With the first quarter of 2022 over, and as I sit here collecting my thoughts and observations of what happened, and indeed what could happen in the future, the world is certainly a different place than at the start of the year!
Download PDF VersionWith the first quarter of 2022 over, and as I sit here collecting my thoughts and observations of what happened, and indeed what could happen in the future, the world is certainly a different place than at the start of the year!
As Russia’s invasion of Ukraine becomes more violent, the world is on the cusp of what may become the worst energy crisis since the 1970s. Whereas those crises only involved oil, Russia is one of the world’s largest producers of nearly every form of energy—oil, natural gas, coal and even the fuel used in nuclear power plants.
The unfolding energy calamity demands an immediate response to keep cars moving, homes powered and heated, and to prevent a global recession induced by high energy prices. But as policy makers look for quick fixes, there is also the urgency of weaning the world from fossil fuels, asa major United Nations report made clear last month. In the long run, doing so benefits not just the climate, but also energy security for large consumers of fossil fuels. Pragmatic policies are needed that ensure secure and affordable energy today, and that helps to bring about a lower carbon future.
The war in Ukraine has escalated and triggered a growing humanitarian crisis. Sanctions have been imposed, disrupting commodity flows and creating extreme volatility in some markets. Cease-fire talks have yet to yield results.
The U.S. stock and bond markets appear to be conveying drastically different assessments of the growth outlook, leaving investors to decide which view will prevail.
The S&P 500 has come roaring back from a -13.04% decline and finished the quarter -5.57% (see table below) after a rebound that has defied worries over tighter monetary policy and geopolitical instability stemming from the war in Ukraine.
Many stock investors have even shrugged off a brief inversion of a closely watched section of theU.S. Treasury yield curve – a phenomenon that has predicted past recessions.
Bond investors appear far more pessimistic on the economy, with the ICE BofA index (an index which tracks US government and corporate debt) on track for its worst start to the year ever on worries that the Fed (The US Federal Reserve) will cause a recession by aggressively tightening monetary policy in its bid to fight surging inflation.
Yields on the benchmark 10-year Treasury are up 81 basis points this quarter and stand near their highest level since May 2019 (a sign of investor sentiment about the economy. A rising yield indicates falling demand for Treasury bonds, which means investors prefer higher-risk, higher-reward investments. A falling yield suggests the opposite).
Illustrating the countervailing forces in markets, the CBOE Volatility Index (viewed as a “gauge off ear” in equity markets) stands not far from its lows of the year, with investors pinning the reversal in stocks on everything from quarter-end rebalancing to buying from retail investors. At the same time, the ICE BofAML MOVE index, which tracks Treasury yield volatility, remains elevated.
Elsewhere, the Fed increased interest rates for the first time since 2018, responding in part to the effect of higher commodity prices on inflation. China, facing its biggest COVID-19 outbreak since the beginning of the pandemic, has signalled a potentially major shift in economic policy.
The World Trade Organisation slashed its global trade growth forecast for 2022 in half because of“the impact of the war and related policies”. The forecast had been for 4.7% growth, now it is 2.5%.Pandemic-related supply chain problems were also to blame. Ngozi Okonjo-Iweala, the WTO’s director-general, said that disruptions will increase the price of food and said she was worried that a“food crisis” was “brewing”.
We ended our report at the end of the last quarter that “we remain steadfast that we should keep a longer-term perspective amid shorter term fears” and this strategy has largely paid off to date, although the volatility in the markets has caused us, and our clients, many sleepless nights.
We have selected four key indices as a representation of the markets rather than a substitute for the whole market as they are probably the most recognizable for our clients.
As you will have noticed, the last few weeks have given strong rises across all the indices so that the figures at the beginning and the end of the quarter do not reflect the volatility.
Stocks have risen in part because rising bond yields and inflation have left many market participants believing that “there is no alternative” to equities. Yet further sanctions on Russian oil could lead to an “unavoidable” recession, according to the Fed.
