Here are the Big Five charts to pay attention to.
The first chart is the price of oil. It seems to have stabilized somewhat in light of Russia’s aggression in Ukraine. Russia is a major oil producer, and reflects concerns over the disruption of oil supplies. Meanwhile, there are many Western companies that refuse to buy or sell Russian oil, while European governments are considering a complete ban on Russian oil.
Chart 1: Brent crude oil prices
Oil prices were recovering even before the war, as mobility restrictions imposed during the global epidemic were lifted. At the lower end of April 2020, a key futures contract briefly turned negative because traders did not know what to do with all the excess oil as storage facilities were quickly filled.The picture looks different today. Demand is strong, but supply is slow.
Many oil producers, especially US shale drillers, have burned their fingers in the 2014 price crash and are now more cautious about increasing production with a focus on profitability.
For the rest of the world, oil acts as a tax. We all have to go around and just cough up the high price of petrol for lack of alternatives.
Outside of a certain unknown point, however, the tension over the purchasing power of the people is too great, companies are shutting down, jobs are leaving and oil spills are needed.
This is called demand depletion and it usually occurs when the price of the product is too high. In addition to destroying demand, higher oil prices will also stimulate production. There is always a potential surplus of oil in normal times, which is why major producers outside the United States have a cartel with production quotas. So oil prices are unlikely to stay high forever.
In the case of the impact of current oil inflation, it should also be noted that the recent rise in oil prices is relatively restrained compared to the surge of growth in the 1970s, especially considering how dependent the world was. Then the oil.
The rate of inflation jumped to the last level seen in many countries in the early 1980’s. Significantly, inflation in the United States, Europe and the United Kingdom is higher than in South Africa at the moment.
Chart 2: Consumer inflation rates in selected countries,%
The global rise in inflation is partly due to the rapid rise in oil prices and the even greater rise in natural gas prices in Europe.
Inflation also reflects other distortions caused by the epidemic. Consumers quickly and unexpectedly shift costs from face-to-face services such as gyms and restaurants that can be eaten at home, such as a large TV. In rich countries, families benefit from huge financial outlay. In the case of the United States, for example, overall household income increased rapidly in 2020, despite declining incomes from wages and wages.
Although demand for the product increased, supply was severely limited. Factories could not function properly due to social distance and quarantine rules, nor could logistics firms. And as many countries have closed their borders to people, cross-border shipments of goods have suffered. The global supply chain, usually highly efficient, was stuck and plagued by delays and shortages. So high demand and limited supply have been seen at much higher product prices.
Neither the price effect nor the epidemic-related distortion should be a permanent driver of inflation.
Since inflation is measured on a yearly basis, as long as prices remain stable – even at high levels – the rate of change will eventually decrease.
From the central banker’s point of view, the problem is not necessarily the effect of these transient factors, but the spread of inflation in other cases. Again, this is especially the case in the United States where core inflation, which excludes volatile items, continues at 6.2% although headline inflation is slightly below its recent high. While core inflation is more sensitive to demand, and unemployment is extremely low and labor shortages are high, demand is likely to remain strong in the coming months.
So since the beginning of the year, there has been a sharp outlook on monetary policy. The Fed and others are raising rates to reduce demand and ultimately inflation. They are noticing a ‘soft landing’ where inflation falls without causing a recession. But given the level of inflation and its expanding base, it will be difficult to bring inflation down to the 2% target without a recession.
This brings us to Chart 3 …
Central banks control short-term rates, usually overnight funding rates for banks. The market determines a wide range of long-term interest rates, but they all refer to the central bank’s policy rate. In developed markets, bond yields have risen sharply, with the central bank offering a number of future rate hikes.
Chart 3: 10 year government bond yield,%
Despite SA’s low inflation rate, we will not be relieved of the pain, as the South African Reserve Bank underlined its 0.5% repo rate hike last week and warned that further growth is possible.In doing so, the bond market has already provided a sharp dose of monetary tightening ahead of central banks. Even if you consider that private borrowers provide a spread on government yields. If the spread widens and the base yield increases – as has been the case with the US mortgage rate – it is a double dose of hardening. Not surprisingly, the equity market is under pressure.
A correction or a recession prediction?
This chart shows the highest drawdown of the MSCI All Country World Index since its inception in 1988.
Chart 4: Global Equity Drawdown (MSCI AC World Index US)
The last few months have been rough as high interest rates and other macro concerns (such as the war in Ukraine) have caused the market to slump. In other words, investors are willing to pay less for every dollar worth of profit in an environment where they have more options to earn interest income and where they are generally more risk averse. Therefore, the forward price-earnings ratio has come down from the recent top of 20 to a more reasonable 14.5, which is slightly lower than its 10-year average.
Looking at the drawdown chart, a few more things stand out. First, the volatile nature of the equity market is very clear. Second, a fall of about 10% is very common and usually not long lasting – these are called corrections. Third, a fall of more than 20% that takes longer to recover is almost always accompanied by a recession, especially in the United States, where the global markets for economics are the most cautious.
Which is called beer market. The beer market usually starts before the recession starts and bottoms out before the end.
Equity markets are looking ahead and that is why it is so difficult to determine the timing of equity markets. The current downturn is about 20%, so the market is currently close to a recessionary discount in the US. A lot of bad news is already priced in equities.
The bottom line is that looking at this chart, you can conclude that equity is too volatile to bother with investing. However, during this entire period investors who invested entirely through volatility and reinvested dividends earned 8 8% per year or a total of 300 1,300.
The rand was its usual volatile self this year, initially strengthening with rising commodity prices (coal prices, one of our main exports in the wake of the Russian invasion, have risen more than oil).
Chart 5: Rand-dollar exchange rate
By doing so, the RAND has curbed the downward trend of many currencies against the stronger US dollar. In mid-April, the pressure on a strong dollar proved too much, and the rand weakened sharply, although Chart 5 indicated that it was by no means an unusually large depreciation. The RAND is reasonably stable compared to other emerging market currencies.
After refraining from global returns for the first quarter, RAND is again helping local investors boost global returns somewhat. SA bonds and equities also hold better than their global counterparts, meaning a typical South African equilibrium fund has declined slightly since the beginning of the year, nowhere near as bad as the record decline in equilibrium suffered by equilibrium funds in the United States and Europe. As bonds and equity tandem fell.
So why is the dollar so strong? It benefits from two trends. First, in times of high risk, people jump to dollar security. Second, US short-term interest rates are expected to rise much faster than in Europe and Japan, with the dollar having the added benefit of yielding much higher yields. So in recent weeks the greenback has reached a 20-year high against the euro and yen.
For Rand, his outlook clearly depends on where the dollar is going, what the price of the product is, and the general sentiment towards emerging markets. One thing we do know is that this is never a one-way bet, even if the long-term side of the journey is weak against the dollar.
One dollar bought R8.20 a decade ago, today is about R16, but most of the depreciation happened in the first five years. The second five years have seen a lot of volatility but with an upward trend.
The Big Five charts paint a picture of a complex world that is still recovering from the epidemic but is now facing new threats, such as the new Chinese lockdown, the Russian war, and the impact of many central bank policies tightening.
While the environment may be unique, equity market volatility is not. We’ve been here before.
History has shown that equity market downturns are frequent but rarely have a lasting effect on a portfolio if investors avoid knee-jerk changes.
The key is to have an investment strategy that is properly diversified to eliminate volatile market volatility. Currently the markets are already releasing a lot of bad news, and there is ample opportunity for patient investors to make adequate valuations in local and global assets that could set the stage for future real returns.
Isaac Odendal is an investment strategist at Old Mutual Wealth.