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Citation - Third Quarter 2022



Maarten Ackerman
Chief Economist
Estimated reading time: 19 minutes 43 seconds read

This year has been tough. What’s more, a number of economic and geopolitical events have destabilised the global economy. So, when I ask, “Are we there yet?”, I am not referring to the end of 2022, but rather whether the global economy has reached peak inflation. This is the point where global central banks can adjust their rate hikes and pivot away from their hawkish views, slowing down the pace of interest rate hikes we have seen in 2022.

Key themes for the year: Inflation and the mighty dollar

If you look back to our first edition of Citation this year, we examined some of the themes that we could expect in 2022. At number one was inflation, together with resulting central bank policy, illustrating that Citadel was clearly prepared for what has transpired. Although these key themes were further escalated by the war, it is the speed and the magnitude at which central banks started to hike rates that has shaken the markets.

The other key theme at the moment, is the dollar’s strength against its peers and emerging market currencies. The reason that this is so important in an investment environment is that it sucks liquidity out of the entire system. So, if you look back in time at the tech bubble, the housing bubble, the great financial crisis, and the sovereign debt crisis, although economies floundered, we did not have the same level of inflation that we are currently experiencing. Central banks were therefore able to step in and either lower interest rates or “print money” in the form of quantitative easing. This time, an economic crisis is developing with unsustainable levels of inflation, meaning governments will be able to do very little to help buoy economies.

The US leading global central bank complacency in the face of runaway inflation

This is the first time since the 1980s that the world has seen these levels of inflation. As such, the concern amongst the financial fraternity is that central banks have become complacent and are late out of the starting blocks. While they were slow to respond, when they did, they did so with great aggression. This has resulted in economists asking whether central banks are overreacting with the speed and level of rate hikes, and whether this will result in a much harsher landing than what has currently been priced into the markets.

United States (US) Federal Reserve (Fed) Chair, Jerome Powell, has stated that to reduce inflation, the banks are prepared to endure a period of below-trend growth. But while higher interest rates, slower growth, and a softer labour market will bring down inflation, they will also result in tough times for households and businesses. The big concern is, however, whether this current interest rate cycle is going to lead to a global recession and how serious that recession will be.

Central banks appear to understand that interest rate hikes will hurt economies, but when will they be comfortable enough to start slowing down those rate hikes? The argument is that the earlier they start doing so, the softer the landing will be, but many economists believe that they have gone too far already, and that the global economy might be heading for a tough recession. However, central banks are anxious, and want to convey the message that they are not going to allow a repeat of the mistakes of the 1970s.

On the back of these hikes the dollar is extremely strong. This year, the Japanese yen fell to 32-year lows against the dollar. The British pound, not helped by the United Kingdom’s (UK) tax cuts and fiscal spending announcement, plummeted to a 37-year low against the dollar. Government bond yields have also been repricing rapidly pulling even more liquidity out of the system. This again shows how complacent the global economy became, as bond yields just moved lower and lower over the past few decades.

In the red – the Citadel Recession Scorecard

At Citadel we have a recession scorecard where we look at 10 fundamental factors. Again, referring to our first edition of Citation this year, you will remember that our scorecard predicted less than a 25% chance of the world moving into a recession. Now as we start the fourth quarter of 2022, this has rapidly deteriorated. The scorecard now indicates that there is more than a 90% likelihood that we will see a global recession in 2023, with only one of our indicators still green, and the rest having switched to yellow or red.

The current green indicator on our scorecard is the state of the US labour market. Recessions go hand-in-hand with rising unemployment, but the US economy is still in a state of full employment. This is good news.

However, as we enter the final quarter of the year, the US economy has already experienced two quarters of negative gross domestic product (GDP) growth, which is the textbook definition of a recession. Consumers are under pressure and household debt has increased significantly over the past few months. This reflects a cost-of-living crisis, which means that people are taking on debt to keep their spending up at normal levels. This year we have seen a 13% jump in credit card debt compared to a year ago, the highest rate of increase in 20 years. However, a case for a softer landing with regards to a US recession is that the US economy is driven by the consumers who are still relatively financially healthy. So, although debt is increasing, this is off a very low base. But increasing debt levels are a red flag.

