Well, it seems that the worst of the COVID pandemic is now behind us, from an economic perspective, as nearly 7 billion vaccines have been administered globally. This has led to a reduction in the successive waves of deaths globally and has led to the hope that global herd immunity can indeed be achieved. New mutations of the virus are bound to affect us for some years to come, but at least the world is learning how to live and deal with the threat. Global economies have rebounded sharply and in many cases are now ahead of where their trend extension would have been at the end of 2019!

Last quarter, I highlighted the impeding peak in economic growth rates globally was well and truly in our sights. It is now abundantly clear that the second quarter of 2021 indeed saw the peak of growth for most of the developed world, and emerging markets will follow soon. There’s one major important aspect about this specific cycle though, and that is that we’re not expecting global growth to go into a recessionary contraction, but merely to slow down from record levels to normal long-term averages. So, despite talking about a phase of economic slowdown that is upon us now, it’s merely a deceleration of growth.

Equity earnings followed the growth cycle perfectly, and we experienced massive global earnings growth for the year up to end of September. Bloomberg consensus is for another 25% of earnings growth during the next 12 months. This very strong earnings period will materially derate equity valuations and dispel fears of overvalued equity markets globally. However, earnings alone, aren’t going to deliver a smooth ride and a glossy gift to equity owners. This post-pandemic festival faces several speedbumps ahead.

Inflation has become the hottest topic under discussion, as the Federal Reserve’s (FED’s) Federal Open Market Committee (FOMC) described the current surge in inflation as merely transitory and is no cause for concern. Supply-chain bottlenecks and overall disruptions, however, are leading to enormous shortages across a wide variety of products, causing a strong surge in prices. Add to this a consumer starved of services for the past 18 months, with a healthy discretionary spending balance, and you have surging prices for services too. This fiery inflation cocktail is bound to be with us somewhat longer than what the FOMC anticipated with their original statement.

This fear of higher inflation and how that might impact the FED’s actions has shown up in the world’s most important bond market. United States treasuries started selling off, pushing their yields higher, and with them the global risk-free rate. Discounting future earnings at higher yields, leads to lower present values and so equity markets became more volatile as yields began rising. Now add to this a European energy crisis, with oil, gas and coal prices going through the roof, and you have inflation front and square ahead. Should the FED become overly concerned about inflation getting ‘out of control’, the market will fear faster, or sharper rate increases than what has already been priced into markets. Such rate hikes could cause market turbulence as various future rate scenarios get discounted by risk assets.

The other factor that started influencing the market’s assessment of future conditions is the Chinese regulatory environment. China, or maybe President Xi Jinping himself, decided to intervene in several industries under the theme of ‘common prosperity’. Several regulations were published in quick succession to regulate a variety of issues across the healthcare, education, technology and property sectors. Everything from the time children can spend on electronic games, to the prices of property, came under the spotlight. These regulations, literally by the stroke of a pen, rendered specific companies out of business and/or bankrupt. President Xi called this ‘communism with a Chinese flavour’. His motives are clear, as he tries to gain valuable support in his bid to be elected as lifetime leader of China during party elections early next year. The fact that the largest property development company in the world is being forced into bankruptcy is merely fodder in this political game with such an enormous prize. Real estate, credit, and investment markets globally are now all grappling with the possibility of knock-on effects and trying to discount ‘China-risk’.

So, the major global factors to watch now, are economic growth slowdown, inflation, the FED’s reaction to inflation, and Chinese policy actions. Whilst in South Africa, we are heading for local elections and the medium-term budget, we are nett beneficiaries of the higher commodity prices globally. As this tailwind fades into 2022, our domestic economic and political fundamentals will become more important drivers of our own journey. Markets are pricing in several interest rate increases for South Africa over the next two years, as we must keep up with global monetary policy tightening. Equity markets have not fully priced in significant further earnings gains for resources companies, making our local equities quite defensive, relative to their global peers. Our domestic financial markets will be caught in between slowing global dynamics and attractive domestic valuations. The result: Volatility!

At Citadel, our investment philosophy acknowledges that the future is uncertain and bound to surprise. This philosophy ensures that we analyse various future scenarios and implement investment solutions that are well diversified to navigate through periods of high volatility.

I hope you enjoy this edition of the Citation.

George Herman – Chief Investment Officer: Citadel Asset Management