By Tim Sharp
In a world that is suffering from high inflation due to supply disruptions, the tragic Russia – Ukraine conflict represents another supply shock for the global economy, the impact of which will depend largely on the length of the war and the effectiveness of the sanctions imposed upon Russia. The European Union does not have a good track record for decisive action but the implementation of the policies against Russia have probably surprised many, particularly the historic changes in foreign policy by Germany in support of Ukraine. Higher commodity prices are likely to have a global impact with oil, industrial metals, and agricultural commodities all impacted by the conflict, but the effects of European gas prices will ensure that Europe is hardest hit putting pressure on prices that will squeeze household incomes, and likely depress European growth. Europe is also likely to question its energy policies going forward with the long-term implications to growth and strategy that will cause. Higher commodity prices can correct lower through changes in supply, and although the US announced that it would use its strategic oil reserves to bolster supply shortages, this coupled with the uncertainty regarding the ongoing conflict, and the effectiveness of sanctions, has so far failed to pause the rising price of crude oil. The alternative potential headwind to higher commodity prices is lower demand caused from tightening central bank policy response, and an unwillingness from the consumer to spend in uncertain times when household incomes are under pressure. Absolute Strategy Research (ASR) point out commodity price inflation tends to fade with world trade growth[i].
Judging by Jerome Powell’s speech to the House of Representatives Financial Services Committee, the US feels far enough removed from the Russia – Ukraine crisis for it not to affect Federal Reserve policy. Governor Powell intimated that policy was likely to tighten 25bp at the March meeting drawing a line under the speculation that the rise might be 50bp or even deferred due to the conflict in Europe[ii]. The speech also confirmed to us that the Fed’s attention has turned firmly to inflation at the expense of growth in the short term. We believe wage inflation is a big consideration for the Fed because the policies used by the US during the pandemic did not furlough workers but offered direct financial compensation. This has led to a much higher flexibility within the employment market, a higher churn rate, and in turn, a boost to workers’ bargaining power as they re-enter or move around the jobs market. Therefore, the fed appears to fear that sustained wage growth through pressure in the labour market may keep inflation elevated. We believe that wage growth and earnings will be key to Fed policy going through this year as balancing upward wage pressure against corporate earnings will provide an indication as to how the economy is progressing. We have been mindful of the possibility of a central bank mis-step due to the delay in quantitative tightening reducing the tightening landing strip and believe that the Russia-Ukraine conflict has heightened the possibility of this occurring. While earnings are growing albeit at a slower pace, it is unlikely that the economy will roll over into recession, but a war that is likely to drive inflation higher and eventually cause global growth to contract will create a more difficult environment for central banks to set appropriate policy.
Following the invasion of Ukraine, equity markets reacted in line with our expectations by selling off on uncertainty before rebounding once the facts of the situation start to be released. There is still much that is unknown regarding the geo-political risk surrounding Russia’s overall intentions, the likely protraction of the conflict, and the fallout from the aftermath. There seems to have been very little evidence of the “buy on dip” mentality that had underpinned equity markets throughout the pandemic. ASR point out that fundamentals suggest that US equities are trading in line with their 10-year average trailing earnings of 21 times, while Europe are trading on a 20% discount to their trailing earnings of the last decade of 14 timesi, so we would argue that there is little need to rush back into risk assets but remain in defensive equity strategies.
The rotation into quality stocks with strong earnings protection and predictable dividend policies suggests that investors are also focusing on high inflation rather than slowing growth. We believe it is unlikely that the global economy rolls over into recession while earnings are growing, therefore, reporting seasons in the second and third quarters will be key to understanding the impact of the current pressures on earnings. This also spreads to the ability of companies to maintain dividend policies in the light of potentially tighter margins, and we feel that the maintaining of dividends will be another touch point for signs that companies are under pressure. The threat of recession and stagflation has seen bond yields fall once more and yield curves flatten putting pressure once more on the banking sector, particularly in Europe where exposure to Russia is inevitable. The iShares Euro Stoxx Bank ETF is now 24.77% weaker year-to-date having fallen 11.61% in February.
This environment seems to favour the mix of companies within the main FTSE UK indices which are dominated by energy, pharmaceutical and domestic banking stocks and possibly explains the outperformance of the FTSE 100 Index when the main indices have been in drawdown. Over the month of February, the S&P500 fell 5.01%; The German DAX was down 6.53%; and the Nikkei 225 in Japan fell 1.76%, while the FTSE 100 fell just 0.08%. Oil prices remain elevated, particularly as US allies discuss adding oil to the growing list of sanctions against Russia, and inventories remain very low, which will continue to support the earnings, and dividends paid by the energy sector. After years of underperformance since Brexit the UK equity markets seems to be rewarding investors with the right breakdown of exposures in the current climate.
We would also draw attention to John Authers Points of Return newsletter dated March 7, 2022[iii] which points out that commodity exporting companies such as Canada, Australia, Brazil, and Norway have also outperformed global indices so far in 2022 and the situation is likely to continue over the rest of this year in the current climate of supply disruptions. More generally we had been researching Emerging Market Local Currency Debt prior to the invasion as a fixed income diversifier but feel that such a move now would add unwanted volatility to portfolios.
China’s policy moves to encourage a more consumer-led economy seem to have been deferred in the latest five-year plan as it looks to boost productivity through manufacturing. This coincides with a need to be more self-sufficient to secure supply chains that have proven frail during the pandemic. Many large consumer countries have suffered from just-in-time delivery problems, and global supply chains that have proven unreliable when challenged by a global event such as Covid-19. An emphasis on onshoring is likely to replace globalisation, in our opinion, to secure manufacturing supply chains, and due to changing views surrounding climate change. This could have implications for growth in emerging markets and the general cost of goods in the future suggesting negative global GDP growth effects.
[i] Absolute Strategy Research – Investment Committee Briefing – March 1, 2022
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