March 2022 - Monthly House Views
Momentum Turns Negative
While we are still only in the first quarter, the year already feels much longer. It began with a sudden shift in the tectonic plates of monetary policy, with central banks grappling with stubborn, persistent inflation by signalling higher rates. The volatility has been exacerbated – greatly – by the Russian invasion of Ukraine. The human toll is grim; and it is tasteless to discuss the markets and make investment decisions in the context of such suffering. Nonetheless, it is our job, and we must proceed with the task at hand.
Firstly, we must recognise that our previous assumptions on inflation are too sanguine in the new context of the war. Until recently, oil prices were elevated but moderating; supply chain issues were widespread but easing. The current geopolitical crisis has sent oil and gas prices rocketing upwards alongside other commodities. In turn, this has exacerbated supply chain issues as fuel costs are the chief input cost in shipping. While we still believe inflation will moderate in time as oil prices settle and consumption patterns revert to pre-pandemic trends (i.e. more services and fewer goods), it is reasonable to expect the inflation peak to be higher, and come later, than prior to the outbreak of this war.
Secondly, as the upside risk to inflation has increased, so too has the downside risk to economic growth. Economic growth globally is still robust, and Russia accounts for less than 2% of global GDP at current market prices. Nonetheless, higher commodities prices will act as a drag on consumption, and some initial estimates suggest Eurozone and UK GDP could be about 0.5 percentage points lower than previously expected for 2022. Furthermore, Russia is a major global producer of not just natural gas and crude oil, but also potash, platinum, palladium, nickel and wheat; Ukraine is also a major producer of corn and barley. Supply for each will be curtailed, perhaps severely, impacting growth. For example, palladium is an important metal for the automotive industry, which is already suffering from a shortage of semiconductors.
Thirdly, the dispersion of outcomes for financial markets has widened. There is of course increased volatility. That is not uncommon. However, there is also renewed radical uncertainty. A concept popularised by the former Bank of England head Mervyn King, radical uncertainty describes a situation where historical data provides no useful guidance to future outcomes. No one knows how long the Ukrainian war will last or what the Russian president is thinking. Few expect this conflict to spill over to the rest of Europe, but until recently, few expected things to get as far as they have done. Many, including us, were too optimistic, and reliant on rationality. Clearly, all expectations on inflation, growth and returns from financial assets must be taken with a pinch of salt given the radical uncertainty posed by the carnage occurring on Europe’s eastern flank. It is fair to assume that the shorter this horror lasts, the less the long-term damage to markets; the longer it lasts, the bigger the downside economic impact will be.
As always, we choose to rely on our investment process, which is designed to guide our risk-taking appetite and investment decisions at all times, but especially when the outlook is cloudy and uncertain. Our process is telling us the following:
The economic outlook remains robust judging by the forward looking indicators we measure. There is no recession on the horizon, and economies are likely strong enough to absorb higher rates and a gradual “normalisation” of monetary policy. Purchasing Managers’ Indices (PMI) for most major global economies are well into expansionary territory, it remains easy and cheap for most households and companies to borrow money, jobs are plentiful and corporate revenues, earnings and margins are all at (or near) record territory.
Valuations had been our biggest source of concern coming into this year, but have moderated as prices for equities have fallen this year while earnings have moved up. Bear markets rarely occur with earnings healthy and rising. Moreover, while equities are still not cheap globally, particularly in the US, they are cheaper than they were, and they still remain more attractive than government bonds, where the real yields remain negative. It is also worth remembering that equities tend to be a better hedge against inflation than bonds, as do commodities.
Momentum for equities is now negative. This is the most significant change in our investment process, and one that we must recognise. Could momentum bounce back into positive territory? Of course it could, and if and when it does, we will take that into consideration. For now, this is a strong signal to cut some risk. It pays to remember that bull markets, such as we have been in until recently, tend to deflate over many months, not “burst”, as is commonly perceived. Incidentally, the only remaining asset class with positive momentum at present is commodities.
Sentiment in markets is neutral by the factors we look at. Anecdotal measures of sentiment may be signalling oversold but we are still very much in a “normal” sell-off, and global equities are down less than 10% from their peaks (as of 3 March 2022).
On the balance of the factors above, we have chosen to cut our equity weight from Overweight to Neutral, and gain exposure to commodities. Some may rightly ask if it’s too late to buy commodities given their stunning rise over the last year, and especially recently. However, we believe they are likely tilted asymmetrically to the upside: should the conflict worsen, commodity prices may still increase markedly; should the conflict subside (e.g. say China brokers a face-saving peace for all), commodity markets will likely remain tight given years of underinvestment in areas such as oil and gas. In any event, given that the inflation outlook has changed as a result of the war, the risk / reward equation of holding commodities – a natural inflation hedge - is now more favourable.
Process and Convictions
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C A25 /H1/21 Unless otherwise specified, all statistics and figures in this report were taken from Bloomberg and Factset on 03 /03/2022