Inflation and Interest Rates in the US of A

Well, the time for ginnentonix and lazy afternoon naps has come and gone. We hope 2022 brings happy times and much excitement.

The graph below is of the S&P500 over the last 24 months. The bull run from the bottom of the Covid dip on 23 March 2020 is evident. Since the bottom of the market at the end of the Time-of-the-Big-Trouble (as we call it) in early March 2009, financial markets have been driven by extremely low interest rates and very accommodative monetary- and fiscal policies in the developed world.

International equity markets flourished since 2009, fueled by the factors mentioned above. The Covid short-term bear abruptly interfered for a short period between 19 February 2020 and 20 March 2020 with about a 35% fall in the S&P 500. But soon the bull was back, and the index closed at 4766 on 31 December 2021, a 213% increase.

The post-Covid period brought with it the steep increases in the prices of energy and many other products. We have written about this at some length in a previous Some Notes.  The result is a huge increase in inflation in the USA, UK, Europe and elsewhere.

The Federal Reserve has warned for some time that high inflation is something completely unwanted and that action to curb it will most certainly be taken. The mere threat of interest rate increases, and a less accommodative monetary policy stance, made equity markets very nervous after an almost 13-year period of historically low interest rates, accompanied by an extraordinary expansionary monetary policy. In fact, after the December rally, The S&P500 declined from the 4766 closing on 31 December, to close at 4356 on 26 January 2022. That is a decline of 8.6% during the month of January 2022.

The meeting of the Federal Reserve Monetary Policy Committee took place on Wednesday 26 January 2022. The main observations are:

1. Inflation is a serious problem, and the danger is that it may not be a temporary phenomenon. It is well above the 2% long-run objective.
2. The balance sheet of the Federal Reserve is substantially larger than it needs to be. This will take some time to rectify.
3. The headline unemployment rate has fallen below 4%, though labour force participation is still below its pre-pandemic level. Interest rate increases will not threaten the labour market.
4. The economy is strong enough to stand on its own legs and no longer needs sustained levels of monetary support.
5. Interest rates will start to be increased in March of 2022.

The economic relationship between interest rate levels and stock prices is complex. No rule can be applied to predict the effect of a change in interest rates and stock prices. Intuitively, it seems elegant to argue that the cost of borrowings would have a direct effect on profitability, and therefore on the share price of an equity. In addition, higher interest rates may probably decrease discretionary spending by the public. The relationships between the level of interest rates and equity prices, are not always clear-cut and predictable. For instance, following a 0.25% increase in December 2017, the S&P500 increased by 6% in January 2018.

In a Market Monitor dated 21 January 2022, Goldman Sachs writes the following about imminent rising US interest rates: “While market repricing is expected, we believe risk assets may still post positive returns in the year ahead. Over the last nine Fed hiking cycles, equities and commodities have outperformed bonds and have delivered at least mid-single digit returns on average”.

In fact, their research shows that over the last nine hiking cycles, commodities achieved an average return of 19% per year, while the corresponding number for the S&P500 index, is 8%.

Similarly, the economic relationships between inflation levels and stock prices are also complex. In much the same fashion, it is enticing to argue that increasing inflation may reduce the sales or profitability of a company. But this relationship between the level of inflation and equity prices is not always clear cut and predictable.  We would argue that higher inflation may very probably support equity prices. This relationship is accepted as normal. 

Job openings unexpectedly crept higher in December, as the hiring recovery sharply slowed, and the Omicron variant fuelled a new wave of Covid-19 infections nationwide.

Openings rose to 10.9 million from 10.8 million in the last month of 2021, according to Job Openings and Labor Turnover Survey data published on Wednesday by the Bureau of Labor Statistics. Economists surveyed by Bloomberg expected openings to dip to 10.3 million. The print places openings just below the record highs seen in July, and erases much of November’s decline.

The report all but confirms the labor shortage lasted into 2022, as hiring slowed into the winter. The country added just 199,000 payrolls in December, reflecting the smallest gain all year, and badly missing economists’ estimates. The weak gains led to little improvement in matching jobs with available workers. There were roughly 0.6 unemployed people for every job opening in December, according to the report. That’s the lowest reading in data going back to 2006.