In the near term, we believe that outcomes for markets will focus primarily on the question of when we will reach—or if we have already reached—peak sanctions and oil prices. The answer to this is uncertain, too. Some European diplomats have sounded upbeat about prospects of a resolution to the war, yet their American counterparts have offered more caution, and in a recent German survey,55% of those surveyed are in favour of no longer importing gas and oil from Russia, even if it leads to supply problems.
Given the uncertainty though there are still areas where we have greater visibility about the future.
They are likely to remain in place regardless of whether a cease-fire is agreed in the coming weeks. This means commodities and energy-related equities will continue to do well.
Costs are likely to lift inflation and contribute to higher rates. The Fed has already hiked interest rates and signalled a greater willingness to do more, sooner. In an environment of rising rates global value and financial stocks will be central in a diversified portfolio.
The world may also be heading for the most powerful energy shock since the 1970s. With Russia’s significant petroleum exports reduced, consuming economies are looking to the Organisation of thePetroleum Exporting Countries (OPEC) for relief. With oil markets tight, and prices above $100 a barrel and the prospect of further disruptions from the war in Ukraine, a big increase in output would be welcomed by politicians concerned about soaring petrol prices and rising inflation. Alas,OPEC+ is unlikely to ride to the rescue. One reason is loyalty to Russia. Another is concern about afresh wave of covid-19 cases weakening growth and demand for oil. All 23 of the experts surveyed byBloomberg, predict that the cartel will stick to plans for only a modest increase in production.
In a counterbalance to this President Biden recently announced that his administration would release 1 million barrels of oil per day from the reserve for the next 180 days. The StrategicPetroleum Reserve (SPR) is an emergency stockpile of petroleum maintained by the United StatesDepartment of Energy (DOE). It is the largest known emergency supply in the world, and its underground tanks in Louisiana and Texas have capacity for 714 million barrels.
Russia’s invasion of Ukraine will usher in a new era of security around the world, spanning the areas of energy, food, data, national defence, and climate. We expect heightened international mistrust to spur governments and corporations to put greater emphasis on security and stability over price and efficiency.
Putting this into context Russia and Ukraine together supply 26% of the world’s export of wheat, 16%of corn, 30% of barley and about 80% of sunflower oil and sunflower-seed meal. Ukraine provides about half the world’s neon, used to etch microchips. Russia is the world’s third-largest oil producer, second-largest producer of gas and top exporter of nickel, used in car batteries, and palladium, used in car-exhaust systems, not to mention a large exporter of aluminium and iron.
With higher energy prices stoking inflation, investors should prepare for higher rates.
Following more hawkish (Hawks are seen as willing to allow interest rates to rise in order to keep inflation under control) comments from Fed Chair Jerome Powell, markets are pricing around 200basis points of tightening for 2022, including the 25-basis-point increase earlier this month. That would be the fastest pace of tightening since 1994.
The European Central Bank (ECB) is moving at a slower pace because the inflation it is trying to tackle primarily stems from energy prices, an imported cost that the bank has little control over.
At its meeting ending on 16 March, the Bank of England increased rates by 0.25 percentage points, to0.75%. The Bank was forced to raise rates as annual inflation hit 6.2%, the highest level for 30 years.The Bank is now predicting inflation will hit 8% in the coming months (bearing in mind their target is2%) and is pricing in more rate rises this year. The market is predicting 2% by February 2023 and as high as 2.3% by the end of 2023.
Having considered all potential outcomes we consider a possible future trajectory.
The war continues as no decisive victor emerges, but developments allow sanctions and the oil price to peak by the summer. Falling inflation in the second half of the year allows monetary policy concerns to ebb and markets to move higher. Commodities and energy stocks remain well supported, financials perform well amid rising rates, and quality stocks that have been indiscriminately sold alongside the broader market stage a recovery.
Equally though we could have a more negative, or dare I say more positive outlook, if the war finishes sooner than expected.
We have some interesting conversations looming with the investment managers about the portfolios as I am sure there will be differing views across the marketplace, but as we assess the valuations of the portfolios in the coming days, I would remind you all once again we remain steadfast that we should keep a longer-term perspective amid shorter term fears.”
Mark Estcourt
CEO
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