Markets behaving like an addict with withdrawal symptoms

25 July 2022

Stock market volatility remained the only constant during the second quarter of the year. Given the backdrop of rising global interest rates and the withdrawal of treasury sponsored quantitative easing programmes, these market convulsions can be likened to an addict foregoing their daily fix. There have been a few places to hide as asset classes which usually provide diversification benefits sold off in unison.

Global imbalances due to geopolitics and Covid-19 lockdowns continue to impact supply chains across a multitude of sectors and commodities. These imbalances are taking time to dissipate and have been a driver of developed market inflation rates that we only thought possible in an emerging market context. Second round inflation effects appear to be gaining momentum, providing a sobering dose of reality to the central bankers that had previously been anchored in the mindset that inflation was ‘transitory.’ They are now realising that they are behind the curve in raising interest rates to put a brake on building inflation. Higher interest rates, combined with slowing global growth, point to stagflation taking hold.

Energy prices remain stubbornly high.

We are now paying the price for the lack of investment in replacement hydrocarbon supply to offset the natural production declines of producing assets, mainly due to the environmental, social and governance (ESG) pressure. This lack of new production as well as the withdrawal of Russian energy flows to the western market due to the Ukraine conflict has created a ‘perfect storm’. It has resulted in surging coal, gas and oil prices, adding fuel to the inflation fire. Perversely, the current tight energy market has pushed some developed countries to bring mothballed ‘dirty’ coal-fired generation assets back into production. Nuclear energy, which was not too long ago seen as a pariah in terms of a green solution to future energy needs, appears to be seeing somewhat of a resurgence as the potential solution to future base load power generation.

This cocktail of higher interest rates and increasing inflation has driven many market participants towards hard assets or commodities. These have typically provided refuge for investors during past inflationary cycles. But this crowded trade was derailed early in the quarter by China’s hard lockdown zero Covid-19 policies. With China being the world’s largest consumer of commodities, these hard lockdown policies put a spanner in the works in terms of commodity demand. China lockdowns, together with more recent concerns around slowing global growth, have resulted in commodity prices and equities taking a breather over the last few months after a sustained period of very strong returns. Given the question marks around forward-looking global commodity demand, and the rising probability of a recession, investors are faced with more questions than answers in terms of where to next. 

It is during uncertain times like these we rely heavily on a tried and tested investment process and a long-term mindset.

Trying to forecast short-term macro-outcomes does not add value. Macro forecasts, even from the most skilled economists, are more frequently wrong than right. Our company valuations, which are based on conservative through the cycle assumptions, fluctuate significantly less than company share prices. This means that periods of share price volatility often provide opportunities to buy quality companies at attractive prices. Periods of market weakness affect sentiment and emotions. In this regard we are not immune. We rely heavily on our investment process and systems to highlight emerging opportunities. Experience has taught us to use volatility to tilt the portfolio towards companies that provide better risk adjusted returns for the benefit of long-term portfolio performance. We understand that to outperform, we need to hold positions that are different to the broader market. Doing this seldom feels comfortable. It also shouldn’t feel comfortable because bargain assets are seldom the popular assets.   

Looking at South Africa, unfortunately, we are once again failing to fully capitalise on the full potential of our rich resource endowment, particularly coal, manganese and iron ore because infrastructure constraints have created bottlenecks.

Transnet rail’s operational issues are proving to be the achilles heel in terms of realising our full potential when it comes to commodity export volumes. Many of our key commodity export rail lines are currently operating well below nameplate capacity. On this note, we are cautiously optimistic that some positive changes are afoot as part of the presidency’s operation Vulindlela, which is aimed at eliminating bottlenecks across the economy to boost growth. The government recently published a new rail policy advocating the wholesale opening up of the South African rail network to third party private players.

Despite elements of our rail network being neglected, South Africa’s rail network is equivalent in size to that of Germany’s and with a bit of effort can be revitalised to unlock enormous potential. This would be a critical step in creating a more reliable rail network and boosting export volumes for the benefit of the fiscus and economic growth. Additionally, it will also provide a significant opportunity for private sector credit extension as a substantial investment will be required by private players looking to play a role in future rail services and energy generation. There will no doubt be teething problems as to how the ‘rubber meets the road’ and Transnet’s role will need to be carefully managed to ensure fair access across the network. Government now needs to prioritise implementing the new Vulindlela policies.