This is just some thoughts, on why it is different this time. One thing is for sure I would definitely not buy an index our days. In theory this is where you get the value of active management, and ideally one that can hedge. Note unit trust are allowed to hedge risk, as well as, hedge funds.
In investing it is easy to get caught up in the here and now. The market can be an emotional place even as someone who has been investing for years I sometimes get a sense that I need to act. Fortunately I have enough experience to not to act impulsively. There is a saying worth knowing, “If you not sure, do nothing”.
I don’t normally give market commentary for general public, but if you are interesting in investing I think it is worth having a read, just to get some ideas. Does seem US forward, but need to get through that to get to SA, as the market is integrated.
The big picture
Firstly the current situation is different but let important to understand the “norm”. I have seen three (3) statistical reviews, Deutsche Bank, Credit Suisse and Investec, showing the average length of rate hikes, market movements during hiking cycles, performance post hiking cycles etc. In summary they will say the market will bottom maybe end of next year or sometime in 2024. Post a recession markets, then offer extraordinary returns. (Note: post the recession, so from the bottom), buy today pretty sure that premise would not hold and be different.
Now why is it different? Mainly because of Modern Monetary Theory (MTT). Long story short, wealthy countries want to have a high standard of living, be developed and offer citizens a secure retirement. Now MTT essentially says print money, and build infrastructure, and in the long term growth will then allow you to pay back the debt. Couple this with the fact that developed market currencies have remained strong against emerging and developing markets. The strong currency, low inflation and low interest rates caused a period of general prosperity in developed markets. Money was free, assets only went up and people never had to think about being able to afford retirement.
Then Covid hit. All of a sudden everything that worked stopped. So governments did what they do every time there is a crisis. They printed money, and/or did QE (support market debt), artificially keep interest rates low and make cash available. Sounds good right….. Until you think about it. Have the amount of resources in the world changed? No. Yet the amount of money has gone up. What does that mean for the value of the assets? They go up… And wow, surprise we have inflation. (Obviously could never be transitory, but that’s old news now).
Now in the perfect world with low inflation, no interest retirement wasn’t an issue. However add inflation even just for a few years, the can destroy your retirement savings. Given most developed markets have aging population, and the majority of voters are older people. Inflation is enemy #1. Inflation is also bad for other things, but protecting wealth is probably most NB. Now central banks really have one way to combat inflation, raise interest rates (or basically reduce money in the system). Less money, same assets means value of assets goes down. The issue or raising debt is now governments and people need to pay for their debt. I mean the EU have basically a decade of no interest rate increases. Most people would have forgotten about the implications of having a home loan, or paying off a car.
Some issues that become apparent with inflation and fighting inflation
I saw a tweet, from a friend, forwarded from the US:
Wall Street Silver, “Realtors: Now is a GREAT time to buy a house!!!” Comment by, Danny Baldus-Strauss, to this was “This is crazy: If you secured a 30-year fixed mortgage on a $600 000 home at a 2.6% interest rate in 2021, you have the same monthly payment as someone that just bought a $392 000 home at today’s 6.2% interest rate.”
The issue here is record new houses are being built in the US, and now nobody can afford the houses at close to the prices there were at, what is going to happy? Would be surprised if we don’t see a property bubble….
China is currently having a property bubble. While the government says it is supporting the sector, it is still in a very precarious position. Several big listed entities have defaulted on their debts.
What happened to inflation is transitory? I listen to Bloomberg, most evenings and it is like watching people in complete denial sometimes. Every second day, the Fed is going to slow down, then they not. Mean while the Fed is extremely clear they going to raise rates. Now where the problem lies, is people salaries go up, because their expenses go up so their financial position is not getting worse. Companies have pretty solid balance sheets, people have also saved due to stimulus cheques and lower rates, meaning they are in good shape. Then you get tweets like, Gavin Newsom (Governor candidate, CA). “Gas prices are too high. 23 Million Californians will be receiving up to $1000 starting TOMORROW. This will be the largest state tax rebate in the country.”
Inflation in the US is going to be harder to reduce that the market is pricing, because people are not willing to stop spending. According to Investec the Atlanta Fed has US GDP at 3%. If consumption is strong are prices goes to go down? The one big help though is USD strength, which at least reduces it a little.