The US Fed has implemented three 0.75% rate hikes in a row, and it is talking about another 1% to 1.25% in rate hikes before the end of the year, which indicates that it is serious about getting inflation under control. And for the first time, the Fed has acknowledged that it will hurt the job market with these rate hikes – a blow to our only green indicator on the recession scorecard. Currently US unemployment is sitting at just over 3%, but by 2023, the Fed is expecting that number to rise to above 4.4%, which is a steep increase in the unemployment figure over a short space of time. Should this indicator turn red, then we can expect a full-blown recession in 2023. We think the likelihood of this is quite high.

EU and the UK: energy crisis fuelling inflation and low consumer confidence

The European Union (EU) and the UK are facing similar issues and as a result, their currencies are also adjusting. However, with the energy crisis, they are facing additional headwinds. Germany – the EU’s biggest economy and the region’s manufacturing hub, and the driver of EU growth – has been hard hit by soaring electricity prices that have hit record highs. German power prices have gone up seven times this year. The price that industrial producers are paying for power increased 37% in July – the highest increase on record. Power prices, alone, are fuelling expectations that Germany is flirting with a recession; if they are not already in a recession, with business and consumer confidence sitting at record lows. The potential scenario that Russia will reduce gas or energy supply even further or may cut it altogether as winter sets in, is an additional headwind that will bring the possibility of an EU recession even closer.

Despite this, the European Central Bank (ECB) is aware that it needs to get inflation under control. However, this is a very different inflationary environment as they cannot fight inflation using quantitative easing like they did during the last financial crisis. The ECB is therefore being forced to raise interest rates. Their last rate hike was 75 basis points, which was the biggest rate hike in the history of the ECB, and it has brought the EU’s interest rates into positive territory for the first time in eight years.

In the UK, the proposed fiscal plan with tax cuts caused mayhem in the market. The International Monetary Fund asked the UK government to reconsider its policy, which, when announced, sent the UK bond market into a spin, seeing bonds being repriced and reaching levels we have not seen in a few years.

China, on a different trajectory

Compared to many developed markets, China is in a very different cycle. With their zero-COVID policy and ongoing lockdowns impacting the economy negatively, the country is not sitting with the same inflation problem as the rest of the globe. China is therefore not likely to be raising interest rates any time soon. So, it is expected that China will have a very different 2023 to the rest of the globe.

In fact, the Chinese government is looking at stimulating the economy with a very strong infrastructure spend, which is similar to what we saw in 2016. This move led to a very strong commodity run, which will hopefully support emerging economies. The move has also supported business sentiment on the ground and is in line with some of the debt regulations that have already started supporting the economy, as the Peoples Bank of China is committed to maintaining liquidity to support the economy. With continuous lockdowns due to its zero-COVID policy, China is being forced to revert to its old growth model, growing infrastructure, property and exports. The country has tried to switch its economy over to a consumer-driven one, which worked for a while, but COVID put pause to that.

The Chinese economy has been hit hard by the pandemic, and the World Bank has revised China’s growth outlook for 2022. This will be the first time since the 1990s that China will grow at a slower rate than its Asian counterparts. The new predicted growth rate is 2.8%, which for an economy like China’s can almost be considered recessionary. But if China can get COVID under control, it may actually do much better than other large economies in 2023. Even if it does do well, the world’s second largest economy, unfortunately, will not be able to save the global economy from a recession or growth disappointment.

Summary analysis

We have not seen inflation at these levels since 1985. Without inflation, central banks were able to lower interest rates to zero, or even below, and a high level of complacency set in. When the global economy hit an economic hurdle, governments simply borrowed more money, with low interest rates making this affordable. Rising debt repayments create a very unhealthy environment for the financial system and investors are concerned. Which, again, raises the question, “Have central banks overreacted in rising rates at the pace they have?”

At Citadel, we believe that we are facing a very different decade than we have for a while. To put that into perspective, since the turn of the century, when China joined the World Trade Organisation, peak globalisation started, and it marked a golden age for global economic growth. We saw economic growth numbers averaging around 3.5% per annum which is well above capacity. This environment has allowed companies to grow their profitability, and in real terms they were returning upwards of 10% per annum. The strong earnings growth in turn supported equity markets. We believe that in the next three to five years, global growth is going fall below capacity and may be closer to 2% or lower. This period could also include a period of negative growth if the world dips into recession. But, for now, we can assume that developed economies will grow well below capacity over the next couple of years which creates strong headwinds for company profitability.

