June 27, 2022 

Inflation and Interest Rates Steal the Show 

In the white-hot crucible of a market sell-off, it is perhaps wise to step back and look at the bigger picture. 

Here we attempt this quite literally: the below is the graph of the Standard and Poor’s 500 index, over the last 10 years from mid-June 2012. The S&P 500 is the price index of the 500 largest US listed equities, and although slightly less famous and historic than the venerable Dow Jones Index, it is by far the preferred market measure among professional investors. 

As the figure below clearly demonstrates, price progression comes and goes in waves. Some waves are larger, some are smaller. Much like the sea and its tides, I suppose. This has been, and is, the normal price progression of the markets. 

An armchair analysis of these market tides over the last 10 years produces the following results: 

There are about 50 such waves over the period, depending on how one measures. 

The down legs produce an average negative return of 8.7% and last for 29 days on average. The up legs produce an average positive return of 15.9% and last for 132 days on average – more patient and yet overall, more powerful than the downs. 

The largest down moves were: 

• -17.3% from early October to 21 December 2018, 

• -32% from 19 February 2020 to 20 March 2020 (the Covid plunge), 

• and the three big drops during the first half of 2022: from 3 January to 7 March 2022 the index declined some -12.4%, 

• thereafter it gained 9.5%, before declining -15.3% from 30 to 19 May, 

• subsequently regaining 7% to 2 June before further declining -9.3% to close at 3790 on 15 June 2022. 

2022 has thus seen quite a bit more “action” than most of the past decade! On 31 Dec 2021 this index closed at 4766.18; on 15 June 2022 it closed at 3789.99, a decline of about 20% cumulatively during 2022. This less-than-ideal start to the year – in our metaphor, perhaps a rapidly ebbing spring tide – has several causes. Chief among these are the conjoined twins: inflation, and interest rates. Or more precisely, the fear of high and rising inflation leading to substantially higher interest rates. 

(Source 1) 

Inflation in the USA – The Hottest in 40 Years 

On Friday 10 June the most recent US inflation figures were announced: the Consumer Price Index (CPI) was up 8.6% from a year ago, the fastest pace of price increases since December 1981.The main driver of this was unsurprisingly energy costs, compliments of years of underinvestment, net zero emissions policies and of course the adventures of Vladimir Vladimirovich Putin. 

The Federal Reserve (the US central bank, colloquially and often nervously referred to as The Fed) tends to focus more on “core” prices when setting interest rate policy, as these exclude food and energy prices, which tend to be much more volatile in the short run. Core CPI was up 6.0% from a year ago, a little below the peak of 6.4% in March 2022, but still close to the highest since December 1981. 

(As an aside: while 6-odd percent inflation sounds rather unremarkable to a South African audience, it is worth noting that this rising cost environment is essentially unknown to anybody in the “first world” who wasn’t already at school when Neil Armstrong took his 1969 stroll on the moon!) 

The average price of a gallon of regular unleaded gasoline reached an all-time high of $5.010 in early June 2022. This is up from $3.077 from a year ago, a 63% increase. Nevertheless, despite record high prices, there hasn’t been a drop-off in demand. In fact, weekly data from the Energy Information Administration shows demand being at similar levels to a year ago. 

One may expect that rising gas prices are having a greater impact on lower income households in the US. According to Bank of America’s internal data, average gas spending as a share of total card spending per lower income household was 9.5% during the week ending May 28. This compares to 7.8% for the average household. 

Another one of the hottest categories in the CPI report was airline fares, which soared by 12.6% from April to May. Prices are up 37.8% from a year ago, but it only accounts for about 0.7% of CPI. 

Shelter, however, accounts for a whopping 32% of CPI. Indeed, anyone who makes monthly mortgage or rent payments knows all too well that housing is the biggest expenditure. Rent of primary residence (a.k.a. tenants’ rent) and owners’ equivalent rent (i.e., how much a homeowner would have to pay were they to rent their current home) each increased by 0.6% in May from a month ago – the fastest pace since August 1990. While that may look like a small number in isolation, it piles up very quickly as it compounds. Goldman Sachs calculates that the median monthly payment of a 30-year mortgage is up 56% from a year ago. This is due to a combination of surging home prices and rising mortgage rates. 

Indeed, housing seems to be a category where higher prices are having an impact on demand: the USA housing market is incredibly rate-sensitive, so as mortgage rates increase (driven by the Fed hiking interest rates, more of which anon), demand cools down. The resulting material declines in purchase activity, combined with the rising supply of homes for sale, will cause a deceleration in price growth to more normal levels, providing some relief for buyers still interested in purchasing a home. The Mortgage Bankers Association reports that purchase and refinance application activity in early June fell to its lowest level in 22 years. 

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Overall though, the US public are not daunted! They are traveling, dining out and attending live events. There is a lot of discretionary spending because, generally, consumers are in a strong financial position. Consumer credit balances have increased over time in concert with economic growth over the last few years. 

