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Where does that leave us?

Dr Francois Stofberg
Senior economist and head of sales: Efficient Private Clients

Markets in the United States (US) were shocked when Federal Reserve (Fed) Chair, Jerome Powell, gave his annual address at the Central Bank Summit in Jackson Hole. In the past, this event has been used to make important announcements about central bank policy. In the early 2000s, US central bankers used the event to announce that they would start cutting interest rates to support economic activity, which finally led to the 2008/2009 global financial crisis. A few years later, US central bankers used the event to announce quantitative easing, which supported the recovery, overstimulated global demand, and led to rapidly rising equity prices. Now, more than a decade later, Powell took a firm stand in favour of further interest rate increases in the US “until the job is done” on inflation.

US markets tumbled after the announcement, with the S&P 500 falling as much as 3.4% and the technology-heavy Nasdaq Composite sliding 3.9%. It seems that previous expectations that the Fed might slow down the pace of interest rate increases, or that they were even considering when to start cutting interest rates, were premature. Some analysts even interpreted Powell’s recent message to mean that the US will experience an unpleasant period but that it is needed. By this, they mean that a further economic slowdown and potential market correction is needed to cool off the economy and thereby contain inflation.

Where does that leave us? Well, I think it was a bit silly to believe that the brief slump and the partial recovery that we saw in global markets this year was all that there would be. The pain caused by an interest rate hiking cycle is usually a bit more severe. Although the US entered a technical recession, their economy is still far away from the type of correction that is needed to reduce inflated demand, which was caused by more than a decade of loose monetary policy. For this reason, the Fed is targeting unemployment closer to 4.5%, which they believe is one of the measures that will indicate that inflated demand has, in fact, subsided. We can, therefore, easily see markets in the developed world correct by another 10%, maybe even more, as central banks continue to press for higher interest rates.

But does this mean that the US will enter a long-term cycle of stagnation, where economic growth remains under pressure for more than two years and where markets persistently underperform? Probably not. However, the European Union (EU) might fall into a long-term stagnation because the appropriate response to combat high inflation requires policy flexibility, where each country must be considered individually. That being said, the European Central Bank’s main policy tool is an EU-wide interest rate that lacks flexibility. Increasing interest rates is the fastest way to tame demand-driven inflation, but while Germany will be able to live with higher interest rates, Greece and Italy, among others, will, most likely, enter a persistent slump. Relatively speaking, the US will, therefore, most likely, be in a better position than the EU, which is why the dollar should remain range-bound around parity against the euro in the immediate future. Once the EU has caught up in their rate-hiking cycle, and if they can get the economic block out of recession territory, the dollar might start to depreciate markedly against the euro.

In South Africa, because the balance of payments is coming under pressure, while the economy struggles under the burden of bad policy, a deteriorating Eskom, and silly demands by trade unions, it will be difficult to see the rand return to its long-term natural range of between R14.50 and R15.00. A more appropriate rate which long-term investors should, therefore, consider is R16.00 against the US dollar. We still maintain that the volatility that we are experiencing in markets creates good long-term buying opportunities and we warn against being too conservative. Corrections do not come by very often and they should, therefore, be seen as buying opportunities, not as exit opportunities. Furthermore, when deciding to invest, both the rand and the level of global markets should be considered. Both can be used simultaneously to find appropriate entry levels.

 

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A friendly glance at crypto-“currencies”

Dr Francois Stofberg
Senior economist and head of sales: Efficient Private Clients

The Financial Sector Conduct Authority (FSCA) recently said that it will soon publish the regulatory framework for cryptocurrencies in South Africa. Many in the industry, especially those who support the technology, have been anxiously awaiting this legislation for quite some time. Previously, the FSCA was vocal about declaring cryptocurrencies as financial products and this past week the Prudential Authority Division at the South African Reserve Bank (SARB) shared a similar sentiment. The Prudential Authority also asked banks to work with crypto exchanges instead of simply closing their accounts.

We maintain that more regulation is needed in the cryptocurrency space to protect consumers against all of the scams that we have read so much about during the last couple of years. Only with effective legislation can this superior technology be adopted by the masses. And it truly is superior. Even in its infancy, the cryptocurrency environment is allowing for faster and safer transactions worldwide, often at no cost. The environment also allows markets to be open 24/7, which means that consumers always have access to liquidity. With blockchain technology, the backbone of cryptocurrencies, you do not have to wait two or more days for money to reflect in your account – most of the time it happens instantly. But there are, of course, many other benefits of having a market that is always open. The cryptocurrency market also has fewer foreign exchange controls, which means that no one can tell you what you are allowed to do with your money; a key concern for regulators, of course. Another benefit of some cryptocurrencies is that they allow for decentralisation. This characteristic allows the collective to govern themselves without handing their sovereignty over to the government. But with these and other efficiencies, the technology can also be exploited for the wrong reasons, and it is for this exact reason that clever regulation is needed.

