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Citation - Fourth Quarter 2022



Maarten Ackerman
Chief Economist
Estimated reading time: 19 minutes 11 seconds

At the beginning of every year, the Citadel Asset Management team reviews the themes that played out over the previous year. We then look at the risks and opportunities that we believe will be presented in the upcoming year. This year is no different and in this edition of Citation, we will review the major themes of 2022 and see how they are feeding into what we expect to be the key themes for 2023.

2022 – An annus horribilis

There were three key themes that dominated the markets in 2022. The first was the inflation shock and the resulting interest rate adjustments. The manner and speed in which central banks responded to record-high inflation levels had a huge impact on market liquidity. It was a very difficult year for all asset classes, and with the unprecedented strength of the United States (US) dollar, there was nowhere to hide.

Another key theme was the Russia-Ukraine war, which fuelled inflation further and created much uncertainty throughout the year.

The final key theme was China’s inability to get COVID-19 under control, and as a result, its economy suffered terrible economic losses. As its economic pain became too big, China was forced to loosen its grip on very strenuous zero-COVID policies that were in place for most of 2022.

These three themes had an extremely negative impact on global markets and impacted almost all asset classes negatively. However, despite markets having gyrated on the back of significant rate normalisation and the resulting slowdown in global growth, the world has not dipped into recession yet.

So, the big question now is, have markets priced in the risk of a possible global recession or are we in for another tough year?

2023 – Year of the water rabbit may give a glimmer of hope

As we enter 2023, we will have said farewell to the year of the tiger and have welcomed in the year of the water rabbit. Rabbit years are typically years of hope and after a difficult 2022, many of us will welcome a little more economic hope.

Having said that, previous rabbit years have included little to be hopeful about:

  • 1975 saw hyperinflation which lasted for a number of years;
  • 1987 was the year we experienced the Black Monday crash;
  • 1999 was when we were heading into the tech bubble;
  • 2011 we saw another Black Monday, as Standard and Poor’s downgraded the US’s credit rating from AAA to AA+.

The above is only an interesting aside. Fortunately we don’t rely on the Chinese Zodiac to make investment decisions. We stick to our philosophy and processes that have served us very well over the last three decades. We work to understand the current economic fundamentals and only then do we define possible scenarios and themes that are key to the outlook.

Given the current environment, the following themes are worth noting as we look at the year ahead:

  1. Peak inflation

We can probably expect to reach peak inflation during the year. Some countries are already there, including the US and parts of Europe. But this year will give us a clearer global picture, as many countries are still in their up-phase of inflation.

This is a slightly different inflation theme to 2022, because rather than inflation rising and central banks acting to curb inflation, 2023 will probably see inflation topping out, paving the way for central banks to react less aggressively. The major drivers of 2022’s inflation resulted from the supply shock in the aftermath of COVID-19 followed by another supply shock as the war started. Most of the culprits, including high shipping, energy and food cost are now, however, moderating fast.

Having said this, the risk with peak inflation comes in when we look at when and how central banks reacted to inflation in 2022. We might find in 2023 that the speed and ferocity with which central banks responded to inflation last year, might have been an overreaction. If it was, then its effects will only be felt later in the year, as inflation decreases by more than expected, and the interest rates currently on the table will start to hurt the real economy.

  1. Peak interest rates

Linking into the theme of Peak Inflation, are peak interest rates. That will be the point where central banks will start slowing down the pace of interest rate hikes and may stop hiking altogether. This may happen towards the end of 2023. We may even see some central banks starting to cut rates again as inflation starts to decline and global growth slows rapidly.

  1. Excessive government debt

Government debt has increased significantly over the past decade as governments provided support during the 2008 and 2020 deep recessions. Given stable inflation at the time, this was a viable option at the time. In the current high inflation environment this is not an option and governments should also consider the cost of further debt at much higher interest rates.

  1. The speed and depth of the global slowdown

We haven’t experienced a global recession yet. However, most indicators suggest that the likelihood has increased significantly. The focus this year will be how fast and deep this slowdown might be and how company profitability will be impacted as a result. This theme will have a significant impact on market performance.

  1. Peak dollar

Last year saw the phenomenon of the Big Dollar. The US dollar in 2022 reached record highs on the back of interest rate hikes. The strength of the dollar pulled liquidity out of the financial system and added a lot of volatility to markets and currencies. This is also likely to peak and start moving in the opposite direction, which should provide support to markets.

