Two crises in two years

South Africa went into a hard lockdown two years ago on March 28. At the time, many thought it would take a few weeks or at most a few months. Instead, the Covid-19 pandemic is still with us.

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While we still try to figure out the short- and long-term consequences of the ongoing pandemic, we now also need to consider how the brutal Russian invasion of Ukraine will change the global economic and political order.

In other words, the world has gone through two deep crises in two years. They bring about drastic changes, but what exactly? Understanding the present is hard enough as it is. Predicting the future is virtually impossible.

Much commentary now speaks of the world breaking into two blocs, one led by America and one by China (joined by Russia and other illiberal states).

Where South Africa would fit is unclear.

Local business elites and the middle class tend to look west, but many political leaders look east.

Professionals study logistics

Nevertheless, a likely consequence is a greater focus on resilience and security of supply over speed, efficiency and cost. Anyone running a business will think carefully about where critical input comes from, the risks of disruption, and steps needed to avoid disruption (governments will hopefully do the same).

Shortages of computer chips, for example, have hampered car production for the past 18 months, but more recently German manufacturers have been short of a much less sophisticated part imported from Ukraine, the simple but crucial wiring harness.

General Omar Bradly, the American hero of World War II, is said to have noted that “amateurs talk about tactics while professionals study logistics”.

The Russian generals seem to have forgotten that in planning their invasion of Ukraine, which will leave soldiers without food and ammunition and tanks without fuel, but company leaders will not want to get caught again.

That said, much of the pressure on global supply chains remains the extraordinary demand for goods compared to the past. This is a result of the pandemic that is still with us. Demand for goods, particularly from US consumers, is still well above pre-pandemic trends. Spending on services has recovered, but not back to where it would have been without the pandemic. In this light, supply chains performed remarkably well to produce and ship record quantities of goods. But not good enough to avoid shortages, huge price increases and longer lead times.

US consumer spending on goods and services, rebased

Neither of these two global crises is over.

China has again resorted to harsh lockdowns to contain the spread of the virus. But in most other countries it has thankfully become background noise thanks to widespread vaccination, immunity to previous infection, better treatment options, less severe stress and, frankly, people just wanting to get on with their lives. Whether we really are at the end of the pandemic remains to be seen, but there is reason to be optimistic.

China’s harsh lockdowns of major cities, including Shanghai and Shenzhen, will put further strain on supply chains.

China is and will remain the factory of the world for a long time to come, even as companies diversify away from a country where policies have become less predictable and geopolitics more uncertain.

The war in Ukraine also rages on with no immediate end in sight, even as Russia appears to have given up some of its original war goals. The market reaction – with stocks up since the early days of the invasion – seems to indicate that investors consider the worst-case scenarios less likely.

The Fed is shifting

In the background, however, another important shift is underway.

Central banks, led by the US Federal Reserve, have become hawkish, meaning they want to act to tame high inflation.

The Fed’s preferred inflation gauge hit a four-decade high of 6.4% in February. While fuel prices are part of the story, core inflation excluding food and fuel was 5.4%. Inflation in the eurozone reached 7.5% in March, the highest since the introduction of the single currency in 1999. The energy price spike has played a greater role in inflation in the eurozone than in the US, but core inflation nevertheless reached a record high. 2.9%.

Faced with historically high inflation and historically low unemployment rates, central banks will continue their policies despite the increasingly uncertain growth outlook. For most of the past 14 years, central banks, especially the Fed, have been seen as friends of investors. This was particularly the case two years ago when they unleashed an unimaginable stimulus in response to the Covid shock.

Not anymore. What awaits us will increasingly be a trade-off between sustained growth and lowering inflation. There is every indication that the Fed and the company will now focus on the latter.

No quarter given

Despite the interest rate risk, most major global equity benchmarks were positive in March, with the notable exception of China. However, the returns of global equities in the first quarter were decidedly negative. Aside from the shock of the war, stock markets have had to discount rising interest rates.