We are still unsure how local regulators will classify and treat this unique asset class. One of the main difficulties that regulators face is the fact that not all cryptocurrencies are the same, so regulation must be more fluid, a characteristic that regulators are not always known for. Precisely because cryptocurrencies are different, it is more appropriate to refer to them as tokens, coins, or even digital assets. Bitcoin, the most widely known and adopted token is, for all intents and purposes, not a currency. Like gold, it is considered to be a store of value because of its limited supply. That being said, its price volatility does not qualify it as a store of value in the traditional sense. Some tokens, like Litecoin, are used as currencies because transactions are fast and cheap. Others are backed by fixed assets: Many of the stable coins are backed by a combination of fiat currency and even bonds. Yet others, like Cardano or Solana, are backed by specific projects and fulfil another function entirely. In this case, they use blockchain technology to execute smart contracts that allow them to build the infrastructure that is needed for things like Web 3.0. And then there are tokens that act like normal shares. Binance, a digital asset exchange, for instance distributes some of their profits towards those who hold the Binance token.

Each of these characteristics, collectively referred to as ‘tokenomics’, makes the token unique and desirable. For this reason, if regulators want to effectively regulate these digital assets, they must differentiate between specific groups of tokens and apply rules appropriately. In the past, Africa has been a leader in terms of creating and adopting financial technologies, like cell phone banking, and our regulations have, in many ways, allowed for the successful adoption of these technologies. We are hoping that we will, once again, lead the way.

 

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US inflation, a slump, and a final buying opportunity

Dr Francois Stofberg
Senior economist and head of sales: Efficient Private Clients

Investors breathed a sigh of relief last week after data from the United States (US) Department of Labor showed that US inflation finally eased from its four-decade high. The Consumer Price Index (CPI), an index used to measure the rate of price increases among households, came in lower than analysts expected: It increased 8.5% from a year earlier, cooling off from the 9.1% high that we saw in June.

The below-forecast reading came on the back of a sharp drop in energy costs and provided a much-needed boost to risk assets globally. Oil prices have now fallen to $97 a barrel as concerns about a recession have reduced demand expectations to below their pre-Ukraine war levels. Lower oil prices were also supported by data showing that US oil stockpiles were at their highest levels since December 2021, thanks to an increase in domestic output. Globally, a tight oil market saw some relief when a dispute linked to sanctions was resolved, allowing oil to flow from Russia to three European countries.

Investors are hopeful that the slowdown in inflation is a sign that inflation has, in fact, peaked and that the US Federal Reserve (Fed) will need to raise interest rates less sharply to keep inflation under control. Markets are now pricing in a 37.5% chance that the Fed will increase interest rates by 75 basis points for a third consecutive time at its September policy meeting; a 50-basis points increase is now the more likely option.

Expectations around less aggressive interest rate increases caused the dollar to lose further ground against other major currencies. This was welcome news for emerging market currencies like the rand, which ended up around R16.27 against the US dollar after appreciating to R16.14, its strongest level since the end of June. This is also much stronger from the slump we saw in July when the rand sank to a low of R17.24.

For now, the US economy remains resilient, producing jobs despite higher borrowing costs and inflation, which is quickly deteriorating the buying power of households and businesses. But while sentiment was positive, analysts warned against getting over-excited as inflation was still high and would take some time to get under control. If we were to take a step back, other global economies are faring a lot worse. World markets have been battered by a range of other issues, including the war in Ukraine, supply-chain snarls, and rising China/US tensions over Taiwan, to name but a few.

For now, we agree with the decision of many to de-risk their portfolios, especially if you are dependent on their income. Global markets might see another round of corrections in the next few months. But we would not have our clients sit on their hands for too long. In fact, this time should rather be used to sort out admin and get cash ready. If there is another slump this will provide long-term investors with the perfect buying opportunity, one which they might not see again for a long time to come.

Another emerging market crisis? This time it is different…

Renier van Zyl, CFA

Portfolio Manager: Efficient Private Clients

Millennials and Generation Z are unlikely to remember that, back in 1997, Asia was dealt a significant blow by the United States (US) Federal Reserve (Fed), who, through their actions, caused the US dollar to appreciate substantially. Halfway around the world it was July 1997 and monsoon season was on its way in Thailand, but that year the country’s currency, the baht, would experience a monsoon of a different kind. When the US Fed raised rates in 1997 to fend off increased inflationary pressures, the Thai baht’s peg* snapped against a very strong US dollar. This led to a series of currency crashes, one after the other, across emerging markets (EMs), such as Indonesia, South Korea, and Russia. What happened to the baht, however, was not an anomaly, as similar events led to the Latin American debt crisis of the 1980s and the Mexican crisis of 1994. This begs the question whether EMs and the rest of the world are in for another round of pain as the US Fed battles eye-watering levels of inflation.