This will however depend on how central banks deal with the current inflation cycle and how quickly they can start to cut interest rates. We must remember that the interest rate hikes we are seeing now will only truly be felt by the consumer and the real economy in about nine months’ time. It is for this reason, that an overreaction by the central banks can have a very detrimental effect on the economy next year. By then it will be too late, as businesses will be under pressure and resulting job losses could lead to higher than anticipated unemployment.

So when we ask, “Are we there yet?”, we are asking has the US economy reached peak inflation? In June this year, the US inflation print was 9%, in September this had fallen to 8.2%. One can argue that they are on a downward phase. So, looking to next year, in the worst-case scenario by the middle of the year, we may find ourselves looking at 6% inflation while the best-case scenario is that we will be closer to the central banks’ targets. These numbers require a lot of assumptions, however.

The first is that the price of oil stays the same or falls, but we know that we are in a world where oil is being used to fight a war. Russia limiting or cutting off gas supply completely to Europe over winter is a very real possibility which will put the oil price on an upward trajectory. This, in turn, will drive inflation higher, meaning central banks won’t have the luxury to slow down interest rate hikes. If you assume inflation is falling, then we will most likely see a slowing of the pace of interest rate hikes by the end of this year. Although inflation is unlikely to reach the 2% range any time soon, a slowing down of rates will give the global economy a softer landing.

South Africa – some green shoots on the distant horizon

Over the last 20 years, South Africa’s growth rate fell well below the global average. This was due to the impact of state capture, which shaved off around 1% per annum from economic growth. South Africa also faces the same challenges that the global economy is facing and will likely see below capacity growth for the next three years. But unfortunately, our below capacity growth is going to be even lower than the revised global growth number, given the added pressure of local challenges. We expect around 1.4% growth per annum over the next 3 years, which is very weak when you consider population growth, which sits at around 1.6%.

In the second quarter South Africa already had a negative print, when the economy declined by 0.7%. Reasons for the poor economic performance were a number of sectoral strikes, ongoing loadshedding, and the floods in KwaZulu-Natal, which contributed to a reduction in exports. Finance Minister, Enoch Godongwana, noted that these developments, in addition to global headwinds, will potentially put pressure on South Africa’s fiscal dynamics. If the economy experiences another negative quarter, we would arguably be in a recession according to the textbook definition. And that is very possible, since this has been the worst quarter on record in terms of loadshedding.

This environment has put a lot of pressure on households, with debt levels going up and consumption falling, as consumers feel the pinch of rising inflation and higher interest rates. Although South Africa’s inflation dynamic is slightly different, as it is more supply-side inflation than demand side, it is still putting a lot of pressure on consumers’ disposable income. In addition, the South African Reserve Bank hiked interest rates by 75 basis points in September – a sixth consecutive hike since November 2021 and in line with the US Fed.

There are, however, some green shoots on the horizon. Firstly, the downgrades in terms of growth for South Africa, by the World Bank and International Monetary Fund, have been much less severe than for the rest of the world, but we are still facing global headwinds, like tighter liquidity, rising cost of capital, and the impact of a stronger dollar on the rand.

A second, but significant, green shoot is an increase in fixed investments. When we look at fixed investment as a percentage of GDP – things like factories, machinery and equipment – that number was around 18% of the GDP in 2014. During the Zuma administration, in an environment of uncertainty and a lack of policy reform, state capture, economic downgrades, and changes in finance ministers, that number fell to around 12% of GDP. However, from the middle of last year, that number has started to turn, and it has been a fairly strong turnaround, with three positive quarters in a row, which we have not seen in decades. This is strong evidence that there is greater private participation in the economy from power generation to logistics, and other private sector investments.

Some positive projects that are worth noting, include the biggest solar plant in the world being built in the Northern Cape, which will create around 2000 jobs. Although it will take another 15 months before it connects to the grid, it is a huge investment. Ford has invested in solar panels on their factory in Pretoria, in Rosslyn, which will take it off grid. The Brazilian branch of Ford will now be consolidated with the Pretoria plant making it one of the biggest motor manufacturing plants in the world.

Vedanta is investing billions into its zinc mine in the Northern Cape, making it one of the biggest mines in Africa. Our agricultural sector is currently booming, and our maize crop this year is expected to be the biggest in 20 years. This is good news as there is a lot of talk around food security. South Africa is only one of two countries in Africa that is a net exporter of food. This makes us a safe haven for food if things really deteriorate in the West. Although it is not all bad news, these projects will take some time before they reflect as sustainable growth.

