When the unthinkable happens
13 Sep, 2022

When the unthinkable happens

Izak Odendaal – Old Mutual Wealth Investment Strategist

Queen Elizabeth II was Britain’s longest-reigning monarch, and her 70 years on the throne saw profound economic change in her country, Europe and the world as a whole. She was also South Africa’s head of state (through her representative, the Governor General) from 1952 to 1961. It is amazing to think how society, politics and technology can evolve in one human lifetime, whether hers or one of our own grandparents. When she was born in 1926, telephones, radios, television and commercial flight were just gaining widespread use for the first time. Horses were still used for transport in many places and Alexander Fleming had yet to discover penicillin. At the time of her passing, technology had revolutionised communications, transport, medicine, entertainment and so much more. Yet, despite all this great progress, the UK and the Europe face a major energy crisis today.

Giving it gas

The immediate cause of this crisis lies in Russia’s invasion of Ukraine, the biggest land war in Europe since 1945. Given her life experience, the late Queen would probably say that nothing is unimaginable and that everything can happen. But some things still come as a shock, and Russia’s aggression to its neighbour was one. While much of the initial surge in commodity prices from this war has worn out, that is not the case for natural gas. Natural gas prices have remained high out of concern that Russia could turn off supplies, something it has now done. Unlike other commodities, the cheapest form of transporting natural gas by far is via pipeline. The infrastructure to supply Europe with liquid natural gas (LNG) brought in by ship is still inadequate, though it is expanding. Weather-related problems have also restricted other forms of electricity generation. The result has been a surge in electricity costs in the UK and across the continent, causing upward pressure on inflation and downward pressure on economic growth.

Chart 1: Natural gas futures prices in UK and Germany

Source: Refitinitv Datastream

That sounds awfully like stagflation, something else that was once thought unimaginable. Prior to the 1970s, it was widely assumed that there was a stable trade-off between inflation and unemployment and that policymakers could fine-tune an optimal balance between the two. But the 1970s showed that unemployment could go up alongside inflation. Weak demand would not be enough to pull prices down when there is a supply shock and inflation expectations become untethered, in other words, when people believe inflation is permanent and adjust behaviour accordingly.

In the subsequent decades, efforts of central bankers to build inflation-fighting credibility that would keep expectations anchored meant that a sustained repeat of stagflation seemed unlikely. And that is why central banks are now acting aggressively. The credibility was acquired at great cost through deep recessions in the early 1980s and it will be costly to maintain it today, but the cost of not doing so is believed to be even greater. The lesson from the 1970s is to act early and not declare victory prematurely. In this regard, Germany’s Bundesbank was more successful than the US Federal Reserve and Bank of England back then, but everyone has now seemingly taken the key learning on board.


Fast forward a few decades and unimaginable things happened once more. A global pandemic delivered a deflationary shock at first as countries locked down worldwide, and then an inflationary shock when demand rebounded much faster than constrained supply could respond. This has now been compounded by the war and the surge in energy prices.

Therefore, central banks across Europe, including the Bank of England and the European Central Bank, find themselves between a rock and a hard place. Their respective economies are under severe pressure, but they do not want an inflationary mindset to take hold. Therefore, they are raising interest rates aggressively at a time when consumers and businesses could use support in the form of lower rates.

Eurozone inflation was at a multi-decade high of 9.1% in August. Though this was largely due to energy costs that central banks normally don’t respond directly to, core inflation excluding food and energy was also unacceptably high at 4%. Meanwhile, the unemployment rate hit a record low of 6.6%. In the UK, headline inflation was 10% in July, the latest datapoint, and core inflation 6.2%. The unemployment rate of 3.8% is also indicative of a labour market with too little workers relative to job openings.

And while there is no evidence yet of expectations becoming unmoored, this is precisely the kind of environment (energy shocks, tight labour markets, second-round effects) where it might happen.

Therefore, the ECB was perhaps looking to belatedly recapture some of the old Bundesbank spirit with the largest interest rate increase in its 24-year history last week. It raised its deposit rate from 0% to 0.75% and signaled more would come, despite the weakening economic outlook.

The Bank of England is also raising rates. Last month it raised its policy rate by 50 basis points to 1.75%, with Governor Baily noting that despite the “uncomfortable position” the central bank found itself in, “there are no ifs or buts in our commitment” to achieving its 2% inflation target. It is likely to continue raising rates at the next several meetings.

Plunging pound

Apart from the energy crisis, central banks in Europe and many other countries face the additional problem of very weak currencies.

The ECB’s aggressive (by its standards) move has not done much to prop up the euro, which continues to trade near 20-year lows around $1. The pound, meanwhile, is trading at $1.16, a level last seen in 1985, even lower than after the shock Brexit vote. New UK Prime Minister Liz Truss, the fourth person to occupy 10 Downing Street in six years, plans to cap surging energy costs for households which will cost the fiscus billions. This will result in a larger fiscal deficit, alongside the already large and rapidly growing current account deficit.

