This does not mean blindly extrapolating trends since what worked in the past might not work as well in the future. But being appropriately diversified, keeping an eye on valuations and being patient will go a long way to achieving the desired outcome.