Despite the temptation at this time of year to try and ordain what may transpire over the next 12 months, it remains a futile exercise. However, it is helpful to reflect on what have been some of the critical macroeconomic dynamics over the past few months, and to consider which ones may be important over the next few.
It makes sense to start in the US, where the most compelling conundrum continues to be inflation, and how the Federal Reserve will react to data throughout 2022. On the supply side, according to the New York Fed’s new gauge of supply side data, some bottleneck constraints are easing, but many are not, with current readings at record highs as post-lockdown blockages persist. Likewise, excess demand in the US seems equally persistent with strong wage growth and tight labour markets, which in turn have amplified supply-side fragilities.
It would seem therefore that inflation could remain persistently and frustratingly elevated through 2022. This is notable for many reasons, not least among them that these levels of inflation have not been experienced in the US for around 40 years, when interest rates were above 15%. However, as ever, what is more important than the level of inflation is where it goes in relation to expectations.
Currently the market is buying the Fed’s assumption that the tapering of the QE asset purchase programme and three planned interest rate hikes this year will result in a deceleration of inflation from the end of the first quarter and into the second, on the back of rapid opening up of supply-side constraints and moderating demand growth.
Break-even rates – measuring the spread between inflation-linked and vanilla five-year bonds – show market expectations of inflation around 3% for 2022. So the question is, by the time of the Fed’s Federal Open Market Committee meeting in mid-June, will it look like inflation will be constrained to around 3-4% for 2022 as expected, or could it be higher at around 4-6%, which might force a stronger hand from the Fed to strangle inflation by the neck?
As for the impact on markets, all things being equal, when there is less money around (or it is more expensive) asset prices face a headwind. As for how strong the headwind, investors would do well to look at the last round of tapering and hiking, from mid-2015 through to late 2018. The initial impact on equities was relatively benign, although it is worth noting that the S&P 500 traded largely sideways from mid-2015 to late 2016, pre-empting the rate rises.
The impact on US Treasuries was far more pronounced, as the US 10-year benchmark rose (yields move inversely to prices) from just over 1% in mid-2016 – almost a year after rate rises had been signalled, and roughly where they are trading now – to peaking at just over 3% in mid-2018.
Should there not be any unforeseen inflationary prints from June 2022 then one could expect more or less this dynamic to play out, with largely flat equities and marginally higher yields by the end of 2022 being a fair assumption. Should there be a few unwelcome inflationary surprises however, equity market investors should prepare for a rapid correction.
Where do these dynamics in the world’s largest economy leave emerging markets, and South Africa in particular? Theoretically, it should only be bad. Rising rates in the developed world tend to mean higher yields in hard currency benchmarks, making riskier markets less attractive and therefore weaker emerging market currencies, government bonds and equities in markets such as South Africa. However, as with inflation dynamics, the question is not so much whether rate rises will have an effect, but rather the current expectations around those rate rises and how they compare to what ultimately transpires.
The key question for South African assets will be how fast the Fed raises rates. At the end of 2021 it seemed that the Fed might increase faster than expected, resulting in the sharp sell-offs in the rand in November (also related to the Omicron strain scare). However, last week’s Fed minutes which seemed to indicate that the Fed was resolved to three rate rises in 2022 barely moved the rand, as it indeed strengthened to move below R16 to the greenback.
This could indeed indicate the expected rate of Fed hiking is “baked into the cake” of South African assets. Are South African assets therefore “fairly priced” and potentially even undervalued if inflation in the US comes in as lower than expected, giving the Fed room to slow down the rate cycle and South African assets room to run higher?
The outlook, as usual with South Africa, looks binary. By the end of 2021 the SA economy was, on the back of surging commodity prices, current account surpluses, lower than expected debt-to-GDP and materially positive real yields, the most investable it has been for years. Not all of this may last, but it could set up the economy and South African equity markets for another strong year.
Which brings us to the final critical dynamic, and indeed for South Africa a potentially even more important one. What will the contribution of China be to global GDP growth in 2022, a variable which will underpin commodity prices more than any other? Last year, 2021, may go down as a watershed year in modern Chinese political economic history, with crackdowns on tech companies and higher regulation around credit growth – particularly in real estate.
For the first time in decades, China in 2021 experienced lower economic growth than the major Western economies. Along with centralising power, President Xi Jinping has shown he is willing to sacrifice economic growth for a supposedly more equitable and regulated society, or at least one which he is able to control more effectively.
For 2022 the question is whether the Communist Party will start to reverse these changes and allow somewhat faster economic expansion on the back of credit expansion, which would prove a considerable boost to commodities and commodity exporters, like South Africa.
Conversely, much has been made of debt levels in the Chinese economy and the dangers that real estate developers like Evergrande and others pose. While the chances of any large-scale bankruptcy, credit crunch and ensuing economic crash in China are slim, the possibility is definitely there, with the global effects – particularly for South Africa – being potentially profound. Of all the risks to the global economy over the next 12 months, this makes a solid case for being the most terrifying. DM168
This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.