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In this week's bottom line - 11 January 2022
As the economic recovery broadens globally and becomes more durable, bond yields will inevitably rise from their extreme low levels. This may affect the more richly priced sectors of the equity market, most susceptible to an increase in the risk-free discount rate.
Contributed by Werner Erasmus
The Absa Purchasing Managers Index (PMI) declined by 3.1 to 54.1, pointing to an easing of economic activity in December 2021. The Absa PMI is a monthly gauge of sentiment in the manufacturing sector and an early indicator of underlying economic activity. A reading above the neutral 50-mark points to expansion and a reading below points to a contraction in the sector. Respondents to the survey turned more downbeat about future business conditions as the index measuring expected business conditions declined for the third month in a row (to 53.1). On the cost front, the purchasing price index rose further to 89.8, the highest level since early 2016. The latest Absa PMI data shows that manufacturing activity weakened at year-end amid the Omicron wave, even as the government opted for less severe lockdown restrictions.
The IHS South Africa Markit PMI declined in December to 48.4, down from 51.7 recorded in November. The headline South African PMI is a composite single-figure indicator of private sector business performance. From a quarterly point of view, the IHS Markit PMI averaged 49.6 in the fourth quarter of 2021, up from 48.9 in the third. The fact that the index remained below 50 in the fourth quarter reflects the adverse impact on activity from load-shedding in October and November, the prolonged steel sector strike in October, the fourth COVID-19 wave (Omicron), and the associated global travel bans to and from South Africa. Looking ahead David Owen, Economist at IHS Markit, noted the following, “confidence regarding future output remained strong and above the series trend, as firms stated that they expect activity to recover quickly as case numbers decrease and vaccine uptake rises. On the risk side, high inflationary pressures will continue to impact businesses at the start of 2022. Supply disruptions also remain, including at local ports and on shipping routes, which is stopping some firms from restocking their inventories.”
New vehicle sales decline 3.5% year-on-year in December to 35 948 down from 37 250 in November. This was due mainly to a sharp drop in sales of light commercial vehicles because of supply problems. Export sales ended the year on a positive note recording a welcomed increase of 19.4% year-on-year in December. Following the massive COVID-19 pandemic-related decline in new vehicle sales from 536 612 units in 2019 to 380 206 units in 2020, a 29.2% decline, the new vehicle market has shown a strong rebound increasing to 464 122 units in 2021, a 22.1% gain on the year. A close correlation exists between domestic new vehicle sales and the overall performance of the economy. The new vehicle market’s performance was aligned with South Africa’s projected GDP growth rate. The industry had various headwinds to contend with during 2021 ranging from civil unrest, Covid 19 lockdowns, global supply chain disruptions, persistent load-shedding, escalating logistics costs, as well as a strike in the metal and engineering sector. Vehicle exports during 2021 recovered well increasing 8.8% year-on-year from 271 288 in 2020 to 295 268. Looking ahead, the new vehicle market is expected to continue its gradual recovery during the year as the economy continues to open up and return to normal. The National Association of Automobile Manufacturers of South Africa (Naamsa) expects a year-on-year improvement in new vehicle sales volumes in 2022 of around 8%, despite continued constraints. These include escalating cost increases, supply chain disruptions and load shedding. Furthermore, the realities of rising interest rates and fuel prices are expected to impact vehicle affordability as household budgets remain under pressure.
SOUTH AFRICA: THE WEEK AHEAD
Contributed by Werner Erasmus
Manufacturing production. Due Tuesday 11 January 2022. Two economists polled by Bloomberg are expecting manufacturing production declines of 2.1% and 5% year-on-year in November. Manufacturing production suffered its sharpest contraction in more than a year in October, falling a surprise 8.9% year-on-year, hit by a combination of strikes, load-shedding, and a dent in confidence in the wake of July’s civil unrest.