With openings still elevated, and employers struggling to hire, the labour market is likely to remain unusually tight well into the new year.

Retaining workers is a similarly difficult task in the pandemic economy. About 4.3 million people quit their jobs in December, down from 4.5 million the month prior. Though the print signals quitting could be easing from levels seen earlier in 2021, it also marks a sixth straight month of more than 4 million people walking out of their jobs.

(Sources 1,2 &3)

Inflation and Interest Rates in the Eurozone

During the first week of February 2022, the European Central Bank held its Monetary Policy Committee meeting. Their situation is not really any different from that of the USA, and there are clear signs of a shift to a more hawkish approach (rising interest rates and less accommodative monetary policy) by the ECB.

Exactly as in the USA, inflation is the primary issue. Of particular concern, is the recent upside surprises in inflation – January’s HICP reading having risen to 5.1% and confounded expectations of a moderation. Both energy and food prices were a factor here, but the signs of broadening inflation were especially noted.

In December the inflation projections estimated HICP standing at 3.2% in 2022, and 1.8% in 2023, but given the persistence of price pressure, these look likely to see a material uplift when they are next updated in March. This is not just to account for the recent inflation surprises, but also improvements in the medium-term inflation outlook, with Lagarde noting three key factors which should lead to inflation being close to target: improved labour market conditions; broad-based price increases; and inflation expectations at, or close to target. As such, and as was stressed several times during the press conference, these new projections will allow the ECB to have an in-depth discussion on inflation, and ultimately the implications for the ECB’s policy stance at the next meeting. Markets (and journalists) are now looking for any clues as to whether the ECB would follow in the footsteps of the Federal Reserve and the Bank of England in beginning to normalise policy. In this respect, perhaps the most notable point was that Lagarde noted that the situation had changed since December and that the probabilities of rates rising this year are now higher.

In the past the ECB have been very clear on policy sequencing. That is, net asset purchases would end first, followed by rates increasing, and finally the end of QE reinvestment. December’s meeting had laid out a glide path for QE across this year, with monthly net asset purchases of €40bn in Q1 and 2, €30bn in Q3 and €20bn in Q4.

However, the tone of the most recent press conference clearly highlights a risk that this tapering is accelerated, which would open the possibility of an earlier rate rise. Investec’s current view is that the first rise in interest rates will occur in June 2023, but the recent meeting has left the door ajar to a move later this year. The March meeting looks set to focus on the recalibrated asset purchases. (Source 1 and 4)

Here at home in SA

Helped by the strong finish in international equity markets to the calendar year 2021, the JSE produced a wonderful return of 24% in 2021. As confidence grows in the strength of the global economic recovery, investment appetite appears to be veering towards more cyclical markets and equity sectors. This trend benefits emerging markets. 

South Africa, a major commodity producer, with the added attraction of low valuations, was a beneficiary of this trend and outperformed the emerging market average. Commodity stocks shone in the final quarter, lifting the Resources 20 index by 22.19%, and 23.27%, for the year. The industrial 25 index gained 16.45% in the quarter, and 22.71% over the year, while the Financial 15 index gained a similar 22.71% over the year, but returns were spaced differently, with a relatively modest Q4 return of just 1.20%.

Equity market returns were even impressive in hard currency terms, despite the rand’s 9.32% depreciation versus the dollar over the year, from R/$14.59 to R/$15.95. However, this meant that the 8.35% annual return in the All-Bond Total Return Index was entirely eroded in dollar terms. The dollar gold price gained in the final quarter by 4.24%, but over the year drifted down by 3.49%, from $1894 per ounce to $1827 per ounce.