The first quarter was even worse for bonds. Rising interest rate expectations boosted yields. US 10-year Treasury yields rose to 2.32% at the end of March, after starting the year at 1.4%. Shorter interest rates rose faster, leading to a flattening of the yield curve. The yield on US two-year Treasuries still ended the quarter at 2.28%, after starting at 0.7%. Yields in other developed countries have also risen, and the stock of negative yielding bonds has shrunk rapidly from a high of $18 trillion to low single digits.

The 8% appreciation of the rand against the dollar since the start of the year has exacerbated losses on global assets for South African investors.

Fortunately, South African bonds and equities were positive, so a diversified portfolio would have held up reasonably well.

The FTSE/JSE Capped SWIX gained 1.5% in March, 6.7% year-to-date and 20% year-on-year. South African bonds returned 1.8% in the first quarter, despite the volatility of local interest rates and the large global bond sell-off. The 12-month yield of 12% is well above cash.

Since bonds, stocks and the currency have been boosted by high commodity prices, they are all at risk if these prices fall sharply.

A year or three

Looking at the three-year returns, covering the last days of the pre-pandemic, the Covid crash and recovery, and the war in Ukraine, an interesting picture emerges.

Annualized three-year asset class return in rand, %

Global equities have returned 14% per annum in US dollars for the past three years, as measured by the MSCI All Country World Index. This is a remarkably good outcome given the turmoil facing the global economy.

As for global bonds, it’s worth noting that the massive rise in the US 10-year benchmark yields brings it back to where it was three years ago. The UK equivalent is about 60 basis points higher than three years ago. Germany is now trading at 0.5%, while it was around 0% in April 2019. It spent most of the next three years below 0%.

While global bond yields have been fantastic as yields have declined, the recent surge in yields has virtually wiped out the returns of the past three years.

Local currency 10-year government bond yields, %

South African equities (FTSE/JSE Capped SWIX) delivered an annualized return of 12% over the three years to the end of March. That is about 7% higher than inflation and in line with the long-term (120-year) average real return.

However, the reality is that there are very few years when stock returns are in line with the historical average.

The average consists of blockbuster years, negative years and years in which not much happens. But average years are rare.

This means that you have to stay invested for several years to take advantage of the good years in which they happen. This also means getting through the bad years, as we cannot predict which years will be good or bad.

This is especially true for returns from local listed real estate. Despite a 26% increase in the past year, the three-year annual return of the FTSE/JSE All Property Index is -4%. This compares poorly with the average real return over 30 years of about 6%.

South African bonds yielded 8.5% a year, well above inflation and despite the government losing its last investment grade credit rating in March 2020. Since the best indicator of future bond yields is simply the yield you pay today, the outlook for bond yields remains attractive, especially given improving domestic fundamentals.

Money market returns are linked to prevailing short-term interest rates. When the SA Reserve Bank aggressively cut interest rates two years ago, money market yields plummeted. They will now follow the repo rate higher again, but are still lagging behind inflation at this stage. We are also unlikely to return to the pre-2020 situation, when short-term interest rates were 2% to 3% above inflation, delivering an attractive risk-free real return.

In other words, the age-old trade-off between risk and return is back.

Finally, at the end of March, the rand was only slightly weaker against the dollar compared to three years ago and not far from where it was six years ago. The idea that the rand is always falling and increasing global returns for South Africans is simply not true. The long-term trend is weaker, but there may be long periods of sideways movement or valuation. This should be considered.

In summary

The world has been through major shocks in the past two years and is undergoing economic and political changes that we do not yet fully understand. Still, investment returns were quite good. Investors who ignored the noise and stuck with their strategy had done well.

It’s easy to get caught up in the bad news of the moment, but with change there are always investment opportunities.

This does not mean blindly extrapolating trends, as what worked in the past may not work as well in the future. But by being sufficiently diversified, keeping an eye on valuations and being patient, we will go a long way in achieving the desired result.

Izak Odendaal is an investment strategist at Ancient mutual wealth.