The Three Big Themes
1. Bond yields spike to the highest levels since the financial crisis.
During this quarter, US Treasuries (US Government bonds) experienced one of their worst market performances, with rates reaching levels last seen during the Great Financial Crisis in 2007. The market’s reaction was triggered by signs that the US economy was more resilient than previously thought, which unleashed a tide of selling. The sell-off gathered pace after an unexpected jump in job openings, signalling that monetary policymakers may not be done with raising interest rates yet. Investors are coming around to the fact that interest rates may remain elevated indefinitely.
The US Treasury market holds global significance as it serves as an anchor rate for valuing assets worldwide. The higher these rates, the more depressed theoretical valuations of shares and properties around the world become. Consequently, equity markets worldwide also declined during the quarter.
Both US authorities and most central banks have been increasing interest rates to bring down inflation.
Since emerging markets, such as South Africa, raised rates earlier than countries like the US, our inflation rate fell back into the target range recently, finishing the quarter at 4.8%.
Source: Bloomberg, Portfoliometrix
2. Policy uncertainty eased in South Africa
Policy uncertainty reached a record high in the second quarter due to the government’s position on Russia, the Phala Phala debacle, and increased load shedding as we entered winter. Thankfully uncertainty eased in the third quarter as data indicated better-than-expected 0.6% growth in the economy over the second quarter. Inflation also eased to 4.8%. Other positive news included improved collaboration between the government and the private sector on energy, transport, and crime, along with South Africa’s successful hosting of the BRICS summit. The government’s clarified non-partisan stance on Russia ahead of the summit was received positively by the market.
South African Policy Uncertainty Index Eases
Source: Bloomberg, Portfoliometrix
3. The budget deficit spooked South African investors.
Over the past quarter, it became clear that the government’s financial position had deteriorated as tax receipts fell short of expectations. Earlier caution about the optimistic economic outlook now seems justified. The budget deficit expectation widened – this is the difference between what the government earns in tax revenues and what it spends. The resulting higher borrowing need (it is normal for governments to borrow money), spooked investors at a time when global debt markets are tight.
Reserve Bank governor, Lesetja Kganyago, said that the government needed to rebuild its fiscal buffers to help bring down inflation and that he expected domestic interest rates to stay higher for longer.
Even the treasury department raised concerns about the need to control spending. We see this as an attempt to reign in the ANC’s desire to loosen the purse strings ahead of next year’s elections.
How did our investments perform?
We concluded in our previous Topline newsletter that when markets party too hard and too early – meaning long before economic conditions start to change - we can expect a reality check. We cautioned that a market correction might occur in the second half of this year. Consequently, we were not surprised to see the pullback in financial markets across the globe.
Source: Portfoliometrix
It was a quarter of pain for investors. There was nowhere to hide other than in cash. Global financial markets declined after a healthy first-half growth. Surprisingly, medium, and smaller shares performed better within the South African equity market, as did financial shares reversing the first-half trend.
Despite the decline in investments over the past quarter, returns over the past year and three years remain healthy. Investments in shares around the world delivered a healthy return ahead of inflation over the past three years, with South African and global markets performing similarly when measured in Rands.
The Rand remained stable against most currencies during the quarter after depreciating 8.8% in the first half of the year.
What to watch out for in the last quarter?
The medium-term budget
We believe the increasing noise around the budget deficit is partly driven by the Treasury’s effort to soften taxpayers for an unwelcome surprise in the medium-term budget. This statement is not normally used to announce tax increases, but the rapidly deteriorating budget deficit may leave room for exceptions this year.
More clarity may emerge in the run-up to this speech.
Although it is disheartening that our fiscal position is deteriorating, it is encouraging that calls for fiscal discipline are driven by the Treasury, the Reserve Bank, and the private sector. It is reassuring that there is at least a desire and understanding of the need for fiscal discipline.
The see-saw between interest rates and economic growth
At this stage of the economic cycle, all eyes are on data regarding global economic health, primarily in the USA. Authorities are aiming for a ‘soft landing’ meaning, an economic slowdown that does not result in a recession. A slowdown is necessary to cool down inflation expectations.
However, financial markets are already looking beyond the slowdown. They want to start seeing interest rates decline. Any signs of a stronger economy, such as unexpected job increases, imply that interest rates will have to stay higher for longer. Perversely, any signs of a hard landing will also be regarded as bad news because it will signal higher-than-expected dents to company profits.
Harsh unexpected policy decisions at this time can be devastating to tight financial markets. Hold onto your seats for this fun ride!
Geo-political tensions
As if the continued Russian war in Ukraine has not been enough, the eruption of war in Israel after quarter-end has divided the world. The unexpected attack on Israel by Hamas, the Palestinian terrorist organisation Israel, has led to a full-scale retaliation by Israel. As with the Russian war, the tensions between the Israelis and Palestinians, have rippled into the global community and further destabilised global geopolitical power balances. In our post-pandemic world, these tensions are likely to increase as power lines are being redrawn. In financial markets that are already nervous, geo-political tensions add more cause for concern.
However, we would warn against taking long-term positions based on these tensions. Financial markets typically do not focus on regional geo-political issues in the long term. It’s best to engage with portfolio managers who have the expertise to understand and assess the impact of these tensions on individual companies that make up the market.
Conclusion
It has been a difficult quarter for investors, with no respite following the quarter’s end. We have witnessed the unravelling of years of overvaluation of the US bond market.
However, investor sentiment is deeply depressed. This is not a time to act based on fears – the tide is already out. We must prepare for the tide coming in by ensuring that we are invested in well-diversified portfolios.
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