  1. The global energy crisis

A theme that cannot be overlooked for 2023 is the global energy crisis. This is not only to do with Russia and Europe. The whole world is looking for a more diverse supply of energy and there is an increased drive for cleaner energy. The speed of the energy transition will have many implications throughout the year.

  1. Deglobalisation

Peak globalisation, that started back in 2000, started to slow even before the COVID-19 pandemic. However, the pandemic, coupled with the start of the Ukrainian war, has further slowed the pace of globalisation. For the first time in years, we are not just looking for the cheapest products and services, we are more focused on national security. Countries are now starting to put themselves first, as they cannot afford another supply shock by only relying on a single source of supply. The process of diversifying the supply chain and also onshoring as much possible supply will continue to be a headwind for globalisation.

  1. Geopolitical tension

The Russia-Ukraine war rages on and we may see an increase in tensions between China and Taiwan as they continue to butt heads. Issues around Iran and North Korea is also adding to the toxic cocktail. This year will also see a number of key elections. Geopolitical tension brings economic policy uncertainty, in an already uncertain environment, and will result in increased market volatility.

  1. China reigniting its economy

China is emerging from three years of COVID lockdowns, and it could be a very positive theme for part of the global economy. This will, however, increase the number of COVID cases and deaths, but China can no longer afford the economic costs of continuing with its zero-COVID policy. As Chinese consumers emerge, they are going to have a lot of pent-up demand, which should boost the Chinese economy. China is also looking to stimulate its economy, which will provide a welcome tailwind in an environment where the rest of the world is slowing down rapidly. So, although China’s re-emergence won’t save the world, it will give commodity markets and commodity-driven economies some support.

  1. South Africa’s structural hurdles

South Africa will continue to deal with its structural hurdles, but with an increased urgency. Speed of reform is going to be front of mind. Unfortunately for South Africa, the country is not only dealing with its local challenges but will also have to navigate global headwinds.

So, while the outlook for 2023 is for a challenging year, there are a couple of green shoots. The world, however, is changing gears, and there are definitely going to be few teething problems that will arise as we move to a new way of thinking and doing things. Added to this, recent central bank and interest rate policy, is probably going to result in the global economy experiencing well below capacity growth this year as some countries enter recession .

US – Recession imminent, depth not certain

As we start 2023, the US Federal Reserve (Fed) is now also talking about a possible recession. During the course of last year, however, based on our 10 recession indicators, we, at Citadel, anticipated a recession to unfold during 2023 way before other market participants.

At the beginning of 2022, all 10 of Citadel’s recession indicators were close to green. Now, a year later, all are flashing red or yellow. The likelihood for a recession has therefore increased significantly.

Recession indicators:

  1. Global trade
  2. The US yield curve
  3. Leading indicators, including Purchasing managers Index (PMI)
  4. Consumer confidence
  5. Household debt
  6. Debt servicing costs
  7. Monetary conditions
  8. Earnings
  9. Economic growth
  10. Unemployment

Currently, the only reason that the US has not declared a recession is that its unemployment figure remains quite healthy. It is, however, definitely slowing and starting to deteriorate. The problem with a strong job market is that we are seeing higher wages which are inflationary and will continue to drive Fed interest rate decisions. Numbers coming out of the US job market suggest that it will be inflationary for some time to come.

Despite the US employment market being strong, when it comes to predicting recessions, what we typically see is that when unemployment starts to rise and its print moves through the unemployment-average of the past 12 months, a recession typically follows within a year. The US has reached that pivot point, and if history is any guide, a recession over the next 12 to 18 months is very likely.

This means that there are tough times ahead for the US and the global economy. On top of that, restrictive monetary policy will remain as long as necessary, and there is no end in sight as to when inflation will be low enough for the Fed to stop hiking rates.

The good news is that even though the Fed is talking about a recession, they predict that it will be mild. The reason for this is that the economy is in a different state to the previous two recessions, in 2008 and 2020. In 2008, we had the financial crisis and in 2020, the COVID pandemic. This time, there are no significant imbalances in the economy. Households have deleveraged which means they have paid back most of their debt in the last decade. This has left them in a better position to deal with higher interest rates, as they are able to manoeuvre the debt service costs. In addition, a large number of homeowners have locked into lower mortgages over the last decade by refinancing, which will also provide a cushion.