But what is needed for an EM crisis? In each of the above-mentioned cases, capital flooded into these markets before the events even started. With their coffers full of cash and most of the debt denominated in US dollars, all that was needed for a financial calamity was for someone to turn up the heat: In came the US Fed with their monetary policy tools and out went most of the capital. This, in turn, highlighted underlying EM problems, such as weak balance sheets, poor regulations, rocky financial systems, etc. Whilst some of the afore-mentioned problems were plain to see before the events played out, it would be naïve to assume that anybody could see the crisis coming, which speaks to the very core of what a crisis is.

Today, investors and economists might scratch their heads and wonder whether Mark Twain was correct when saying that “history never repeats itself, but it does often rhyme”, especially when they assess the current events in Sri Lanka and Argentina. I cannot blame them as these fears are exacerbated by everyday headlines that emphasise slowing global growth as well as the impact of elevated food and fuel prices on companies and individuals around the world. But, upon closer inspection, things look very different compared with two decades ago.

For one, fewer EMs have dollar pegs (like the one that Thailand had) today than ever before. In addition, EMs are less dependent on international financial institutions for financing: Only about 60% (down from 80% in 2006) of financing comes from the International Monetary Fund (IMF). China has replaced a large part of this financing and has become such a large lender to other EMs that its lending habits rival that of the World Bank in scale. And then finally, the countries most at risk of defaulting on their debt today only account for 5% of the global gross domestic product (GDP) and 3% of global public debt, figures much lower than two decades ago.

A bigger threat to global and EM stability today is China, where non-financial sector debt has risen at a breakneck speed since 2008. For now, a silver lining to China’s debt problem is that foreign investors hold only about 11% of Chinese sovereign debt, and with interest rates still relatively low, China still has some room to manoeuvre. Investors must, however, know that the situation can change quite quickly. It would, therefore, be prudent for countries who recently applied for BRICS membership and are struggling with their own woes, such as Iran and Argentina, to not consider China as their saving grace.

Whilst investors might be concerned about how the situation is unfolding in the world right now, it is important to remember that the probability of another EM crisis seems a lot lower than in the past. Also, the impact would almost certainly be more limited than before.

The tale of interest rate increases

Dr Francois Stofberg
Senior economist and head of sales: Efficient Private Clients

During July, the main themes on the economic front were interest rates and the fight against inflation. Most central banks across the globe have now set their firing power against inflation. Past rumours around ‘transitory’ (read temporary) inflation have long since quietened down. In fact, many analysts are now pushing out their forecasts for when they believe inflation will be back in the different target ranges that the central banks have set.

In South Africa (SA), the South African Reserve Bank (SARB) increased interest rates by 0.75% after Statistics South Africa (Stats SA) reported that annual inflation reached 7.4% in June, slightly outside of the SARB’s target range of 3% to 6%. In total, the SARB has now increased rates by 2% since they started this hiking cycle in November 2021, increasing the repurchase rate to 5.5%, and the prime rate to 9%. Consumers who have been worn out by higher fuel and food prices, as well as low wage increases and job creation opportunities, are in a lot of pain. But even on a global scale, consumer sentiment is approaching all-time lows as consumers are wary about their financial prospects over the medium term. Our view is that local interest rates will probably increase by another 0.50% this year, and then by 1% to 1.5% in 2023.

In the United States (US), the Federal Reserve (Fed) also increased interest rates by 0.75% for the second consecutive month. These recent increases are the most aggressive tightening by the Fed in more than a generation, and have taken the federal funds rate (that is, the repurchase rate) up to 2% to 2.25%. Market observers compare these rapid increases with the price-fighting action taken by Fed Chair Paul Volcker in the early 1980s, shortly after inflation peaked at around 14.5%. US inflation has not soared to these levels again but did recently peak at a new four-decade high of 9.1%. For this reason, US officials expect the federal funds rate to reach 3.4% in 2022, and 3.8% in 2023. They are hoping that these additional increases of 1.15% to 1.55% can bring inflation back to their 2% target in late 2024, without pushing the economy into a hard recession in the next 18 to 24 months. Technically, the US has now entered a recession, after their Department of Commerce reported that the economy shrank in both the first and second quarters of 2022, by -0.9% and -1.6% respectively.

However, the US has not entered a ‘hard’ recession yet. This would be characterised by a broad-based and sustained contraction where unemployment increases rapidly. In fact, unemployment remains at a near record low of 3.6% and shows no signs of weakening. Whilst the overall economy shrank in both the first and second quarters, consumption increased by 1.8% and 1% respectively. Demand also remains high because of a decade’s worth of loose monetary policy and the more recent support from fiscal policy. Mostly, it was inventory volatility that caused the contraction, wiping 2% off the economic growth figure. Inventory management has been very difficult the last two years, partly because of supply-chain problems and partly because of hyped-up demand. Higher interest rates have further throttled residential and business investments, which might continue to weigh down economic performance, but we see no sign of the US entering a hard recession. For now, the news of a technical recession will, most likely, not prevent the Fed from increasing rates until they see demand ease off, and unemployment starts to rise.

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