Contributed by Nick Downing
It is customary in early January for investment strategists, economists and soothsayers to make their predictions for the world economy and financial markets. The year has not got off to an especially good start for global equities. The MSCI World index has dropped by 2.03% since the start of the year, led lower by last year’s market darling, the S&P 500 index, down by 2.63%. Undoubtedly the mega-cap technology stocks are in bubble territory with passive investment flows contributing to their excessive valuations. They are ripe for a correction but spotting a bubble is the easy part. Predicting when it might burst is another matter. Top analysts predict stocks are only half-way through their “melt-up” phase. Although expensive in certain sectors in price-to-earnings and price-to-book terms, valuations remain attractive relative to bond yields. In addition, some markets are still attractively priced on all metrics, including China, emerging markets, Japan, Europe and the UK. The US may be richly priced, but its banks and financial stocks are cheap and likely to perform well with rising bond yields and steepening yield curves. The rotation from “growth” to “value” stocks and from US to ex-US stocks could be the winning trade in 2022. Of course, if the US catches a cold all other markets will be affected but provided it maintains its equilibrium other markets should outperform. This is a likely scenario. An implosion of the US market is unlikely unless there is a recession. The combination of healthy private sector balance sheets, expansionary fiscal policy, and very accommodative monetary policy, mean the probability of a recession is very remote. The Federal Reserve will have to do a lot of monetary tightening before policy conditions become restrictive. What could go wrong? Covid mutations could take a turn towards more deadly variants, Russia and China could invade the Ukraine and Taiwan, or inflation could spike even higher than expected. The breakeven rate between 10-year US Treasury bonds and Treasury Inflation Protected Securities (TIPS) of the same maturity indicate a market expected average inflation rate over the period of 2.48%. This would be a healthy outcome and good for equity markets. The slight pullback since the start of the year is also healthy. If markets go up too soon and too quickly, they reduce longer-term prospective returns. GMO’s Jeremy Grantham put it well, “The one reality you can never change is that a higher-priced asset will produce a lower return than a lower priced asset.”
Contributed by Nick Downing
Unemployment dropped sharply in December from 4.2% to 3.9%, reflecting a steady decline over the year and rapidly approaching its pre-pandemic level of 3.5%. Average hourly wages were also elevated, rising by 0.6% month-on-month, lifting the year-on-year increase to 4.7%, well above the 3% pre-pandemic average. The nonfarm payroll data is likely to grab the attention of the Federal Reserve as it prepares for its next policy meeting on 25-26th January. Payroll numbers increased by a lower than expected 199,000 in December down from 249,000 in November, but the previous two months were revised upwards by 141,000. The chances are that December’s payroll will also be revised upwards. The usual difficulties in data collection have been exacerbated by Covid related delays. The relatively weak payroll number is also partly attributed to tightness in labour availability. The labour participation rate, which measures the working age population that is either employed or actively seeking employment, crept higher over the month from 61.8% to 61.9% but remains well below its January 2020 level of 63.4%. Improved labour participation is the key to creating more slack in the labour market and reducing wage pressure. Job seekers have stayed away from the labour market due to fear of Covid, child-care responsibilities and the windfalls from fiscal relief programmes. As the Covid threat dissipates and household savings are run down, labour participation should rise but some analysts believe the pandemic has introduced structural changes to the labour market. The Fed and financial markets will maintain close vigilance of upcoming labour data. The December report was compiled before the Covid Omicron variant wave began. The variant’s effect may result in increased labour market tightness in the January report.
Minutes from the Federal Reserve’s policy meeting on 14-15th December reveal a hawkish tilt: “Participants generally noted that, given their individual outlooks for the economy, the labour market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.” Several policy makers said it would be appropriate to begin lifting the fed funds rate as early as March when the asset purchase programme will have expired. The minutes led interest rate futures to attribute a 70% probability to a March rate hike and economists generally brought forward their projected starting date for the rate hiking cycle from June to March. The “Dot Plot” of policy makers’ individual interest rate projections now signal three 25 basis point hikes in 2022, three in 2023 and a further two in 2024, lifting the terminal fed funds rate to 2.0%. In an unexpected twist, the minutes also revealed discussion over how and how soon to reduce the size of the Fed’s $8.76 trillion balance sheet. After the last quantitative easing taper in 2013-2014, the Fed maintained its balance sheet for three years before commencing a quantitative tightening. Over that period the size of the balance sheet was maintained by reinvested maturing bonds. The Fed stated that current conditions, characterised by stronger inflation, a stronger labour market and a much larger balance sheet (which has doubled in size since the pandemic), warrant a quicker quantitative tightening, whereby maturating bonds are allowed to runoff rather than being reinvested. A more active quantitative tightening may allow for more leeway in raising interest rates.
