Climbing the wall of worry

Quite apart from the costs associated with fighting the pandemic, the restricted movement of people left buildings and factories empty, and the gears of the global economy slowed to a snail’s pace. The Chinese economy that had been growing at around a 6% pace in the previous years slowed to growth of just 2.3% in 2020. That positive growth was an exception on the global stage with most of the rest of the world falling into recession. The US economy contracted by 3.4% in 2020 after growth of 2.9% and 2.3% in 2018 and 2019, respectively. The Euro Area economy shrank by 6.4% after idling along at a 1.2% - 1.9% pace while the UK economy slid from 1.3% growth in each of the previous years to a contraction of 9.4% in 2020. The trend was universal with the global economy shrinking by 3.1% in the first full year of the pandemic after growth of 2.9% in 2019 and 3.6% in 2018.

Monetary and fiscal authorities around the world came out with guns blazing. The fiscal authorities began spending and literally gave money away to help keep businesses and households afloat as they hunkered down behind closed doors. Central banks cut interest rates as much as they could and in the developed world that meant policy rates of zero percent in many instances. With no further ammunition in their interest rate arsenal, central banks turned to buying assets in the open market. Their intention was to keep market interest rates low and to provide substantial amounts of liquidity to the financial system in the hope that households and businesses would borrow more and then spend more. With money and credit so easily available, the intention was to drive up demand for goods and services with that demand spurring greater manufacturing and production to meet that demand and thereby keeping the wheels of the economy turning.

The unprecedented amount of accommodative fiscal and monetary policy had the desired result and the global economy bounced back with growth of 5.9% in 2021. The base of the previous year was clearly lowered by the broad global recession but economies around the world recorded a positive spike in growth in 2021. The US economy grew 5.6%, the Euro Area economy bounced back by 5.2%, the UK economy recorded growth of 7.2% and the Chinese economy expanded at an 8.1% pace. After the big collapse in 2021 and the subsequent rebound in 2021, economic growth rates had started to return to pre-pandemic levels. In 2022 growth is expected to moderate somewhat before returning to pre-pandemic levels of economic expansion in 2023. That’s the base case expectation, but there are a number of unknowns that could impact that result.

Inflation has risen dramatically across the globe and the success of all that easy policy is just one contributing factor. As economies have rebounded, the increase in demand has impacted prices, particularly in the commodity arena. Inflation has also been exacerbated by the shortage of goods and low inventory levels in a growing demand environment. With production stoppages due to the pandemic lockdown, certain components and inputs into production processes have been in short supply and that has reverberated all the way down the supply chain. The most headline-grabbing shortage has been in semi-conductors with computer chips being more and more in demand as technology has advanced over the years. Apple has highlighted the impact of chip shortages on in its production of the iPhone 13 and the new PS5 Playstation is hard to come by for the same reason. With computer chips in so many manufactured goods these days, shortages in the finished goods have driven up prices as demand has grown.

The invasion of Ukraine by Russia and the resultant sanctions on Russian goods has further fuelled the inflation fire. Energy prices and other commodity prices have firmed up again on fears of reduced global supply as Russian output is excluded from the mix. Around the world, higher prices were first felt at the producer (input) level but as pressure on costs mounted, producers were forced to push up their prices, driving consumer price inflation higher. With softer demand in South Africa, consumer price inflation has been impacted to a lesser degree than in economies such as the US where consumption demand is much stronger. The latest reading of consumer price inflation in the US was a multi-decade high of 7.9% with readings of 6.2% in the UK and 4.2% in the Euro area – all well above the 2.0% level targeted by central banks. Energy prices have been the key driver of inflation, but higher food prices have also had a negative impact and the Russian invasion of Ukraine has only made matters worse. The Russian economy ranked 11^th in size in 2019 according to IMF data (and smaller than that of the US states of California and Texas) and the global impact of the Russian invasion is more centred on Russia’s exports than the absolute size of its economy. In 2019, 61% of Russia’s exports were energy-related and Europe has long had a major dependency on Russian gas. Agriculture amounted to 7% of exports, highlighting Russia’s importance as a supplier of goods such as wheat (Russia being the world’s largest producer).

With rampant inflation, central banks have had to quickly revise their approach to “normalising” monetary policy. For a long time, the US Federal Reserve held that inflation was “transitory” and that there was no need for an urgent and dramatic policy response. As inflation persisted and grew well beyond expectations, the need to tighten monetary policy became more urgent. The Fed’s monthly asset-buying programme (“Quantitative Easing” or “QE”) was fast-tracked to zero monthly purchases and interest rates were hiked. Not too long ago the expectation was that interest rates would only rise in the US in 2023 but now the debate is around how many 50-basis point hikes the Fed will push through this year. The US Federal Reserve is not alone in looking to expedite policy tightening but it has certainly taken the lead. The tightening bias is widespread but there are one or two global exceptions, notably China where the authorities are more inclined to provide accommodative policies such as lower interest rates to drive growth higher and raise the well-being of its people.

Higher inflation, the Russian war on Ukraine and the fast-tracked removal of extremely accommodative monetary and fiscal policies are just some of the uncertainties that investors currently have to deal with. The increased oversight of some of China’s largest companies by regulators has also heightened investor angst. The giant technology, media and retail platform companies have borne the brunt of Chinese regulatory scrutiny and the uncertainty over current and future policy direction has seen investors dump the big market favourites and winners of yesteryear. It’s not the end for the Chinese mega capitalisation technology stocks and the regulatory scrutiny may be running its course but there doesn’t appear to be a near-term catalyst for a sharp rebound in their share prices.

Another current headwind for markets relates to corporate earnings growth. The economic rebound of 2021 lifted earnings growth dramatically (off an extremely low base) and that is not going to be repeated in 2022. From global earnings growth of around 50% in 2021, earnings are forecast to grow at a pace approximating 8% this year. That’s a far cry from last year’s growth rate but it’s positive, nonetheless. That should support growth in the equity markets this year, albeit substantially lower than the heady gains of 2021.

Lower corporate earnings growth, tightening monetary policy, potentially less accommodative fiscal policy, the Russo-Ukraine war, rampant inflation, a lingering pandemic, tighter Chinese regulatory oversite and weak east-west relations don’t make for an enticing equity market cocktail. Not only have we not fully overcome the health crisis yet, but more crises have been added to the current market “wall of worry”.

The equity market has seen many crises before and just this millennium the market has had to deal with the bursting of the dotcom bubble, 9/11, the Enron/accounting scandal, the SARS virus, the Global Financial Crisis and Great Recession, the Greek economy bailouts, the Donald Trump election shock (and the whole four-year term), Brexit, global trade wars, the Zuma tenure and the two finance ministers in two days debacle, the COVID lockdown and recession and now the Russian invasion of Ukraine. Over the course of these 21 years the market has grown by 794%, that is an annualised pace of 10.47% p.a. Inflation was up 229% over the same period for an annualised inflation rate of 5.57% p.a., to leave the real returns of the index up 4.9% p.a. Adding an approximate 3% p.a. dividend yield gets you close to a real total return of almost 8% p.a. That’s a good return if one considers all that the world and the markets have had to digest over the period. There is always the caveat that past returns are not indicative of future returns but we have learned the principle that investing in the equity market with all its short-term volatility pays off with a longer-term mindset. Crises come and go and impact the markets negatively for days, weeks, months and even years sometimes but staying the course and not trying to time entry and exit points pays dividends (pun intended) and grows capital.