Equity markets are forward looking. In typical fashion, they looked past the effect of July’s riots, Covid lockdowns, NUMSA strike activity and energy outages, which all conspired to cut economic activity. GDP contracted in Q3 by 1.5% quarter-on-quarter, and the unemployment rate recorded a new high of 34.9%. However, forward-looking confidence measures appear to be recovering. The Absa manufacturing purchasing managers’ index (PMI) climbed sharply in November from 53.6 to 57.2, well above the expansionary 50-level. The survey suggests businesses are looking towards an improving environment in 2022. The IHS Markit PMI, which measures conditions across the entire private sector, regained the key 50-level in November, rising from 48.6 to 51.7. However, the outlook is clouded by a weak reading in the RMB/BER Business Confidence index, which after dropping from 50 to 43 in Q3, remained at that level in Q4, which is discouragingly below the neutral 50 mark. Business confidence is an important ingredient for much needed fixed investment, which helps spur job creation and economic growth.

The South African Reserve Bank, in its latest policy meeting in November, estimates GDP growth in 2021 will register a robust 5.2%, but its forecasts for 2022 and 2023 are comparatively modest at 1.7% and 1.8%, due primarily to continued structural headwinds, including persistent energy outages, fiscal imbalances and insufficient structural economic reforms.

Despite record high unemployment and sluggish economic growth, the Reserve Bank hiked the repo rate by 25 basis points from 3.50% to 3.75%, citing increased inflation risk. Consumer price inflation (CPI) has risen above the mid-point of the SARB’s 3-6% target and accelerated again in November from 5.0% to 5.5% year-on-year. Supply chain bottlenecks and rising commodity prices caused producer price inflation to accelerate from 7.2% to 8.1%, which could spill over into consumer inflation if companies pass on their cost increases.

The SARB projects the repo rate will rise steadily in quarterly increments of 25 basis points throughout 2022, 2023 and 2024, which would result in a terminal rate of 6.75%. This would not exceed the recent 2016 peak of 7.0%, an unlikely eventuality given the considerable slack in the local economy.

Moreover, the unprecedented current account surplus, measuring 3.6% of GDP in Q3, and likely capital flows into emerging markets, should protect the rand from the volatility that typically raises the SARB’s inflation anxieties. As base effects flush out of the system, inflation is likely to ease back over coming months, allowing the Reserve Bank to adopt a more gradual monetary policy normalization and maintain easy settings for longer.

The fourth quarter contained numerous political and macro-economic developments, mostly positive. The ANC lost considerable support in the local government elections held on 1st November, with its share of the vote dropping to 47% compared with 54% in 2016 and 63% in 2011, indicating political and patronage losses for the ruling party. The election resulted in a record 66 hung councils, now run by coalition, including five metropoles, three of which are run by the Democratic Alliance. Encouragingly, the ANC refused to enter coalition discussions with the EFF, signaling President Ramaphosa’s growing authority over the party’s more radical factions. A similar refusal to compromise with the EFF on the proposed amendment to Section 25 of the Constitution, caused it to be rejected by parliament, putting to rest remaining concerns over expropriation without compensation.

Finance Minister, Enoch Godongwana, impressed financial markets in his maiden Budget on 11th November. The Medium-Term Budget Policy Statement (MTBPS) confirmed a R120 billion revenue overrun due to high commodity prices, which together with the beneficial restatement of GDP resulted in a reduction of the projected FY2022 budget deficit from 9.3% to 7.8% of GDP. The debt-to-GDP projection also improved, peaking at 78.1% in FY2026. The MTBPS is committed to fiscal consolidation and debt stabilization, but controlling expenditure will not be easy amid public sector wage negotiations, financial support for state owned enterprises, and demand for social support measures. Pressure will mount for a permanent extension of the R350 per month Social Relief of Distress Grant. Social grants are paid to 27.8 million people – 46% of the population. Godongwana said, “A fast-growing economy will allow for greater revenue collection, making it possible for more comprehensive responses to the challenges we face.”

Amongst the positive policy developments over the final quarter, the government announced the preferred bidders for the fifth round of the Renewable Independent Power Producer Procurement Programme, which will add 2500MW of capacity. The Independent Communications Authority of South Africa issued its final invitation to apply for high-demand mobile spectrum, in an auction valued at an estimated R8 billion, and expected to bring numerous efficiency and cost savings to consumers and businesses. South Africa also secured R130 billion in concessionary financing at COP 26 towards accelerated decarbonisation. These incremental developments and improving fiscal outlook, caught the attention of Fitch credit rating agency, which moved South Africa’s sovereign risk outlook from “negative” to “stable”.