Wells Fargo (a large US retail bank) reports that by most measures, household borrowing remains far from a point of concern. As a share of disposable personal income, consumer credit remains below its pre-pandemic level of around 25%. Further, many measures of consumers’ monthly or quarterly debt obligations as a share of income remain near record lows. And according to Bank of America’s internal data, savings and checking account balances continue to be much higher today than they were before the pandemic. Furthermore, credit card spending as a share of card spending are right where they were before the pandemic. This is across all income categories. 

In the USA, inflation has indeed been running hot. The problem, ironically, is that consumers and businesses are in unusually strong financial positions. And while this may prevent any economic slowdown from becoming economic calamity, it’s also a curse in that it has enabled consumers and businesses to pay the higher prices. 

And so, in the US, we continue to get a lot of good news about the economy, which is unfortunately bad news for inflation. However, just because consumers’ strong finances are enabling them to pay up, doesn’t mean they have to like it. In fact, the University of Michigan’s consumer sentiment index tumbled to a record low this month amid concerns over inflation (see the comment above highlighting how most Americans have never actively experienced high inflation). Consumer sentiment has been falling for a full year, despite consumer spending trending higher. 

It’s quite a contradiction, and one which could very well continue to hold if (and only if) consumers can afford to pay higher prices. After all, the cure for higher prices, is high prices! The idea is that when the price for something goes up by too much, fewer people will be willing or able to pay for it. As a result, demand eventually diminishes and the price decreases. 

(Source 1 & 2) 

So, Quo Vadis Equity Markets? 

Central banks around the world have a traditional model that tells them how to control rising prices: in essence, they must raise interest rates higher than the measure of inflation that they are using as a benchmark. The hypothesis is that interest rates need to have some real return – i.e. the percentage rate of interest earned should be higher than the rate of inflation – to discourage consumption and encourage savings, until such a time that inflation cools down. If the Core CPI in the US is 6%, then interest rates need to be above 6%… well above, we must add, as there is little incentive in deferring consumption for only a marginal increase in spending power. 

There are valid question marks around efficacy of this approach, outside of credit -driven sectors like real estate and automobile sales, as well as the appropriateness of the inflation benchmarks used (don’t get us started on the South African one!). Central banks though have, in the Fed’s words, only a “limited and blunt” set of tools wherewith to attempt to rein in higher inflation. Being mere mortals like the rest of us, they also have no crystal ball revealing the future, and thus often err on doing too little (like the past decade of extremely low rates) or taking an overly heavy-handed approach to inflation and interest rate increases. 

The last increase in the Federal Funds rate was 0.75% to the current 1.75%. It would take quite a few more of those to get the rate to catch up with inflation, even with inflation hopefully and probably starting to ease over the next few months as supply chains globally recover. Thus, further rate hikes should be regarded as a near certainty over the rest of the year. Were inflation not to be materially eased by rising interest rates – by no means a given – regular rate hikes could continue well into 2023 or even beyond. 

Now, the most important point here is that high and rising interest rates are most certainly not necessarily detrimental to equity markets. Listening to the excitable financial press, one would be tempted to conclude that financial Armageddon is about to erupt any second now, and temporarily there may indeed be an adjustment like we have seen during the last months, but the truth is that in the past bull markets have often been accompanied by high and rising interest rates. The important indices are made up of large, successful companies and their pricing power increases in such times. 

Every environment has winners and losers: some thrive in circumstances others cannot survive in. A high interest rate environment will favour those with a high return on capital, a low level of gearing and who are able to increase their selling prices without difficulty. That is, those with pricing power, the ability to pass cost increases on to their customers as opposed to having those eat into their profit margin. These companies will achieve earnings growth because of their pricing power. 

It may even be said that inflation is good for quality assets over the longer term – even most counter-intuitively well-run banks. 

Then there is the Russian-Ukraine war, with its serious impact on the prices of food and energy. Marc Mobius (a legendary and rather colourful character in financial circles – ask us who he is if you wish) recently did a little study looking at the Korean War, the Vietnam War, and World War II. During all these wars, the S&P in fact trended up. 

A war does not necessarily mean that the markets will go down. All over the NATO and Western world, countries pledge unwavering support for Ukraine – the defence spending of all such governments is growing. In the past, high defence spending has been healthy for a wide variety of businesses and by extension for 

equity markets in general. It is an interesting and counter-intuitive phenomenon that a war does not necessarily imply a bear market, it historically correlates with bull market. (Sources 1 and 3) 

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At the current time, our investment portfolios are very well diversified and consist of quality companies with international exposure, listed here and elsewhere. We tend to avoid exposure to companies that do business in SA only as much as possible: exposure to the latter in our portfolios is currently at levels of around 10%, or less in many instances. This has been our approach for the last three years or so: after all, one wouldn’t place a bet on a hospital patient completing a marathon, and with every Stage XYZ loadshedding announcement, the SA economy takes one step close to the ICU ward. 

Markets go through phases (or waves as we have called it here) as is clear from the above graph of the S&P500. Strong bull runs are stopped and corrected by various forces and fears throughout history. But soon the sun rises, and the darkness is forgotten. 

We enter the second half of 2022 with cautious optimism. Well-diversified portfolios of quality equities, with worldwide revenue exposure across many economic sectors, will remain key. ‘Twas ever thus. 

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