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Citation – Fourth Quarter 2021


“Make my day!”

George Herman
Chief Investment Officer
Estimated reading time: 5 minutes 10 seconds

It was a bit like a gold rush in the markets last year. Although, Omicron sent new case numbers through the roof, it fortunately has had a low death rate. Markets applauded this development with a wonderful festive-season rally in just about all asset classes around the world. Developed-market equities enjoyed an enormous growth in earnings during the year and as such, earned their high valuations around mid-2021. Emerging-market equities were less well-heeled, but were still able to end the year strongly while still looking fairly valued. Global bond markets had a somewhat tougher time as the United States (US) Federal Reserve (Fed) turned decidedly more hawkish on the interest rate outlook for 2022. That didn’t bother South African bonds though. They too had a good festive season rally, coming off a solid year which saw them deliver returns double that of cash.

So, as we kickstart 2022, the markets are suggesting a slightly different year:

The Fed needs to tackle high inflation. Current inflation in the US is at its highest in 40 years, yet bond yields have hardly risen at all. Despite inflation going from 3% to 7% in a very short period, 10-year yields have only moved from 1.20% to 1.80%, leaving real rates dramatically negative. This is telling us that the bond market clearly assumes that inflation will return to more normal levels relatively soon, closer to the Fed’s target of 2.5%. This is what the Fed referred to in its original “transitory” description of inflation. This is a dangerous assumption as many of the components of current inflation, don’t look that temporary to us. The FED recognised that they may have got things wrong at their December meeting and their subsequent statement made it clear to the market that they are ready and willing to hike interest rates to fight off inflation and immediately start reigning in quantitative stimulus measures. This process is commonly referred to as quantitative tightening as bond coupons and maturities are not reinvested by the Fed, allowing their balance sheet to gradually reduce in size.

  • With liquidity tightening, continued company growth may face some headwinds. Our economics team is confident that global growth, led by the US, has enough momentum, thanks to healthy consumer balance sheets and sentiment, to keep growing despite interest rate hikes. Most developed market equity markets, however, have started the year on the back foot as interest rate fears trip up growth and technology stocks.
  • In South Africa we’re experiencing some extreme weather patterns with both droughts and floods causing chaos in different regions of the country. Our agricultural crops have been severely disrupted and food inflation will be strong over, at least, the first half of 2022. Currently corn and sugar are up more than 25% since the start of 2021 and soybeans are up over 55%.
  • The South African equity market started 2022 in a very good mood following the festive rally and have extended their gains. Stubbornly high commodity prices underpin our resources sector, whilst value in the market has predominantly been seen in the local banking sector. The performance of the commodity and financial sectors last year, helped the Johannesburg Stock Exchange (JSE) to achieve record highs. This market is now in-between two mighty forces and will be asking for a lot of forgiveness as volatility is sure to follow. On the one hand global liquidity will recede and place all emerging markets under pressure, but on the other hand the JSE is valued very cheaply and is more compelling compared to its competitors.
  • The rand is also asking for a second chance, after losing more than 15% during the second half of 2021. However, stepping into the ring against a dollar that just won’t weaken despite everybody calling for its demise, is a stretch too far. South Africa’s exposure to commodities is positive, but its fiscal erosion is constant and powerful. Despite bouts of strength, the end- result for the year will be inevitable.

But here is the key issue we are facing in 2022:

The major reflation – trade that started at the end of March 2020 and carried on to the end of 2021 – saw global central banks, led by the Fed, create a very loose and supportive liquidity environment by lowering interest rates and adding quantitative easing support to the economy and markets. Despite what you thought about valuations or pandemic risks, you were told: “Don’t fight the Fed”. This school of thought became endemic and so all asset classes rallied without much volatility. Anybody questioning this development was castigated by a herd of young, know-it-all buy-the-dippers. They even ventured into new strategies of buying bankrupt companies; creating short squeezes on hedge funds; buying worthless assets and creating so much hype that even savvy investors started experiencing FOMO – fear of missing out. Now it is time to question this wisdom. With global central banks hiking interest rates and quantitative tightening commencing; will these same assets still be able to continue on this ‘fabricated’ growth trajectory?

In addition, several analysts have criticised the Fed, saying that they are “behind the curve”, implying that they are too late in their bid to raise interest rates and fight inflation. In the December Fed statement, the Bank boldly stepped out into the street, and like a cowboy in a western movie, tipped its hat and put a hand on its revolver. Everybody else scampered away, except those mighty buy-the-dippers, who stared down the Fed down with their laser eyes. As I dived behind a barrel of diversification to avoid the coming showdown, I saw the mighty Fed, narrow its eyes, as it said: “Make my day!” The herd of retail traders reached for their margins at the first dip in the market and raced towards them. What followed was an onslaught of 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.