High inflation, tighter monetary policy and China's economy reopening are set to continue driving markets in 2023.
The JSE started the year on a good footing, hitting a record high of above 80,000 points in January, while global sentiment is still somewhat shaky with investors assessing how far the US Federal Reserve will go in hiking interest rates, despite evidence of inflation cooling.
Business Day caught up with Herman van Papendorp, head of investment research and asset allocation at Momentum Investments, for a closer look at markets prospects this year.
What do you think drove the JSE to a record high in January?
For the largest part of 2022, most asset classes around the world performed particularly poorly. But in the fourth quarter of 2022, once it was deemed that global inflation had peaked, markets started expecting international interest rates would stop rising some time during the first half of 2023.
The reopening of the Chinese economy in December and the abandoning of the zero-Covid policy ignited renewed risk appetite among global investors in recent months, which led to a relief rally in most global asset classes.
The US equity market rose 14% from September 2022 to the end of January and US bond yields fell by more than 30 basis points. More risky asset classes in the world — such as equities and bonds in emerging markets like SA — typically benefit significantly from such a rise in global risk appetite.
SA equities and bonds are cheap, both relative to their own histories as well asto their international counterparts. This has provided a big underpin for the returns of these SA assets, resulting in a strong performance since September, with the local equity market up about 25% and SA bonds returning 9% to the end of January.
Markets participants are keeping a close eye on the Fed. So far, data has shown that its aggressive monetary tightening mission is starting to work. Can you really say this is indeed the case, especially after Friday’s unexpectedly strong jobs data?
The jury is still very much out on whether the Fed’s policy tightening up to now will ultimately be successful in bringing inflation down towards its 2% target, or how much more tightening will be needed to eventually reach that point.
What we have seen since inflation’s peak in June 2022 has been the normal base effects working through the system, as well as an improvement in supply chain blockages forcing inflation on goods lower. But services inflation has been more sticky, with its dominant driver, wage inflation, on a downward path, but still some way off levels close to ensuring a sustainable 2% overall inflation level.
How can markets navigate these moves?
While the Fed grapples with the uncertainty of how much tightening is indeed needed to get inflation to eventually settle at a level around the implicit target, financial market volatility will be high as global markets continually react to the ebb and flow of Fed guidance on the future policy path, as well as every data release on the US economy.
With SA assets largely derivatives of global sentiment and trends, local markets should face similar volatility and are likely to take their direction from risk-on and risk-off periods.
Locally, we still have big headwinds — including the energy crisis and issues with Transnet. How much do the energy issues affect the market, as we face the risk of even higher load-shedding stages? Or is the worst priced in?
The aggregated SA equity market is dominated by large companies that generate most of their earnings outside the borders of SA (like Naspers, Prosus, AB InBev, British American Tobacco and Richemont), and are thus not affected by negative developments like the energy crisis within the SA economy.
In reality, the largest part of the SA equity market is not really affected by developments in the SA economy. Only for the companies that solely or predominantly operate in SA, do local economic realities matter. And many of these companies have for years had to operate in a low-growth and business-unfriendly environment and have learnt to work around these negatives.
For SA bonds, local factors are indeed more important than for equities, with the fiscal realities of efforts to solve the operational and financial realities directly affecting the fiscal and country risk premiums attached to the asset class.
What sectors and/or asset classes do you think will do well this year? And which ones might have a difficult time?
For SA investors, our expectation for some rand appreciation as global risk appetite improves later in 2023, would erode the local currency returns from global assets. Together with the more attractive valuations available from SA assets that provide a high margin of safety, we prefer SA asset classes over global assets in 2023.
The cheap valuations of SA equities and bonds should provide a big fillip for the returns of these assets this year.
Excellent value now available in SA equities should be beneficial to the asset class during times of possible declines in international equity markets, but even more so during subsequent recoveries when global risk appetite rises again.
Despite SA’s fiscal challenges, yields on SA vanilla government bonds are still high enough that they already discount a large amount of bad news on the local economy, thus sufficiently compensating investors for the associated risks.
Fundamentally, the expected decline in local inflation should also support the SA bond market in the next 12-18 months. The large contraction in corporate bond spreads in recent years due to the lack of sufficient supply to satisfy the increased demand, has made corporate credit valuations unattractive relative to both historical corporate spreads, as well as to government bonds.
Is there anything else worth mentioning that market participants should look out for in 2023 — both locally and internationally?
An escalation of the Russia-Ukraine war remains a global risk this year.
A further global risk in 2023 would be a widespread upsurge in civil unrest around the world as pressure on the disposable incomes of the general population from the sharp cost of living increases widens inequality levels.
The US Congress split after the 2022 mid-term elections could cause the approaching debt ceiling to once again be used as a political bargaining tool as the year progresses, leading to anxiety in financial markets during the potential standoff periods between the parties.
Policy errors from central banks overtightening policy in response to inflation fears, hence causing severe and extended growth recessions, could also disrupt financial markets.
Risks to SA economic growth in the coming year from elevated frequencies of Eskom load-shedding, operational issues at Transnet, or disappointing progress on economic reforms, would result in an increase in SA’s risk premium as an investment destination.
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