Contributed by Nick Downing
Survey data confirm a recovery in China’s economic activity. The improvement is attributed to a shift in policy from the People’s Bank of China (PBOC) and from government. The PBOC cut its key one-year prime rate in December for the first time in almost two years while the government pledged more fiscal support. The official National Bureau of Statistics manufacturing purchasing managers’ index (PMI) increased in December for a second straight month, rising to 50.3 from 50.1 in November and 49.2 in October. The 50-level demarcates expansion from contraction. The official non-manufacturing PMI, which includes services and construction, also improved, from 52.3 to 52.7. While the construction sub-index fell from 59.1 to 56.3, the services sub-index gained from 51.1 to 52.0. The independent Caixin PMIs also improved: The manufacturing PMI gained sharply from 49.9 to 50.9 amid easing cost pressures and strengthening domestic demand, although survey respondents expressed concern over Covid flare-ups and weakening export demand. The Caixin services PMI improved from 52.1 to 53.1, while the composite PMI, which includes both manufacturing and services activity, gained from 51.2 to 53.0. Overall economic confidence is expected to maintain its recent uptrend over coming months, helped by policy reflation. China appears to have successfully navigated the main threats from last year, including surging commodity prices, power outages and the debt crisis among real estate developers. However, China’s zero-Covid policy remains a key risk to domestic demand and supply chains. Authorities may ease Covid restrictions after the Beijing Winter Olympics, which run from 4-20th February, but a full relaxation of Covid policy is unlikely before the 5-yearly National Party Congress in November. The Communist party will want to avoid any outbreak ahead of its key event, when President Xi Jinping will likely be appointed for a third term.
Contributed by Carel La Cock
The Bank of Japan (BoJ) announced at the end of last year that it will dial down its support for the economy, mimicking other G7 central banks responding to rising inflation. However, Japan’s inflation, anchored at 0%, does not pose a threat and the BoJ is encouraged with the state of recovery in consumer sentiment while seeing “no sign at present of a sharp drop in demand.” Given the progress made by the economy, the central bank will taper purchases of corporate debt and commercial paper to levels before the pandemic but will extend assistance to small businesses hit by the pandemic by a further six months. The BoJ will also keep its benchmark rates unchanged, as was expected by the market. The announcement has left the BoJ as one of the most dovish central banks amongst developed economies and has put pressure on the yen which has lost more than 11% of its value against the dollar in the last year. Analysts believe that this trend will continue into 2022 as the Federal Reserve is likely to hike rates more aggressively than previously thought, causing further pressure on the yen. A weaker yen will boost exports especially in the automotive sector, once supply bottle necks clear.
Contributed by Carel La Cock
The European Central Bank (ECB) announced at its last monetary policy meeting of 2021 that it will end the Pandemic Emergency Purchasing Programme (PEPP) in March this year, responding to rising inflation and sufficient economic recovery that warrant a “step-by-step reduction in the pace of asset purchases”. However, ECB president, Christine Lagarde, conceded that accommodative monetary policy was still needed to stabilise inflation at the target rate of 2%. The ECB forecasts that inflation for 2021 will be 2.6%, increasing to 3.2% this year before easing to 1.8% in 2023 where it will remain the following year. The benchmark rate was kept unchanged at minus 0.5% and the ECB plans to offset the tapering of PEPP with an expansion of its earlier asset purchasing programme (APP) from its current level of €20bn to €40bn in the second quarter, winding down to €30bn in the third and back to €20bn thereafter. Compared to the purchases of €90bn during most of 2021, it represents a significant tapering from the second quarter onwards, but analysts do not expect a rate increase until early 2023. Lastly, the ECB extended plans to reinvest proceeds from maturing bonds in the PEPP until at least 2024 and will pivot these purchases towards buying Greek bonds to prevent a repeat of the European debt crisis.
