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Dear Investor

General Market Overview

The coupled macroeconomic factors of interest rates and inflation and continued geopolitical manoeuvring continue to dominate the global market and economic landscape. In terms of interest rates, all eyes are on the United States (US) Federal Reserve (the Fed).

Each year, the Federal Reserve Bank of Kansas City hosts central bankers, policymakers, and academics at an economic policy symposium at Jackson Hole. Statements from Jackson Hole are closely scrutinised, particularly those from Fed Chairman Jerome Powell.

Recent statements under scrutiny are from the Fed Chairman’s third Jackson Hole address since inflation emerged as a major macroeconomic issue. These addresses are significant because they frame the monetary policy debate for the coming year. In summary, Jerome Powell said the Fed are “prepared” to raise interest rates further if needed but will proceed carefully and that the Fed will keep its 2% inflation target. Much of what was communicated has been interpreted by market participants that the Fed may not hike interest rates again but will likely leave them unchanged at a higher level for longer to ensure inflation is tamed.

While the federal funds rate is an anchor on the US yield curve, interest rates across a range of maturities have hit 16-year record highs during August. The 10-year yield reached 4.35%, while a 3-month T-Bill yields over 5.5%. Higher interest rates across the yield curve add to the government interest and debt burden. Newly issued debt is now yielding more than the long-term expected growth rate of the US economy. When the interest rate exceeds the economic growth rate, there is a real risk that debt continues to grow, increasing the debt-to-Gross Domestic Product (GDP) ratio even if government spending is curtailed.

In a move common within a South African context, credit rating agency Fitch downgraded the US top credit rating from AAA to AA+ in early August, citing “fiscal deterioration and repeated debt ceiling negotiations that threaten the Government’s ability to pay its bills.” Of course, the US Treasury and the White House strongly disagreed with the decision, calling it “arbitrary” and based on “outdated data”.

From a global perspective, the genuine concern is that while inflation has recently declined from its peak a year ago, the inflationary pressures have not disappeared. Some market participants have drawn comparisons with the shape of the past decade’s inflation curve, which shadows the path from 1966 to 1976 before inflation accelerated in the late 1970s.

It remains to be seen how the macroeconomic environment unfolds, but it seems unlikely that US interest rates will be cut, which means the era of easy money is over.

Another market in which inflation and interest rate decisions are monitored closely is Japan. After 14 years of deflation, Japan’s core inflation has risen and stayed elevated. Between 1998 and 2013, consumer prices fell a cumulative 5% in Japan, -0.4% year-over-year (y/y), but recently, headline and core inflation rates have been the highest in 30 years.

The uptick in inflation can be primarily attributed to a rise in wages. According to Rengo, representing 5,000 unions across multiple industries, workers recently won their highest wage hikes in 30 years. Besides keeping up with inflation, the wage gains are partially due to the extreme shortage of workers. Japan’s labour market tightness for prime-aged workers (25 to 54 years old) is the most extreme among major nations.

The Bank of Japan (BoJ) has kept rates at -0.1% since 2016 and left this unchanged at their recent meeting. Since 2016, the BoJ has maintained negative short-term rates and held the 10-year government bond yield at around 0% with a fixed band of 0.5% above and below this rate. This policy has been known as yield curve control (YCC). However, in late July, the BoJ “tweaked” their YCC policy, stating that they would allow the 10-year to move above the 0.5% band as long as it stayed below 1%. Given that inflation has remained above the 2% target for longer than was expected, the slight loosening of the YCC policy allows a little more flexibility in Japanese interest rates and “sets the stage” for further future monetary policy amendments.

Outside of macroeconomic indicators, another feature of the current global geopolitical environment is the ongoing Western sanctions on Russia designed to affect the country’s economy and make financing its war effort in Ukraine harder.

However, several trade anomalies have appeared, and it doesn’t take much insight to “join the dots”. United Kingdom (UK) goods exports to Kyrgyzstan jumped by over 4,000% in 2022/23, with overall exports to the country more than doubling. Over a similar period, Kyrgyz exports to Russia also doubled.

You may be forgiven for not knowing exactly where to find Kyrgyzstan, officially the Kyrgyz Republic, a landlocked country in Central Asia (OK, OK…in the spirit of transparency neither did we!)

The UK’s impressive export growth to Kyrgyzstan contrasts with the official stance: “We have introduced the largest and most severe economic sanctions ever imposed on a major economy and have wholly or partially sanctioned over 96 per cent of goods traded with Russia in 2021.”

The UK is not alone; Germany’s exports to Kyrgyzstan in the first half of 2023 are up 1,400% relative to the first half of 2019. The most significant component of this increase is the export of motor vehicles, up 6,000%. It would seem Russian oligarchs still want their luxury German cars!

It’s not just Kyrgyzstan that has been the recipient of German exports. Exports to Georgia were up 87% in June 2023 from June 2021, while exports to Kazakhstan were up 137% over the same period.

Similarly, China export data shows a marked uptick in exports to Turkey, Belarus, Uzbekistan, Kazakhstan, Kyrgyzstan, and Azerbaijan.

Goods are flowing in the other direction, too. Russia exports 83% of its shipborne oil from the Black Sea and Baltic ports. Despite European Union (EU) sanctions, Greek-owned oil tankers make up 75% of tanker capacity out of Black Sea ports and 60% out of the Baltic, meaning Greek shipping companies have continued to profit irrespective of the politics. Where there’s money to be made, the (free) market will find a way.

General Conclusion

The global economic landscape is a constantly shifting terrain marked by complexities and uncertainties. Central to this landscape is the role of the Fed and its pivotal stance on interest rates, especially in the context of US economic developments. Jerome Powell’s recent statement that the Fed is “prepared” to raise interest rates, if necessary, albeit with a cautious approach, has ignited discussions about the potential trajectory of monetary policy. Many market participants interpret this as a signal that interest rates might remain stable but higher for an extended duration, aimed at tackling the potential threat of persistent inflationary pressures.

In the broader geopolitical context, the ongoing Western sanctions imposed on Russia continue reverberating through global trade patterns. These sanctions have given rise to some intriguing anomalies in trade data, one of the most notable being the surprising surge in UK and German exports to Kyrgyzstan. This peculiar trend raises important questions about the efficacy of sanctions and underscores the remarkable resilience of global trade networks in finding alternative routes when faced with regulatory obstacles.

What becomes evident from this trade data is that no matter how rigorously regulations may attempt to control market participants, especially in situations where substantial profits are at stake, markets demonstrate a remarkable capacity for adaptability and resilience. This inherent ability to find alternative paths and workarounds is an intrinsic feature of free markets. Put differently, hypocrisy is, as ever, alive and well (thriving even).

The lesson for investors and policymakers is to remain flexible and responsive in the face of evolving economic dynamics. The complexities of the global economy mean that it is challenging to accurately anticipate all potential outcomes and ramifications of policy decisions. The need to remain flexible in the face of new data is valid for investors and policymakers as it is always difficult to fully predict the “second-order effects” of policy decisions.

15 September 2023

General Market Commentary Q3 2023
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