Our growth assumption for 2023 is that the US is likely to grow 50% below capacity which will have a massive impact on company profitability. Then from 2024, we can expect back-to-capacity growth which brings US average growth over the next 3 years to around 1.2% per annum.

Europe – regional and global headwinds driving down growth

In addition to global recessionary risks, Europe has its own set of challenges. The region is trying to get its energy mix right and diversify its supply away from Russia. Europe’s largest economy, Germany, is sitting with inflation in double digits for the first time in 70 years. This has lifted eurozone inflation to its highest levels since inflation started being measured. So the inflation theme is being played across the eurozone, which will add to global peak inflation in 2023.

Germany has also started with gas rationing in an attempt to get a 20% reduction in usage, as it attempts to avoid shortages. This is especially challenging given the current winter season. Without alternative energy sources, this move is going to be growth negative for the European Union (EU) economy, and we believe its impact on growth will be felt, not only for 2023, but going into 2024. There is also a risk for some pent up structural inflation in the EU, as alternative gas and energy sources are not going to be as cheap as their historical Russian supply.

Consumer and private households will bear the brunt of these increases, with a huge loss in purchasing power. This will further add to the slowdown in economic activity. Retail sales, for example, are already down 2% compared to a year ago. In addition to consumer spending, industrial production is also under pressure and declining. European consumer confidence collapsed to levels lower than 2008 and 2020, which were two periods of severe recession.

Europe is also facing global challenges in addition to their local headwinds. Global growth is under pressure, and as such so are Europe’s biggest trading partners. We anticipate the EU will have a very tough year and experience below-capacity growth of around 0.7% in 2023. In 2024 they will revert back to capacity bringing the growth rate for the next three years to about 0.9% per annum.

China – bucking the trend with easing policy and economic rebound

As China starts to open up, they can expect a late COVID growth-cycle like we saw in developed markets two years ago. People will return to the shops with their extra savings and pent-up demand. We expect to see growth returning to around 5% in 2023, up from only 3% in 2022. So it is a very different environment compared to the rest of the global economy. But to achieve this, they will have to continue with the unwinding of their zero-COVID policy.

This rebound will come off a low base in 2022, where Chinese growth was at its lowest levels in more than three decades. The government’s desire to save lives was to the detriment to the economy. Until recently, China’s economy has been driven by exports and property infrastructure. They decided they wanted the consumer to start playing a bigger role. However, due to the zero-COVID policy, consumers were not able to spend. In 2022, China’s retail sales growth almost halved as consumers were forced to stay at home. In addition, as the world slowed down, exports and property and infrastructure spend was down, putting further pressure on the Chinese economy.

Last year also saw manufacturing come under pressure with orders down 40% as global demand slowed. Shipping containers to the US were down 20% compared to a year ago. While this speaks to lower demand, it will be deflationary and a welcome relief to global inflation. Now as demand falls, so too do shipping costs and that will help lower inflation. Also, both China’s exports and imports, to and from the US, are now less than they were a year ago, an indication that both economies are slowing down.

In addition to opening up their economy post-COVID, we are also expecting to see the People’s Bank of China give additional stimulus well into 2023, which will give the weak environment much-needed support. This is counter-cyclical to the rest of the world, which is in a monetary tightening and rate hiking cycle. However, China’s boom will come at a time where the world economy is slowing down. And the world, really is China’s biggest trading partner, which means their exports will be impacted. We expect, however, that stimulation will help stabilise the activity in China and help accelerate growth to reach 5% in 2023.

 South Africa – a challenging year but a golden thread gives us longer-term hope

The global economic outlook is going to provide a very difficult backdrop for South Africa in 2023. The country has a very open economy, and given the slowdown of the global economy, we are on the backfoot before we even look at the local headwinds facing the economy.

2022 will go down as the year with the most loadshedding ever, and we don’t see a solution to the country’s power crisis any time soon. In addition, the country has experienced a number of strikes. October’s 11-day Transnet strike cost the country R65 billion worth of lost exports. Increasingly, we are also seeing a wave of demands for above-inflation wage increases, which is not helping an economy showing distress from global headwinds.

Additionally, the country is sitting with high unemployment and dwindling consumer savings, as high inflation and tight monetary policy start to bite. This pressure on the consumer is problematic as South Africa is a consumer-based economy with consumers making up over 60% of the country’s gross domestic product (GDP). The latest GDP data, however, showed that consumer spending contracted by 0.3% over the previous quarter. That is a big decline for a big chunk of the economy, showing it is under severe pressure. So while South Africa is looking at 2% growth in 2022, this is based on volatile sectors such as exports and agriculture.