Given the headwinds the country is facing, we are not going to see the benefits from these within the timeframe that we would typically look at. So, although we will eventually see the benefits of an improved private sector, we can expect to face some tough times over the next three to five years, and then after that, if we continue with reform, we can expect a period of above-capacity growth.

A volatile rand driven by local and global events

During the COVID-19 pandemic, the rand benefitted greatly from the commodity boom and agricultural exports. The trade surplus generated by exports greatly enhanced the strength of the rand. That surplus, however, was already under pressure before the world economy started to slow down. Now, with us paying more for fuel, petrol and the import of diesel to support Eskom turbines during loadshedding, we have turned this surplus back into a deficit. Also, as our imports increased, exports were also dramatically affected by the floods in KwaZulu-Natal, as harbours were put under pressure in the second quarter. When we were exporting more than importing, we were earning hard currency, which gave the rand room to breathe and ultimately strengthen. Now, as our imports surpass exports, the rand has been put under pressure, and the currency has weakened to levels north of R18.00/$.

But it is not just about a weak rand. The dollar, on the back of rate hikes, is sitting at a 20-year high, and the strong dollar has put a lot of pressure on emerging market currencies. The rand will remain under pressure until the dollar starts running out of steam. We expect the currency to trade back to around R17.00/$ over the next couple of months.

Investing to sleep well, eat well, live well

Given the issues discussed, markets have taken a battering since the beginning of the year. The US’s S&P 500, alone, is down more than 20%. Typical safe-haven assets were not spared, and global bonds and gold have been negatively impacted as rates started to normalise.

It has been a very tough year so far, and there has been nowhere for investors to hide. The Citadel Asset Management team, believes that the only thing that will preserve wealth in this environment, is optimal portfolio construction, and keeping our eyes open for opportunities – and there are still many good opportunities.

The recent repricing of US bonds brought 10-year yields back to 4% – making this an asset to consider again, whereas before, for many decades, they just weren’t an attractive investment option. Local 10-year bonds are currently trading around 11%, making South Africa one of the most attractive emerging markets, given the issues being faced by some of our peers, like Russia, Brazil and Turkey.

South African equity markets are facing some headwinds as lower growth will result in lower profits for companies. The question is how much has been priced in after this year’s strong sell-off? From a valuation point of view the JSE is looking attractive and is trading at price-earnings levels that promise good returns over the next three to five years. Global equity is slightly fuller valued but still offers some solid inflation-beating returns at current levels.

Also, it must be remembered that very tough years, like we have had in 2022, are historically followed by much better years, unless economic fundamentals get worse. This means we should see a strong rebound in many asset classes from these levels, despite the environment being quite challenging at the moment. However, we are going to have to remain agile as the next two to three years will depend on how central banks pivot and how quickly they start slowing interest rate hikes. This will not only impact the global economy but will also affect how quickly markets sentiment changes.

Now, more than ever, you need to stick to your cashflow plan. The first part of the plan is about “sleeping well”. You need to think about what money you are going to need over the next two years – your stable component, money in the bank that will experience no volatility. And because inflation is rising, it is best to keep this amount limited. You are not going to beat inflation with this money, but you can sleep well knowing you have enough to cover your immediate expenses.

Then, the next four to six years of cash will be invested into low-volatility investments, which have the potential to beat inflation and will act as a shock absorber during difficult times. Currently South African bonds should play a big role in this part of your portfolio. This is the “eat well” category, where the purchasing power of your money stays intact.

Then, finally, the money that you do not need in the short to medium term, you keep invested in growth assets, which will predominantly be equity markets. We believe that you need a long-term investment approach and we advise against trying to time the market. Things change quickly and this year the markets have been extremely volatile. What needs to be remembered at this time is that equities are cyclical and over the long term will usually always beat inflation, meaning this part of your portfolio is your biggest inflation hedge. This is the “live well” part of your portfolio where in time proper real returns can be generated.

So, as we prepare for 2023, this year will be remembered for themes like the Ukrainian war, the return of inflation, and central bank wake up calls. The current environment suggests we are in for a couple of difficult years. It will come down to how central banks will balance liquidity in the system. But given how Citadel constructs its portfolios, clients can rest assured that our processes and hands-on approach will ensure that over this festive season, and beyond, our clients can relax and “eat well”, knowing their wealth is in safe hands.