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ECONOMICS
Russia’s invasion of Ukraine represents the greatest shift in European security since WWII, and it has rattled global financial markets to levels of volatility and uncertainty few could have predicted at the start of 2022. Nonetheless, analysis of the situation on the ground suggests that Russia’s advance has not gone according to plan amidst stiff resistance, logistical issues, and heavy losses. At this stage, the jury is out on how long the conflict will go on, with geopolitical analysts cautioning against optimism over what seems to be a de-escalation of the conflict. The situation remains fluid, making it increasingly difficult to predict the extent of the global economic fallout. Nonetheless, what is clear is that the impact on economic activity is set to spread beyond Ukraine and Russia’s borders.
A key factor here is commodities, with Russia and Ukraine representing sizeable proportions of global trade in energy, wheat, and fertilisers, amongst others. Energy has been in sharp focus given Europe’s dependence on Russian gas, with little in the way of sufficient and easily available substitutes. To date, pipeline gas flows to Europe have largely been unchanged, but a risk would be if Russia were to cut off supplies leading to shortages and rationing, although this seems unlikely at present. However, developments related to foodstuffs are also a key concern. Thus, further pressure is clearly being levelled on the cost of living given the surge in commodity prices. Whilst energy prices have been the central focus, food security is an important issue too and could have unforeseen consequences.
As a result of Russia’s invasion of Ukraine, broadly the supply shock in commodities is set to prolong some of the supply chain issues that emerged from the pandemic and which we had consequently hoped would begin to ease. As such headwinds to global growth are rising, with global growth forecasts slowly being adjusted lower across the board. Whilst COVID-19 is no longer a predominant issue, it is worth noting that Covid cases have once again been rising across the globe, and China has implemented several citywide lockdowns recently, further compounding the increasingly complex global macroeconomic environment.
The US Federal Reserve (Fed) kicked off its rate tightening cycle this month with a 25-bpt hike to the Fed funds target range to 0.25%-0.50%. Reflecting on the high inflation backdrop, Federal Open Market Committee (FOMC) members scaled up their rate expectations for the year ahead. This aggressive tightening path reflects the FOMC’s unease about the high rates of inflation. The eurozone’s geographic proximity to the conflict in Ukraine, and its greater trade ties with Russia and Ukraine, naturally leave it more exposed economically to the war than other parts of the world. A key worry is the region’s energy dependency on Russia; reducing it will not be simple, nor cheap. Nevertheless, we expect the European Central Bank (ECB) to remain fairly cautious in moving towards rate hikes, certainly relative to market pricing.
Whilst the growth outlook is highly uncertain, we expect the direct impact of the Russia-Ukraine conflict on SA to be limited, given the minimal direct trade links. We believe the indirect impact is likely to be larger should the Russia-Ukraine conflict dampen the euro area and UK growth outlook as exports to the region account for 27.7% of SA’s total exports. While a positive terms-of-trade shock could theoretically result in higher export volumes, in practice this is unlikely given ailing Transnet rail infrastructure, port bottlenecks, and electricity shortages, which combined is likely to put a cap on mining output and thereby exports. A potential key positive outcome for SA is that mining companies could use the windfall from higher export commodity prices to expediate their plans to invest in green energy and remove themselves from Eskom’s electricity grid. This increase in investment would be positive for GDP growth. While SA is likely to miss out on the current commodities boom on the growth (real GDP growth) front, higher export commodity prices will be positive for the current account and fiscus.
The 2022 Budget, presented in February, reaffirmed the government’s commitment to fiscal consolidation while continuing to support vulnerable households — a balance made possible by the commodities-induced tax revenue windfall. Despite the upward adjustment to expenditure, the spending outlook is clouded with risks, stemming from further state-owned enterprises (SOE) bailouts, continued extension of the Social Relief of Distress (SRD) grant or implementation of a basic income grant, and higher-than-budgeted public sector wages. Given the downside risks to the global growth outlook stemming from the Russia-Ukraine war, the SA Reserve Bank’s (SARB’s) Monetary Policy Committee (MPC) will be weary to hike rates aggressively as that would be negative for growth. Thus, the SARB will be cautious when considering the current path of interest rates, not wanting to raise rates too fast and thereby suppressing the current local economic recovery, but equally not wanting to raise rates too slowly and thus allowing inflation to rise rapidly, resulting in sharply higher inflation across all categories. Consequently, we believe the SARB will continue to follow a gradual rate-hiking path.
SA EQUITIES
The first quarter of 2022 saw the local equity market experiencing one of the strongest relative performances in recent memory, delivering a total return of 6.7% (FTSE/JSE Capped Swix) in rand and 16.2% in US dollar terms against the MSCI World, which delivered a negative total return of 5%. Its strong performance over the past three months (1Q22) puts the JSE ahead of global equity markets by 10.8% over the past 12 months – a showing that has surprised many analysts and strategists and, if anything, once again highlights how difficult the job of forecasting equity market returns really is. The recent strong performance of the JSE, largely fuelled by cheap relative valuations and a healthy weighting towards the basic materials sector as opposed to great secular growth prospects, has resulted in a reduction in our 12-month total return expectation for SA equities from 12%, at the beginning of the year, down to 9%. This is slightly below our total return scenario for domestic bonds and does not compensate for the additional risk inherent in the rand vs US dollar exchange relative to global equities and, as a result, we move from overweight local equities to neutral.
The JSE has, without a doubt, been a big beneficiary of the ‘growth to value’ regime shift in global markets that kicked off in late 2020 and really accelerated from mid-November last year. We have often written about the composition of the local market which, after years of stagnant economic growth and a commodities bull market, resulted in large index weightings in value-heavy sectors of the market such as basic materials and financials.
Much has been written about supply chain disruptions brought about by government efforts to contain the spread of the COVID-19 pandemic, and additional demand created by government stimulus in response to receding economic growth with the overstimulating of demand resulting in elevated inflation levels. Up until a few months ago, the inflationary pressures were largely expected to moderate towards 2H22, as government stimulus moderated, and supply chains eased. However, Russia’s invasion of Ukraine has resulted in new pressures on the inflationary backdrop as the supply of certain key basic materials have once again been disrupted. The net result has been an appreciation in SA’s key exports – greatly benefitting the local economy and the domestic current account surplus.
Turning to the JSE, SA finds itself in the unique position that its own top-down investment case screens more attractively now than it did towards the back-end of last year, when the outbreak of Omicron (the so-called ‘South Africa’) variant was still dominating headlines and there was significant uncertainty around how much more the local economy could absorb in terms of lockdowns.
Thankfully, the Omicron wave turned out to be far milder than experts initially expected, and attention was once again drawn to company fundamentals, with a fairly strong reporting season from domestic stocks in particular. Towards the middle of last year, we started turning bullish on the SA banks, with the investment cases largely being underpinned by undemanding multiples, and a far bigger earnings recovery out of COVID-19 than was initially anticipated. The call to be overweight banks turned out to be the right one, with the most recent earnings season well received by investors. With banks being one of the best-performing sub-sectors on the JSE YTD, and with a healthy 15% index weighting going into the year (now up to 17%), the contribution to the total 1Q22 return (+4%) was over half of the 6.7% delivered by the FTSE/JSE Capped Swix. The basic materials sector made up the balance (+2.7%) – with the rest of the JSE largely flat. Naspers (JO:NPNJn) and Prosus (JO:PRXJn) combined was the biggest detractor from the performance of the Capped Swix at close to a 3% negative drag and, for the quarter, was the only meaningfully negative contributor to returns.