By David Crosoer and Prieur du Plessis
The year 2022 has been a challenging period for investors, with global inflation continuing to surprise on the upside, and central banks responding by hiking short-term interest rates aggressively.
At the same time, global growth has slowed materially, and geopolitical concerns have increased uncertainty.
Compared to previous periods of heightened short-term market volatility, this year so far does not stand out as exceptional, although the negative surprises have caused short-term volatility in financial markets to increase, as market participants have had to change their minds as how best to price these assets to better reflect the perceived risks.
To date, South African and foreign equities (in rands) have experienced negative daily moves of more than -1% once every five days, compared to an historical average of once every seven days.
This contrasts with 2008, for example, when the South African equity market had similar negative daily returns almost once every three days.
The major drivers this time around for short-term volatility are that investors are less certain where the terminal short-term interest rates will end up (this impacts on the discount rate that is applied to future cash flows) and unclear about how bad the near-term recessionary environment will be (this impacts on the immediate cash flows).
The South African Reserve Bank (SARB) has hiked the repo rate five times this year, the first two times by 0,25% (in January and March), and then by 0,5% in May, and 0,75% in July and again in September.
While the repo rate at 6,25% remains low by historical standards, market expectations are for a further 1,75% increase over the next 12 months.
The US Federal Reserve is also now expected to hike the US Federal Funds rate to 4,5% over the next year, after already having raised interest rates five times this year (including three 0,75% hikes in June, July and September). This is a material change in expectations compared to the start of the year, when consensus was that the US Federal Reserve would only start hiking interest rates in 2023.
The increase in interest rates, plus concern that this might result in a significant slowdown in economic activity, has adversely impacted the perceived valuation of many companies whose future cash flows are both less certain and now discounted at a higher rate.
The crucial short-term question is whether markets have sufficiently priced in a negative outlook, or even priced in too negative an outlook.
Unsurprisingly, perhaps, this question is difficult to answer, and partly explains why we have also had large positive up days almost one day out of five this year, compared to an historical average of one day out of seven.
In our view, today, market expectations are now more realistic about the future path of interest rates, and consequently it is less clear whether the interest rate hiking cycle will surprise on the upside or downside compared to current expectations, especially as a highly inflationary outcome from this point is arguably less likely than inflation starting to surprise on the downside.
At the start of the year, financial markets were not priced for aggressive interest rate increases and below-trend growth. Then, most market participants felt that global inflation would not persist as a problem as global supply chain constraints would ease, and demand shift from goods to services.
In practice, inflation has stayed elevated as a result of the energy supply shock from the war in Ukraine and supply chains have remained disrupted from persistent Chinese COVID lockdowns, while the interest rate response from central banks has yet to take effect on excess demand.
The risk now is that markets may have gone too far the other way and are expecting too negative an outcome with inflation and interest rates. Of course, further shocks could negatively impact the path of inflation, and central bankers could continue to raise interest rates. Nevertheless, investors could be rewarded for holding equities from here, especially if inflation falls faster than most investors are now assuming. Future interest rate increases are more than sufficiently priced into financial assets.
In the long term, the attractiveness of holding equities over a multi-decade time horizon is not that sensitive to the impact a recession might have on cash flows over the next year or two. While market participants are increasingly concerned about the prospect of a global recession (especially if central banks hike severely), we as long-term investors know we need to have meaningful exposure to equities through the investment cycle, even at times when it might be uncomfortable in the short term.
While our portfolios today are holding somewhat more cash than we would in a less uncertain environment, we remain significantly invested in equities, and our appointed equity asset managers have typically invested in companies they believe have strong prospects and are trading at reasonable valuations.
Markets today have priced in a fairly negative outlook, and while a global recession could undoubtedly make equities even cheaper, such an outcome is not inevitable, and there is a case that things could turn out better than most investors are fearing.
Regardless, as a multi-manager ourselves, our goal is always to ensure our portfolios are well diversified across managers and markets, and we have the appropriate combination of risk and return to deliver consistently to our clients over the long term.
David Crosoer and Prof. Prieur du Plessis are Chief Investment Officer of PPS Investments and Chair of PPS Multi-Managers Investment Committee respectively; email: [email protected]
BUSINESS REPORT