Dollar Demand Dominates

Global equity markets fell for the third straight quarter, the longest stretch in quarterly declines since the dark days of the global financial crisis which took place over a decade ago. The MSCI All Country World Index, a broad measure of global equity markets, declined 6.8% during the third quarter of 2022 as central banks around the globe held firm in their stance to tackle soaring levels of inflation.

The preferred approach by central banks to tame inflation is through increasing interest rates. Higher interest rates are expected to have the desired impact of reducing demand for goods and services which in turn should lead to a slowdown in price increases. The US Federal Reserve (“Fed”) has already hiked interest rates five times this year. The most recent increase, which happened to be the Fed’s third consecutive 75-basis point increase, came after August inflation surprised to the upside. On an annual basis, CPI rose 8.3%, below the 8.5% seen in July but higher than Wall Street’s prediction of 8.1%. Even core inflation, which excludes items such as energy and food, remains persistently high having risen 6.3%, an increase over July’s annual figure of 5.9%.

Despite having raised its benchmark rate by a cumulative 300 basis points year-to-date, with half of that increase coming through in the third quarter, we are yet to see a meaningful decline in the rate of inflation. While this remains the case and unemployment levels remain low, there is a high likelihood that the Fed will maintain its aggressive hawkish policy. Comments by Fed chairman Jerome Powell stating that monetary policy needs to be “more restrictive for longer” further underpins this possibility. Longer-term interest rates have certainly begun to reflect the increasing likelihood of higher interest rates for longer as the 10-year US Treasury ended the quarter at 3.80%, its highest level in over a decade. The shorter-term two-year US Treasury, which is relatively more sensitive to policy changes by the Fed, reached a 15-year high before closing the quarter out at 4.20%, notably above its longer-term counterpart. Normally the longer-term treasury reflects a yield above that of the two-year but in situations where the opposite applies, one that is termed an inverted yield curve, it can often be considered a pre-cursor to an impending recession.

The trajectory of stock prices and interest rates are typically inversely related. Rising interest rates tend to lead to lower stock prices as the value of future profits generated by the companies are reduced owing to higher interest (discount) rates. With interest rates rising during the quarter, stock prices have fallen, leading to a 5.0% decline in the S&P 500 Index. Perhaps surprisingly, the decline in the Nasdaq Composite, which is tech-heavy and relatively more sensitive to changes in interest rates, was less severe than that of the S&P 500 Index, having “only” fallen by 4.0% during the quarter.

In Europe, inflation is running even hotter and showing no signs of slowing down as the eurozone’s annual rate of inflation rose 10% in September. Energy prices in the region continue to soar as Russia has effectively turned off the tap for gas supplies to its European neighbours. Core inflation, which again excludes the likes of energy and food, rose 4.8%, higher than the 4.3% level seen in August. In response, the European Central Bank (“ECB”) raised its benchmark rate from zero to 0.75%, its highest level in over a decade. ECB president Christine Lagarde has warned that there would be more interest rate hikes over the coming months in a bid to bring inflation back down to the central bank’s target level of 2%. As with the US, European stock prices have also fallen as interest rates continue to be pushed higher. During the quarter we saw declines in European indices such as the Dutch AEX (-2.2%), French CAC 40 (-2.5%) and the German DAX (-5.2%).

It has been a particularly eventful and challenging quarter for the UK. Inflation continues to trend close to 10%, compounding the cost of living crisis on the island, Liz Truss was sworn in as the new Prime Minister and the nation lost its beloved and longest reigning monarch, Queen Elizabeth II.

The passing of the Queen may not have been a market moving event but the budget introduced by the new Chancellor of the Exchequer, Kwasi Kwarteng, certainly was and not for the right reasons. In an attempt to stimulate growth, the budget proposed by the chancellor contained £45 billion of debt-funded tax cuts, including the scrapping of the cap on banker bonuses and the abolition of the top income tax rate of 45 percent for people earning more than £150,000 – the latter has been met with significant pushback and may end up being scrapped. In addition, it contained a slew of energy subsidies intended to insulate the consumer for soaring energy bills.

How did the market react? The combination of lower government income courtesy of the tax cuts and an increase in proposed spending sent the UK government debt market into a “kami-Kwazi” freefall. Concern over the impact that this budget may have, led investors to rapidly ditch gilts (bonds) leading the yield on 30-year gilts to rise from 3.8% to 5.1% in a matter of days. The steep fall prompted the Bank of England (“BoE”) to intervene with a £65 billion bond-buying programme to stem the crisis. To make matters worse, the performance of the pound sterling has been anything but as it hit its lowest level against the US dollar since 1985. Besides trying to quell panic in the debt market, the BoE has also been raising interest rates with two 50-basis point hikes during the quarter leading the UK base rate to reach 2.25%, its highest level in over a decade. Despite all the turmoil and rate hikes, the fall in UK stock prices has not been as severe as one might expect, with the FTSE 100 Index falling 2.7% during the quarter.