Chart 2: Pound and euro versus the US dollar

Source: Refinitiv Datastream

The dollar benefits from higher carry (better short rates) and its safe-haven status. But it is also clear that among the major economies, the US is by far the most resilient, partly due to it being self-sufficient in energy. Apart from Europe’s problems explained above, Japan’s economy has not yet recovered to pre-Covid levels and it too is a net energy importer. China continues to lock down large cities to prevent the further spread of Omicron, and also battles a drought that has disrupted hydroelectric production.

The US resilience could become a liability if inflation doesn’t continue declining. The stronger the economy, the more the Fed would then have to raise rates to force inflation lower. That could put even more upward pressure on the dollar.

The dollar’s dominance in global commerce and finance was formally established in 1944 at the Bretton Woods conference, in the dying days of WWII and a few years before Queen Elizabeth’s coronation in 1952. The pound become a secondary currency in global markets and would, in fact, experience periodic crises, including 1947, 1967, 1976 and 1992.

Throughout this time, particularly after the Bretton Woods system was abandoned in the early 1970s, many commentators have argued that the dollar’s dominant role was on the verge of ending with potentially catastrophic results for financial markets. These calls grew louder firstly after the rapid expansion in US money supply in the pandemic and following the imposition of sanctions on Russia, who has now started pricing its oil in other currencies.

Foreign exchange markets have different ideas, however, and are telling us there are too few dollars, not too many. We should be a lot more worried about a strong dollar than a weak one.


The strong dollar has similarly put the rand on the back foot in recent weeks. The rand is stronger against the pound and euro so far in 2022.

The rand has in fact been remarkably resilient in the face of the dollar surge because of the country’s strong export performance, due to elevated commodity prices, particularly coal. Amid worries of natural gas shortages, utilities in Europe and Asia have been burning more coal. This may be bad for the environment, but good for South Africa’s export earnings.

However, the country posted a surprise current account deficit in the second quarter. Though the trade balance was positive at R272 billion, the service, income and transfer deficit jumped to R358 billion. The Reserve Bank noted that this was largely due to higher dividend payments by local companies to foreign parents.

Chart: Current account deficit as % of GDP

Source: Refinitiv Datastream

Generally speaking, a country that runs a current account deficit has to fund it by attracting foreign capital inflows. This is of course more difficult in an environment where higher US interest rates exert a gravitational pull on capital. While one quarter’s data does not equal the start of a new trend, a more sustained shift to deficit territory would complicate things.

For one, it will certainly weigh on the Reserve Bank’s Monetary Policy Committee when it meets later this month, increasing the odds of a 75 basis-point hike. It looks like 75 has become the new 50, which itself only recently became the new 25 for global central banks.

Nonetheless, the current account is still in much better shape than in 2013 to 2015 when the previous Fed hiking cycle kicked off and South Africa was considered a member of the “Fragile Five” group of emerging markets with large current account and fiscal deficits.


There are a number of implications of all the above for South African investors. The first is that the grass is not always greener and South Africa is not the only country where crises happen. Even though Russia’s invasion of Ukraine was unexpected, European leaders were extremely shortsighted in allowing their economies to become hooked to cheap Russian energy. Diversification of energy supply is just as important as diversification of investment portfolios.

Secondly, not all global is equal. Local investment commentators often draw the sharp distinction between “local” and “global”. But the mere fact of getting money out the country is not enough to guarantee better returns. It depends where you go with it. Similarly, a lot of locally listed investments are actually not linked to the domestic economy, such as rand-hedge shares on the JSE. In the current strong dollar environment, it would not have helped much if your global assets weren’t dollar-based. Exposure to sterling or euro-based cash would’ve delivered negative returns in rand year to date, while dollar cash has delivered double digits.

Lastly, it is very important to note that we are still in a rising interest rate environment, rates will settle at levels that seemed unlikely a few short years ago, and they will probably remain at elevated levels until central banks have certainty that inflation is under control. In particular, it is the US Federal Reserve’s actions investors will need to pay attention to. While the US is not experiencing the same energy crisis as Europe, American inflation is nonetheless unacceptably high and needs to be tamed too.

This world of higher interest rates and greater uncertainty over the inflation outlook is very different to the preceding decade or so. On the one hand, it offers better returns from fixed income for conservative investors, but for others it demands a far greater focus on a margin of safety in valuation and appropriate diversification.

Finally, it is notable that the Queen reached the age of 96 while her late husband passed at the age of 99 last year. People are living longer and longer. Indeed, the increase in longevity is one of the great achievements of the past century, brought about by better healthcare, better diets and less violence. But it does mean that a person retiring at age 60 should expect to live for at least 20 or 30 years. This means saving enough pre-retirement, but also thinking like a patient, long-term investor with a meaningful allocation to equities after retiring. The Queen probably never had to worry about appropriate asset allocation, but the rest of us do.



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