Contributed by Carel La Cock
The Bank of England (BoE) hiked its benchmark interest rate by 15 basis points in its December monetary policy meeting, citing a risk of inflation hitting 6%. It makes the BoE the first major central bank to hike rates in contrast to other big central banks that have only started tapering asset purchases. There was only one Monetary Policy Committee member that voted against a rate hike as other members agreed that the central bank had to take action to prevent the economy from overheating. BoE governor, Andrew Bailey warned that a “very tight labour market” coupled with “persistent inflation pressures” was cause for concern in the medium term and there will likely be further modest rate increases to bring inflation back to the 2% target. Economic forecasts are already showing the negative impact of Omicron on economic growth in the last quarter of 2021 and the first quarter of this year, however the effect on inflation remains unclear. There is anecdotal evidence that an already tight labour market has tightened further which will add to inflationary pressure. The BoE believes that the hike in interest rates will stop a spiralling effect of higher prices driving higher wage demands and becoming entrenched in company pricing policies.
FAR EAST AND EMERGING MARKETS
Y to D %
JSE All Share
JSE Fini 15
JSE Indi 25
JSE Resi 20
Y to D %
THE BOTTOM LINE
Contributed by Nick Downing
After a short pause in the third quarter (Q3), global risk appetite resumed in Q4 powering equity markets to new highs. Economic momentum recovered from the temporary setback caused by the Covid Delta variant and earnings growth continued to beat expectations. Companies maintained their profit margins despite rising cost pressures. Central banks began to withdraw their pandemic monetary stimulus but at a slower pace than expected by financial markets, so the impact was negligible. The Covid virus mutated again to the Omicron variant, first discovered by scientists in South Africa. Markets shuddered but rapidly regained their poise. The variant is more contagious but far less deadly, which lessens its economic disruption and brings closer the goal of eventual herd immunity.
US markets led the way lifting the S&P 500 index in Q4 by 10.66% capping a stellar return in 2021 of 26.89%. The UK and Germany also provided respectable returns, the FTSE 100 and Dax 30 climbing by 4.46% and 4.01% in Q4 and 14.58% and 15.70% in 2021. Far East and emerging markets fared less well, dragged lower by regulatory constraints in China and stricter Covid lockdowns. The Shanghai and Shenzhen CSI 300 index gained just 1.5% in Q4 and lost 5.3% over the year. Japan’s Nikkei 225 index lost 2.2% in Q4 and returned a relatively modest 4.94% in 2021. The divergence in stock market fortunes is evident in the performance of the MSCI World index versus the MSCI Emerging Market index, with the former rising 7.49% in Q4 and 21.04% in 2021 while the latter fell by 1.68% and 7.30% over the respective periods. A recovering global economy pushed oil prices higher. The Brent crude price gained over the year by 52.24% from $51.09 to $77.78 per barrel. The US dollar index also gained over the year from 89.93 to 95.97, a 6.72% increase, while the all-important 10-year US Treasury bond yield climbed from 0.93% to 1.51%.
Bull markets climb a wall of worry. There is no shortage of concerns worrying investors. Share price valuations are a chief concern. Some pockets of the equity market are excessively priced, offering investors a sparse margin of safety, but these are concentrated in the mega-cap US technology stocks. Their valuations have been distorted by passive investment inflows, which now account for almost half of all equity assets under management. Other US market segments are less richly priced. Looking beyond the US market, valuations are far less demanding. European equities trade at a 35% discount to the US on an estimated forward price-earnings (PE) basis, the biggest gap ever. The same goes for Japanese equities, trading at a 45% discount. Emerging markets are at their cheapest on a relative basis since 2003. Many markets, including the UK, Japan, China and emerging markets are still cheap in absolute terms, trading cheaper in PE and price-to-book terms than their own long-term averages. Even the US market, by some measures, continues to offer considerable value. Although close to its record peak set in 2000 on a PE basis, the market is very cheap relative to the 10-year bond yield, which determines the discount rate against which all financial assets are priced.
