STUART THEOBALD: When it comes to asset outlook the worst is not being priced in

The Overton Window describes the acceptability of policy ideas to the electorate.

Radical and unthinkable ideas fall outside it, and within are the range of options that an electorate would consider sensible or even popular. Radical populist politicians can expand it, widening the space for more mainstream politicians to be seen as sensible.

I recall this concept because it is vaguely like a problem I’ve been trying to describe about financial markets: how big is the window of economic scenarios that investors are comfortable with? That window has been expanded dramatically in the past few years because once radical and unthinkable events have happened, and we’ve survived. We have had a once-in-a-century pandemic, the invasion of a sovereign democratic country by a world power, and now generational inflation highs. Yet global markets have largely taken these in their stride. Almost any economic scenario, no matter how damaging to growth, seems to elicit barely a shrug from investors.

This is at least in part because of the credibility gained by central banks and policymakers since the financial crisis. When Covid-19 hit, they promised to do everything to protect economies and largely succeeded, relying on the playbook written during the financial crisis 14 years ago. But the kryptonite that policymakers have always acknowledged would undo their efforts is now here: inflation. It destroys the one superpower they have had, the ability to create money with little to no cost.

While global markets are down 14% in the year to date, that is from the record high at the end of 2021, which was 80% up on levels just before Covid-19. Equity markets seem to be pricing for a quick phase of inflation that will do little to trip up growth or policymakers’ efforts to stimulate profits. But debt markets are looking rather different. A year ago, interest rates were expected to stay under 1% for the next seven years. Today, the US yield curve is showing that rates will rise sharply to almost 3.5% over the next year and stay close to that level for the next 30 years. That is a dramatic shift in the cost of capital in the global economy, yet equity markets aren’t feeling it.

It’s not that no-one is saying anything. JPMorgan CEO Jamie Dimon two weeks ago caused ripples by saying he saw a 10% chance of avoiding a recession, and then put equal odds on the kind of recession being mild, “harder” and “something worse”. Other global bank CEOs have also been sounding alarms. Goldman Sachs CEO David Solomon said in an interview last month: “Any time you have high inflation and go through an economic tightening, you wind up having sort of an economic slowdown.”

This view is largely shared by our banks, though the language is more guarded. Nedbank noted in its results earlier this month that “the global economic environment is expected to deteriorate further before recovering”, and Standard Bank said “global growth is expected to slow as tighter financing conditions take effect”. Both banks are more sanguine about local SA prospects, protected by a somewhat better inflation outlook and a stronger post-Covid recovery trajectory.

The worry is that global inflation may take hold, cascading through supply chains for years even as energy prices fall. The Ukraine war looks interminable with long-lasting effects on food and energy prices. Supply chains are still not working at full capacity thanks both to ongoing Covid-19 disruptions in China as well as the war.

SA benefited from a spike in commodity prices, particularly platinum group metals, through Covid-19 and into the Ukraine invasion. That had a particularly positive effect on government finances, allowing SA to turn the national debt trajectory a little sooner than expected. But those prices are now at pre-Covid levels, and a global recession would likely push them down further. There are certainly countervailing narratives — climate change adaptation is going to drive consumption of several commodities that SA produces (from chrome to nickel) so even within a recession, prices will find support. But overall, things are not going to be as robust as they were the past two years.

So what should investors be doing? My view is that the economic Overton window has expanded too far. We are too at ease with a seriously negative outlook. The era of cheap money is over and if there is a global recession, SA’s relatively stronger story is not going to stand against it for long. If inflation proves persistent, markets will have to adjust to price in a higher cost of capital and a darkened earnings outlook for companies. Both should be sharply negative for asset prices.

Of course, we should always hope for the best, but we must prepare for the worst. At the moment, the worst is not being priced in.

 Theobald is chairman of research-led consulting house Intellidex. This article first appeared in Business Day.