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Investment Perspectives – Second Quarter 2022

02 August 2022 Reza Hendrickse, Portfolio Manager at PPS Investments

What were some of the key themes shaping this quarter?
This quarter we saw a broad-based sell-off in financial markets, which continued to grapple with the main drivers from the prior quarter. These included higher inflation, interest rates, recession fears and geopolitical tensions. Consumer sentiment also dipped sharply, amid continued severe loadshedding and sharp petrol price hikes.

Tell us about the economic backdrop
One of the main concerns is the deceleration in global growth this year, at a time of increased geopolitical risk, and into a headwind of tighter central bank policy aimed at combating stubbornly high inflation.

Growth was expected to slow once the strong rebound coming out of the pandemic normalised to a more ordinary rate of growth, so some slowing is entirely justified. What was unexpected though, was the war in Ukraine and its broader economic impact, as well as further lockdowns in China, both of which dented economic activity. These also contributed to the persistence of the pandemic-related inflation shock, which central banks have now had to respond to for credibility’s sake.

Currently, the consensus view is that the US will experience a recession during the next year or so, with most market participants assigning a higher probability of recession than at the start of the year. Leading indicators, such as manufacturing indices, have also rolled over and economic surprises have largely been negative in recent months, while financial conditions have tightened.

It is too soon to call for an imminent US recession with a high degree of confidence, but admittedly the economic backdrop has deteriorated this quarter. Perhaps the biggest concern is that the US Federal Reserve (US Fed) has shown resolve to continue hiking rates aggressively while inflation is high, and perhaps until slack emerges in its tight labour market. This is important because historically, recessions have tended to be brought on by either a major economic imbalance of some sort, or overly restrictive monetary policy heading into an economic slowdown, and the current environment risks developing into the latter.

For now, the bear case is that the US Fed could tighten beyond the economy’s “neutral” or “equilibrium” rate of interest, and choke the economy into a recession, while Europe’s energy crisis might also drag their economy into a recession. China might also be unable to kickstart their economy, and all of these combined, could tip the global economy into a recession.

It is also worth considering the bull case, however, where the current inflation shock will inevitably pass (and might even have already peaked), prompting the US Fed to turn dovish, with the current phase having potentially been a little more than a mid-cycle US slowdown. In the rest of the world, China’s efforts to reflate could be rewarded. However, Europe may struggle even in an optimistic scenario due to their energy supply uncertainty.

For now, we are keeping an open mind on the path of global growth but recognise that the direction of change, as it relates to global macro conditions, remains negative.

In the case of South Africa, the local macro environment is also currently fluid, dependent largely on global factors. Domestic growth has reverted to its low growth trend (for which high unemployment and low productivity are primarily responsible), but the risk now is that any pronounced slowdown in global growth would potentially spill over into SA, constraining output growth.

Under this scenario it is reasonable to expect cyclicals, such as commodity companies, to suffer temporarily, even though the longer-term outlook remains compelling for base metals. Unlike previous commodity booms, what is encouraging is that mining companies are not using their strong balance sheets to ramp up capex like before, so supply will remain constrained.

Although our base case view is that SA could possibly still muddle through as it has repeatedly done for many years (with the record current account surplus being a significant positive for the economy), the recent sharp drop in consumer confidence undoubtedly sums up sentiment in the face of severe loadshedding, the impact of sharply higher fuel and food prices, and increased debt servicing costs.

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