Though it remains elevated, inflation levels in South Africa are not as severe as what we are currently seeing in the US and Europe. Some have even suggested that the 7.6% annual headline CPI reported for August could mean that inflation in South Africa has already peaked as it came in below the 7.8% figure for July. The South African Reserve Bank (“SARB”) is yet to be convinced and remains cautious in this regard. Central bank governor Lesetja Kganyago noted that until “we feel that inflation is now under control and is on a downward trajectory towards where we want, which is the mid-point of our inflation targeting range the bank must do whatever it takes to nip inflation in the bud”. The above sentiment from the SARB was echoed in its recent 75-basis point hike, the second for the quarter, which resulted in South Africa’s prime lending rate increasing to 9.75%.

The JSE All Share index posted a slightly better, albeit it still negative, performance relative to other markets having declined a little under 2% for the quarter. The financial sector was the largest contributor to the quarterly decline in the local bourse, despite the continued rate hikes from the SARB which are expected to boost the profitability of banks. With the exception of coal miners such as Exxaro and Thungela which continue to see strong gains, resource counters in general declined during the quarter as commodity prices for metals such as aluminium (-9%), copper (-7%), iron ore (-24%), nickel (-4%), platinum (-4%), tin (-23%) and zinc (-8%) softened. It was also a disappointing quarter for Sasol which had initially benefited earlier in the year from a rising oil price following the start of the Russia-Ukraine war. However, the increasing likelihood of a recession in Europe as well as the US, along with continued lockdowns in China courtesy of the country’s zero-COVID policy, have dampened the outlook for oil demand. This has led to the prices of Brent crude and America’s West Texas Intermediate (WTI) falling by more than 25% during the quarter as they ended September at $88 and $79 a barrel respectively.

The third quarter has been particularly challenging for Chinese equities. Hong Kong’s Hang Seng Index declined 20% during the quarter and the mainland CSI 300 Index was down by over 14%. The property sector crisis that the country is currently experiencing, whereby homebuyers are refusing to pay mortgages on unfinished homes, has sent the stock prices for property developers tumbling, many of which are listed on the Hang Seng. To make matters worse, large parts of the country have been placed under stringent lockdowns. Even reassurances from Beijing that the crackdown on big tech companies would be relaxed did not help. Alibaba lost a third of its value and Tencent lost close to a quarter of its value – the driving factor behind similar declines in the prices of Prosus and Naspers during the period.

The Bank of Japan (“BoJ”) is one of the few central banks that continues to main an ultra-loose monetary policy in the face rapidly rising prices. Inflation for the land of the rising sun is well below that of other countries with August’s annual figure coming in at 2.8%. However, it is still above the BoJ’s target rate of 2% and well above historical levels for Japan. The Japanese central bank’s reluctance to increase interest rates has seen the yen tumble against the US dollar to an almost 25-year low. Rather than raise rates to protect the currency, the BoJ opted to spend close to $20 billion to prop up the ailing yen.

This brings us to probably the most significant item of the quarter, not the intervention of the BoJ but rather the strength of the US dollar. During times of distress and uncertainty as we are seeing now with rapidly rising interest rates and the possibility of recessions hitting many major economies, investors and traders alike will seek protection in safe haven assets and in this particular instance the US dollar has been the preferred choice.

The United States Dollar Index, which measures the performance of the US dollar against the likes of the yen, euro, pound sterling, Swiss franc, Canadian loonie and Swedish crown, increased 7% during the quarter, bringing its year-to-date performance close to 17%. Notably, the rand declined nearly 10% during the quarter against the US dollar before closing just below R18.

To further emphasise the strength the world’s reserve currency, if we convert the performances of non-US equity markets from their local currencies into US dollar terms, the outcome goes from bad to worse. In this scenario, the declines for European indices such as the AEX (-8.2%), CAC 40 (-8.7%), FTSE 100 (-10.8%) and the DAX (-11.2%) are much larger. South Africa’s JSE All Share Index declined 10.6% in US dollar terms and Japan’s Nikkei Index went from a relatively small decline of around 1% to a much steeper 7% fall when measured against the US dollar.

The US dollar’s strength has also not been beneficial for other safe haven assets such as gold which fell 8% during the quarter to end September below the $1,700 level at $1,672/ozt. Perhaps surprisingly, the price of gold’s new age alternative, Bitcoin, experienced a somewhat milder quarter, only falling around 3%, as it hovers around the $20,000 level. One does however have to put this into context and consider that the cryptocurrency is down close to 60% year-to-date.