Strategy
Another Inflationary Shock
The first quarter of 2022 was an eventful one. The sharp hawkish turn by global central banks - particularly the US Federal Reserve - and Russia’s invasion of Ukraine dominated the landscape, with inflation being a common thread.
It was hoped that the pickup in inflationary pressures seen last year would start to abate as the world returned to normality after the pandemic and demand shifted from buying durable goods back to services. However, late last year it became clear that inflationary pressures were broad based and not purely confined to the sectors most exposed to the pandemic, such as used cars, computer hardware and furniture. Central banks had characterised the rise in inflation as “transitory” but at a Congressional testimony in November, Federal Reserve Chair Jerome Powell admitted that it was “probably a good time to retire that word”.
Russia’s invasion of Ukraine in late February has been a humanitarian tragedy, a significant wakeup call for the West and an untimely inflation shock in the form of higher commodity prices. This shock is a global one. While Russia represents only around 1.7% of global GDP, Russia and Ukraine together have sizeable commodity exports spanning energy, metals and agricultural goods. Europe is the region of the world most exposed to higher energy costs given their reliance on Russia for oil and natural gas and rising food prices will hit Emerging Market consumers and those on low incomes particularly hard. It is estimated that the bottom quintile of earners in the US spend around 27% of their after-tax income on food. In a letter to shareholders, Blackrock CEO Larry Fink recently wrote: “the ramifications of this war are not limited to Eastern Europe… they are layered on top of a pandemic that has already had profound effects on political, economic and social trends. The impact will reverberate for decades to come in ways we can’t yet predict.”
Geopolitical experts and Russian-focused academics both failed to predict, or assigned a very low probability to, a full-scale invasion. Occupying Ukraine and toppling the government was not seen as a realistic prospect. The invasion therefore came as a shock to financial markets and the initial response was somewhat calculable: the US dollar appreciated, US Treasury yields fell (prices rose), equities sold off and commodity prices jumped higher. After these initial moves, the bond market began to appreciate the Russia-Ukraine conflict was unlikely to derail the Fed’s plan to move interest rates higher, especially as it has added to inflation expectations.
Unlike Europe, the US economy is relatively well positioned to cope with supply disruptions to energy, agriculture and other commodity exports from Russia and Ukraine. The US has a balanced to modest surplus in both energy and agriculture trade in addition to the world’s largest defence sector, which is likely to see increased orders from Europe. The sanctions imposed by the West on Russia have been designed to inflict maximum economic pain on the country and minimum cost on the West, meaning natural gas has continued flowing into Europe which is critical for German industry. However, there are now growing pressures to increase sanctions and move away from reliance on Russian energy supplies. The decision by the US and its allies to freeze Russia’s foreign reserves, stockpiled to guard against inevitable economic sanctions, has been hugely significant. It has also unleashed an intense debate about the future of the international monetary system and the role of the US dollar at its heart. Importantly, all G7 countries moved to freeze Russia’s foreign currency reserve assets, so while the US dollar may now be less attractive as a reserve asset, the alternatives with sufficient liquidity and allowing for the free movement of capital are extremely limited.
Overall, financial markets bounced back strongly in the last three weeks of March. While Russian equities only account for around 0.2% of the MSCI All County World Equity index, the spillovers from high commodity prices increase the risk of an economic slowdown or potential recession in Europe. Real incomes were already under pressure from inflationary pressures. Economic growth forecasts have been revised down while inflation forecasts have been revised higher; not a good mix. This means earnings growth will come under pressure this year.
We took some steps to reduce risk at the beginning of the year: reducing credit risk in bonds and cutting Consumer Discretionary exposure in Equities while adding to Consumer Staples. Portfolio turnover since the Russia-Ukraine invasion has been low but our portfolios are designed to be resilient to a range of shocks. Our underweight to Fixed Income and overweight to Alternatives (especially commodities and gold) were very beneficial in the first quarter.
Equities
Surprising Resilience
Global equity markets gained +2.7% in March to finish the quarter down -5.2% in US dollar terms, recovering from a significant -12.9% intra-quarter drawdown. Markets recovered in March despite rapidly rising interest rates, with the US Fed looking to combat ongoing inflationary pressures by hiking rates for the first time since 2018 and raising expectations for both the pace and magnitude of tightening to come. Oil and gas prices spiked as the Russia-Ukraine conflict escalated before declining towards the end of the quarter with an announced release of one million barrels per day from America’s Strategic Petroleum Reserve.
Emerging Markets were mixed with Russian assets seeing precipitous declines, other commodity exporters such as Brazil and South Africa benefiting, and Chinese equities experiencing significant volatility. In March, China’s top economic official intervened with a rare wide-ranging statement suggesting the government would take measures to “boost the economy” and introduce “policies that are favourable to the market”. The comments were made after a special meeting of the State Council’s Financial Stability and Development Committee, which oversees the country’s main financial regulators, including the central bank and securities watchdog. Investors in Chinese companies had been buffeted by slowing economic growth, inflationary aftershocks from the war in Ukraine, a long-running government crackdown on companies in the Technology, Education and Property sectors, and China’s zero-tolerance policy on COVID-19 despite the more transmissible Omicron variant.
A common market narrative has been that high equity valuations were supported by ultra-low interest rates, especially for companies with low or no current earnings but the potential to generate higher earnings in the distant future. It is interesting to note that in recent weeks, these high growth stocks have been performing well even with interest rates on the rise. While it is intuitively attractive that high discount rates reduce the value of cash flows paid out far in the future, the recent disconnect demonstrates the risk of leaning too heavily on apparent relationships and correlations between asset given that they can shift quickly. This is especially the case in a world where global events are moving so fast and rapidly impacting both newsflow and sentiment. The more recent narrative has been that equities are an inflation hedge, supported by a company’s ability to raise prices. It’s worth being wary of shifting narratives that both environments support high stock valuations.
A backdrop of higher commodity prices and broad based inflationary pressures is one in which there is a lot of dispersion between the winners and losers of such an environment. Most obviously, commodity producers benefit from higher commodity prices, while companies using commodities as an input see profit margins pressured. The Energy sector significantly outperformed the overall market in the first quarter and continued its recovery from the depths of the COVID-19 crisis in March 2020. This also demonstrates the importance of diversification and building portfolios resilient to withstanding a range of different economic shocks. The Materials sector performed well as the Metals & Mining stocks saw broad based gains, with Fertiliser and Agricultural Chemicals companies also making good progress as global commodity prices rose. From an economic perspective, the risk with higher commodity prices is that the benefits accrue to a relatively narrow range of producing companies or countries while the pain is spread widely across all consumers. This is something we are monitoring closely and this squeeze on real incomes was a factor as to why we reduced our exposure to the Consumer Discretionary sector and increased exposure to Consumer Staples in the first quarter.
Analysis of investor flows show that leveraged investors (hedge funds) have been aggressively reducing their equity exposure. Short covering by these investors can help to explain why some of the longest duration equities have recently risen sharply despite rising interest rates and a more hawkish Fed. Retail investors have also continued to buy the market dip, deploying cash holdings and reallocating from bonds into US equity funds.
Prior to Russia’s invasion of Ukraine, the global economic picture was one of ongoing recovery from the pandemic. The latest data placed growth in the US, Euro area and UK above trend and the services sector recovery is moving past its Omicron setback. The Fed’s view is that recession is not imminent and the US economy remains strong enough to weather higher borrowing costs. Nevertheless, the outlook for growth has become a lot more challenging as the war in Ukraine has increased commodity prices at a time when inflation pressures were already elevated.