The UK has even bigger problems, mainly self-inflicted, but in summary the outcome is higher inflation and the bank of England, had to start buying UK government bonds, or retirement funds will go bankrupt! I.e. Retired people will have no assets. The EU also has massive issues, mainly due to energy prices going through the roof, driving inflation and with Russia at war this is unlikely to stop for a while. This is slowing, but still an issue. I can go one for days on why they have issues, but lets leaving it at there is inflation going round for markets that are not used to interest or inflation.
Second issue with EU and UK is they outsourced a lot of their work to overseas countries, Russia, China, Eastern Europe etc. So currency strength and supply chain are important to maintain their systems. The UK through Brexit felt this impact. Where post Brexit they had a shortage of cheap labour, and become uncompetitive. Now the EU has no energy. These countries are built into a global system, and rely on that system to function. While now they are frantically trying to resolve this, it is going to happen fast. The world basically needs to move towards “Local is Lekker”.
On the brighter side, inflation does seem to be turning, but remember there is a long way between 8.5%-10% to 2%, so its not about it turning it is about the time it takes to reduce, and to reduce substantially, and this takes time. The issue is the longer the time with high rates the bigger and harder the recession. Also the more the US raises rates, the more the EU and UK have to raise rates to lower inflation.
So given the above what happens to stocks
This is quite simple really, interest rates go up, discount rates go up, stocks go down. Then on the micro side, inputs go up, consumers becomes more price sensitive because cost of money goes up, which means can’t pass on prices, means your margins (gross and net) decrease. If your company has a lot of debt, you also get hammed again due to increased financing cost.
This obviously does not happen instantly. So it is a lagged impact, as first people burn through savings first.
So stocks go down, both because discount rates go up and margins go down. So you might say well this is obvious and priced in as markets are down (sometime on the morning of 10 October 2022):
· UK 100 52 week High 7 687.27 vs current spot 6 936.7
· EU STOXX 600 52 week High 495.46 vs current spot 388.63
· S&P 500 52 week High 4818.62 vs current spot 3 639.66
· JSE ALSI 52 week High 78 297.38 vs current spot 64 682
Firstly the market does forward price. Also currently there is tons of money sitting in cash, because if you own bonds, their prices decrease with interest rates, also if you own stocks, your price also goes down. So there is cash, and cash actually seem logical, provided cash holds its value. The issue with all the cash, is people will spend it to sustain their current lifestyles. This is what causes the lag impact, so raise rates longer, then market only tanks after the cycle ends.
This is very the fun starts. So the value of your currency obviously impacts the price you pay for goods internationally as the world is globalised. So to protect your currency against currency induced inflation, you need to offer investors a relative return. So what we seeing is everyone raises rates, at the same time and similar amounts. Even though we are all in different situation. So this just dries up money everywhere, and demand and margins contract globally. This sounds like a global recession, and unfortunately global recession is not good for anyone, but worst for the poor (like SA).
Last but not least South Africa
So what about us? While the Rand is essentially a “commodity” currency. There are studies showing correlations to copper price. With copper basically being driven by Chinese industrial needs. Given the worlds demand, slowing, this means Chinese production will slow in lag to that. Secondly given property development is slowing as well as fertility rates falling. China’s economy is not looking hot, this is not good for SA.
Add to that that South African parastatals actually disable the economy, take for example Transnet calling Force Majeure, Eskom essentially unable to get away from load shedding. Government red tape making it so difficult to doing business. Also show we a society in the world were excluding any part of the population helps the country grow and be sustainable, but in SA that is written into policy.
The MPC, is obsessed with inflation. While this is good for a few reasons, it has some very dramatic consequences. As the USD strengthens as they raise rates, we effectively follow. Our interest rates are already high, our employment is high, our economic growth is low. So raising rates, essentially makes things worse on all fronts.
On top of that, markets have become more and more integrated over time, so when the US market goes down, essentially all asset classes follow. Also the higher the uncertainty, and the greater the perceived risk the more money floods into “safe” assets, i.e. out of SA to the US.
Is it all doom and gloom
In a market where there is huge uncertainty, and high information asymmetry there is massive opportunity. So while this sounds doom and gloom, I am still essentially net 100% in equities, because I am not buying an index, I can actually chose quality stocks, I can also hedge and short the index (which I am).
What is important to realise is the question isn’t is the market cheap or is the knife going to keep falling. The knife is going to keep falling, everyone knows that. The market may look cheap, but what people are missing is the market is pricing risk. Also the market is pricing forward. Forward discount rates are higher, forward margins are lower. The real question you should be asking is, “do you understand what is happening? If not do nothing.”