Are you dreaming, or did US inflation just go all banana republic on you?
Those of you plying your trade at the Southern tip of Africa, or in a handful of other emerging market economies, will be quite familiar with high inflation and interest rates. In fact, citizens in our northern neighbour, Zimbabwe, have gone through multi-decades of struggling with the inflation end-game, also referred to as hyperinflation. As for South Africa, the worst you and I would have experienced was around 1986 when inflation hit 20%. But that is a tale for another day.
Wheelbarrows of money, truckloads of cash
In layperson’s terms, hyperinflation is when you need a wheelbarrow full of cash to buy Monday’s bread and milk, and a minibus load of banknotes by Friday. For the more serious among you, Investopedia.com defines hyperinflation as the “rapid, excessive, and out-of-control general price increases in an economy”. Hyperinflation is something you might expect from a banana republic, which is a derogatory term for “a small state that is politically unstable as a result of the domination of its economy by a single export controlled by foreign capital”. PS: South Africans tend to use the phrase incorrectly to mean an economy constrained by a political regime. PPS: Clearly, the US is not a banana republic, that may have been a clickbait headline!
The story that got this writer started on inflation appeared on CNBC.com under the tag: ‘US inflation rises 7% over the past year, highest since 1982’. You read it here first, dear reader, the US inflation that analysts told us would prove ‘temporary’ or ‘transient’ looks set to stay, at least for the time being. According to the article, “the annual move was the fastest increase since June 1982 and comes amid a shortage of goods and workers … it came on the heels of unprecedented cash flowing through the US economy from Congress and the Federal Reserve”. Your only surprise should stem from how long it has taken for inflation to ramp higher given the US$14 trillion or so that the world has printed in response to the Covid-19 pandemic.
US inflation has SA inflation whipped
The result is that US consumer price inflation (CPI) is sitting two full percentage points higher than that of South Africa, currently pegged at around 5%, a reality made more absurd by our respective central bank lending rates. One of the obvious consequence of rising inflation is that the Federal Reserve will have to begin hiking interest rates to bring prices back under control. This was something that analysts expected to happen late in 2022 or early 2023; but their response will now have to be swifter.
In a recent media release, Senior Emerging Markets Economist at Schroders, David Rees explained the risks to emerging markets from US rate hikes and other quantitative tightening measures that the Federal Reserve will have to embark on. “The news is instinctively worrisome for investors in emerging markets [because] although the economic consequences of quantitative tightening appear manageable, it is likely to be a headwind for the performance of markets,” says Rees. These measures are certainly bad news for US equities which have started 2022 rather sketchily.
Local investors will be more concerned over whether looming monetary policy actions out of the US will spell disaster for emerging market equities, most notably their SA-facing portfolios. “Expectations for Fed tightening have continued to grow in recent weeks,” wrote Rees. “These have been fanned by the hawkish tone of the minutes from the December meeting of the Fed’s rate-setting committee”. At this meeting, voting members raised the possibility of raising rates sooner than had previously been expected as well as reducing the size of the Fed’s balance sheet.
When the US stops printing money…
The problem for South Africa and its EM peers is two-fold. Firstly, higher interest rates will put pressure on US equities and have a knock-on effect on global equity markets. And secondly, EM economies and assets are historically sensitive to big swings in US dollar liquidity. Rees argued that quantitative tightening, and more notably the increase in US Treasury yields, would not necessarily increase macroeconomic risks to EM countries; but he warned that the Fed’s actions could cause problems for financial markets. “The last time the Fed shrank its balance sheet [in 2018] there was a wobble across EM financial markets,” he wrote.
The good news for EM investors is that “the relationship between gyrations in the size of the Fed’s balance sheet and EM markets is not particularly convincing”. Instead, EM investors should take a steer from global central bank liquidity. “A broad measure of global central bank liquidity has a far better relationship with movements in EM asset prices,” wrote Rees, referring to the aggregate of the Fed, European Central Bank, Bank of England, Bank of Japan, People’s Bank of China, Swiss National Bank and Sweden’s Riksbank, in US dollar terms. “Global central bank liquidity is expected to shrink in 2023, and while not the only driver of performance for markets, this will probably be a headwind for EM assets,” he concluded.
Reacting to the Omicron variant
Keith Wade, Chief Economist & Strategist at Schroders, took a wider view on inflation in his recent note: ‘Omicron pushing US Fed into action’. “Speaking at his nomination hearing last week, Fed chair Jerome Powell said that the US central bank would prevent high inflation from becoming entrenched,” wrote Wade. “This task will be made more challenging by the spread of Omicron, which is disrupting supply chains as it surges through the country”. The dominant Covid-19 variant is causing havoc with US workers staying home due to positive infections and entire Chinese cities go into lockdown, among other developments.
The 7% US annual inflation number reported mid-January 2022 is adding to the pressure on the Fed to tighten monetary policy. “Omicron is helping to speed the Fed into action, but there is a risk that rates rise faster and further … if inflation becomes entrenched as a result of extended supply disruptions or the emergence of a wage price spiral, the Fed would have to act more aggressively,” concluded Wade. Schroders expected the Fed funds rate to reach 1.5% by June 2023, from the current 0.25%.
Writer’s thoughts:
At the time of writing, the tech-heavy US NASDAQ index was down more than 8% year-to-date, in US dollars; by comparison, the SA JSE All Share was down only 1.38% in rand. Are you concerned that rising US inflation will trigger an interest rate hike tsunamic that will in turn cause significant damage to your offshore investments? And do you think that the global inflation outlook could contribute to outperformance from SA and other EM equities? I would love to hear your thoughts. Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