However, looking to 2023, there are a number of positives that are on the horizon. While the positive effect of surging commodity exports over the past few years are starting to fade as the global economy slows, if China does kickstart its economy, this can provide some renewed support to commodity markets and commodity-exporting countries like South Africa. We have a big trading partner in China. If this happens it will be a welcome tailwind in terms of stronger commodity exports and a likely underpin of the fiscus through tax collection.

Another positive for the economy is that business confidence, along with fixed investments, continues to improve. This is no longer a green shoot but rather a golden thread. If you face loadshedding on a daily basis, it is easy to think things are getting worse and that there is no improvement, but these are longer-term projects that will eventually lead to more sustainable economic growth. The country’s corporate balance sheets are relatively healthy, and South African corporates have deleveraged a lot. We are also seeing private investments picking up which should support growth in the longer term.

The latest fixed investment numbers revealed the fourth positive quarter in a row and was an unexpected, pleasant surprise. South Africa has not had four positive quarters in a row in over three decades. This means 2022 was a robust year in terms of fixed investment growth. A welcome and first step toward more sustainable economic growth.

Despite our long-term outlook looking better, South Africa’s leading indicators are suggesting that 2023 is going to be tough. Our PMI is below 50, which implies that the economy is contracting. The employment component of that is closer to 41, which is no surprise when you consider our unemployment numbers. We are facing a challenging 2023 with growth of around 1.2% which remains below population growth.

The markets – Peak themes see more pain before a rebound

So, it is clear that the economic environment is under pressure, and we are moving towards the peak themes, mentioned above, and we are in for more volatility before we will see some economic normality returning.

Last year was one of the worst years for multi-asset portfolios, in fact the worst performance for any multi asset portfolio since 1871! All assets were sold off, equities slumped significantly and even safe-haven assets, like government bonds also recorded negative double-digit declines as interest rates normalised. In the US, interest rates jumped from almost 0%, a historic low, to 4%. There was nowhere to hide for multi asset portfolio investors. Even gold, the ultimate safe-haven asset recorded negative dollar returns in 2022.

However, it must be noted, in history there were only three periods where a difficult year was followed up by another difficult year: the depression period in 1930; the ‘70’s where we had hyperinflation for a number of years given the oil embargo and lastly, the Nasdaq bubble in 2000, where it took three years for the tech bubble to deflate.

The question now is, will 2023 be as bad for markets as 2022? It is safe to say that volatility will remain elevated as the peak themes play out. Markets can certainly test previous lows but at the same time has already priced in many of the risks that we have highlighted.  The current environment is very different compared to the three periods explained above. If history is any guide, difficult periods, like 2022, are typically followed by strong rebounds.

When it comes to the Citadel investment strategy in this environment, being well-diversified, not selling at the wrong time and ensuring a defensive position is crucial. Our investment philosophy remains constant. We invest in good-quality companies, locally and abroad, where valuations make sense. These portfolios have the ability to beat inflation over time and being more volatile it is part of the long term portion of the portfolio where we have time on our side. This part of the portfolio will benefit from any future rebound in markets.

We will complement the equity portion with alternatives like protected equity. This strategy has served us very well in 2022, protecting the downside and putting you into the position where you have less of a loss to make up to previous highs. Added to the mix will be fixed income asset classes, currently offering good value after last year’s rate normalisation.

The rand – volatility offers opportunities as well as a risks

In an environment like this, where we have global headwinds, local challenges, volatile commodity prices and an uncertain local political landscape, we have a cocktail that guarantees rand volatility. We can expect the rand to continue to be volatile throughout 2023. And again, depending on the local political environment and other fundamental factors, we expect to see the rand swing from R16.50/$ to as much as R20.00/$ throughout 2023.

While currency volatility is typically a risk, we do use it as an opportunity in our portfolios through currency hedging. We make sure we fully hedge the currency when it reaches the top side of the range and then as the rand gets stronger, we ‘unhedge’ the portfolio to make sure we benefit from the weakening currency on our offshore assets. So, despite the expectation of extreme volatility, we will make the most of it to enhance returns across our portfolio.

In conclusion

While 2023 is going to be a challenging year, we at Citadel Asset Management, are confident that the market offers enough opportunities to ensure that your wealth will be protected, and will continue on a strong inflation beating trajectory over time.