Inflation is also a concern amid signs that cost pressures could be more persistent and widespread than initially predicted by central bank policy makers. The Federal Reserve no longer describes the inflation spike as “transitory”. US consumer price inflation reached a multi-decade high of 6.8% in November. Core inflation, which strips out the effect of energy and food prices due to greater volatility, increased to 4.9% well above the Fed’s 2% target. In the Eurozone, inflation reached 4.9%. From the current high base, inflation readings should dip in 2022 helped additionally by an easing in Covid related supply chain blockages and a moderation in economic growth as fiscal and monetary stimulus is withdrawn. Wage pressures should also reduce as safer conditions attract more job seekers. While the debate over rising inflation remains wide open, companies have on average coped well with this year’s inflation spike, able to successfully pass on rising costs and to protect their profit margins. A moderate increase in inflation is good for equity markets.
The Fed began reducing its massive $120 billion per month asset purchase programme in October by $15 billion per month and accelerated the monthly “taper” to $30 billion at its December policy meeting. This means the programme will be reduced to zero by March, which will pave the way for increases in the fed funds rate, currently at zero percent. The Fed predicts three rate hikes in 2022, three in 2023 and a further two hikes in 2024, each of 25 basis points. This should not alarm the markets. The terminal fed funds rate would settle at 2.0%, only 25 basis points higher than its pre-pandemic level and still at a negative real rate, in the safe assumption that this will be less than the prevailing inflation rate. The Fed predicts that the core personal consumption expenditures index, its favoured inflation measure will subside to 2.1% in 2024. Other central banks, in the UK, Canada, Australia and Scandinavia and most emerging markets have already started lifting interest rates, but at a very gradual and well telegraphed pace. The Eurozone and Japan are still many months, possibly years from their first interest rate hike, while China is likely to cut rates in 2022. The adjustment in monetary policy from its pandemic era largesse will be extremely gradual. Policy makers will err on the side of caution in removing stimulus. While concerned about the inflation risk, they are even more anxious to avoid sluggish growth. With interest rates already negative or close to the zero bound, there would be little ammunition left to fight a recession.
Global economic growth is exceptionally strong. The IMF forecasts global growth in 2022 of 5% almost equal to the tremendous growth rate in 2021, estimated to be 6%. Following a prolonged period of deleveraging in the wake of the 2008/09 Global Financial Crisis, and helped by extraordinary pandemic-era fiscal stimulus, businesses and households have strong balance sheets and significant excess savings. Due to supply chain disruptions, inventories are sparce and need to be replenished. Strong employment and wage growth add to the robust demand outlook. The protracted economic upturn will encourage increased business investment spending. Credit expansion is ticking up and unlike the past decade of deleveraging, has capacity to add significantly to the pace of economic growth.
As the economic recovery broadens globally and becomes more durable, bond yields will inevitably rise from their extreme low levels. This may affect the more richly priced sectors of the equity market, most susceptible to an increase in the risk-free discount rate. However, last year’s market laggards, the so-called value and cyclical equity sectors and markets, should thrive in such an environment. Industrial, energy, commodity and financial sectors and on a geographical basis the more cyclical markets, including Europe, the UK, Japan, China and emerging markets, tend to outperform when bond yields rise. Provided the US market does not enter a bear market, which is unlikely given the strong growth expected in its economy in 2022, the rest of the world will be able to catch-up in valuation terms over the course of the year, providing solid returns in a globally diversified portfolio.
*All writers’ opinions are their own and do not constitute investment recommendations or financial advice. Speaking to a qualified wealth and investment professional is crucial before making financial decisions.
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