Some concern has been voiced over a repeat of the 2013 “taper tantrum”. When the Federal Reserve reduced its asset purchases that year, financial markets rioted, and emerging market currencies were particularly badly affected. The taper this time round has been much better telegraphed. Financial markets have already discounted the event. Moreover, emerging market currencies are now largely undervalued, compared with being overvalued eight years ago. At that point, there had been excessive capital transfers into emerging markets. The reverse is true today. In 2021, the JSE suffered net foreign selling of R140 billion. Also, in contrast to 2013, emerging markets are supported by stronger terms of trade. In the 11 months to end November 2021, South Africa chalked up a massive R412.7 billion trade surplus. The current account surplus will strengthen the rand’s resilience.

Following a dismal year in 2021, China’s economy is expected to recover its momentum in 2022, as regulatory constraints ease and authorities step up policy stimulus. An upgrade to China’s forecasts is positive for commodity prices and emerging markets generally. As the global recovery extends beyond the US, which enjoyed exceptional growth last year, capital flows will gravitate towards more cyclical markets.

South Africa, which is a “high beta” cyclical economy, with an outsized stake in commodities, will benefit in this expected scenario. JSE valuations are still compelling, despite last year’s 24% return in the All-Share index. The index trades on a price-earnings multiple of 12.7x cheaper than its 5-year average of 14.1x. The price-to-book ratio is also undemanding at 2.17 – well below the 2007 peak of 3.07. The 3.72% dividend yield is attractive when compared with current money market rates.

Money market rates will rise in line with the Reserve Bank’s monetary tightening cycle. However, a stable rand, backed by capital inflows, buoyant commodity prices, and robust trade and current accounts, should enable the Reserve Bank to lag its rate hike projection, providing an added tailwind for the economy and its markets.

(Source 5)

So, Quo Vadis equity markets?

One thing is for certain, no one can tell the future. We have pointed this out in several of our Some Notes.

History shows that the S&P500 index has historically generated an average 12-month return of 8% in environments of positive, but slowing economic activity, and rising interest rates. The US is very probably entering just such a period at the present time.

Goldman Sachs expects the S&P500 to rise to about 5100 at the end of 2022. This will be a gain of about 13% from the current level of just below 4500. If the US produces a positive equity sentiment and environment, it is highly likely that world markets will follow suit.

The following factors will support the US markets through 2022:

• Firm earnings by S&P500 companies: Goldman Sachs estimate earnings will grow by 8% in 2022 and sales by 9%.
• In addition, companies are able to pass on inflationary pressures to their customers. 
• The average annual US GDP growth from 1947 to 2021, is 3.2%. The growth rate expected for 2022 is just a little over 2%.
• Corporate tax rates will probably remain unchanged next year and remain a tailwind to profits.
• Households own half of the $28 trillion in U.S. cash assets, an increase of $3 trillion since before the pandemic. Expect households to move some of this capital into equities over time during 2022.

(Source 1)

At the current time, our investment portfolios are very well diversified and consist of quality companies with international exposure, listed here and elsewhere. We avoid exposure to companies that do business in SA only as much as possible. The latter exposure in our portfolios is currently at levels of around 10%. Even less in many instances. This has been our approach for the last three years or so.

We enter 2022 with optimism, though with the usual caution. Well-diversified portfolios of quality equities, with worldwide revenue exposure across many economic sectors, will remain key. As usual.

Do not be shy.  Give us a call.

Amanda Witherspoon	amanda@7sc.co.za and 072 658 4481
Andre Greeff	info@7sc.co.za and 072 797 1797
Charles Snyman	cns@fal.co.za and 082 377 9335
Ian Lane	info@7sc.co.za and 076 165 5166
Jacobus Strauss	info@7sc.co.za and 082 818 2044

Source 1: FAL7SC Research.

Source 2: CNBC. Update on the FRMPC. 26 January 2022.

Source 3: Goldman Sachs. Market Monitor. 21 January 2022.

Source 4: Investec Economics: ECB Reaction. 3 February 2022.

Source 5: Overberg Asset Management Economic Commentary. Nick Downing. January 2022.