The situation in Ukraine has become extremely serious. Our thoughts go out to all those suffering in the conflict.
This note provides a brief comment on some of the economic and financial market developments of 2022 to date and revisits the positioning of our recommended portfolios. The headline is that investors, having started the year believing that economic growth would remain robust despite rising interest rates, now must contend with an energy price shock bearing down on the growth outlook and adding further upward pressure to inflation. We remain of the view that growth will be prioritised over inflation and therefore expect interest rate increases to materially undershoot current expectations. In this scenario, despite its short-term appeal, cash has no place in portfolios. We continue to focus on the medium term – with an eye to protecting against further near-term shocks – while looking for opportunities to add to areas which become attractively valued.
Economic Background
Even prior to Russia’s invasion of Ukraine, markets were becoming increasingly volatile. The key driver of this volatility was the abrupt change in the outlook for monetary policy.
At the very end of last year, Jay Powell, chairman of the Federal Reserve, blinked when confronted with a series of inflation readings that exceeded forecasts. Almost overnight, his policy stance changed from one of patiently waiting for the lockdown-related increases in consumer prices to pass through the system, to becoming acutely focused on resetting inflation expectations with a series of quick-fire interest rate increases. This had driven a fierce rotation in equity markets, with investors, for the first time in several years, shifting towards stocks that would benefit from a higher interest rate environment and continued robust economic growth. As part of this shift, government bond yields charged higher as expectations built for a rapid tightening of monetary policy. We resisted following the herd. Our conviction remains that growth will not endure for long in an environment of sharply higher interest rates – and that it would be unwise to reposition towards beneficiaries of economic growth or higher rates (such as commodities and banks) if there was a risk that this would prove short-lived.
Such was the situation when Russia invaded Ukraine on 24th February. The economic response from western governments has been rapid and aggressive. Following the implementation of sanctions, what had initially been an issue of supply disruption for energy, materials and other commodity markets became even more serious, with energy users facing the possibility of going without Russian oil and gas supplies for a prolonged period, perhaps even permanently. Unsurprisingly, the result has been a huge jump in energy prices. This will inevitably bear down on economic growth, as business and consumer spending is diverted into meeting these higher costs. JPMorgan estimates that were oil and gas prices to remain at current levels it would be equivalent to an additional tax of €550bn on European businesses and consumers – equivalent to 4.5% of eurozone GDP. Hence, the consensus outlook has changed quickly from one of stronger growth but higher inflation, to slower growth but even higher inflation – at least in the short term.
Considering investment markets, the result of war, spiking energy costs and a sharp increase in risk aversion has been marked weakness in equities. At the extreme, Russian companies have been excluded from the global economic system and their stock market remains closed; Russian stocks, including those listed in London, have effectively become worthless. Elsewhere, it has been a case of the further away from conflict the better. Europe has fared poorly, as have emerging markets. At the other end of the scale, the US, being less exposed to Russian energy supplies, has fared better. Considering sectors, banks and other financials, a favoured area through January, have been particularly hard- hit as the quantum of likely interest rate increases has been pared back. By contrast, as one might expect, the energy and resource sectors have been strong (see below).
In fixed interest markets, government bond yields, having marched relentlessly higher through January and early February, have failed to make further headway, though with some interest rate increases still on the cards they have not retraced much of their earlier increase. Another beneficiary of risk aversion has been the US dollar, a traditional safe haven in times of financial market stress.
Portfolio Positioning – Defensive assets
Broad diversification within our fixed income allocation has served us reasonably well through 2022 to date. Perhaps unsurprisingly, at the top of the pile are inflation linked
bond funds which have benefited from higher inflation expectations and low real interest rates. Additionally, exposure to the US dollar via the CG Dollar fund of US Treasury Inflation Protected securities has been helpful. With limited exposure to the risk of rising interest rates, short dated corporate bond funds have proven fairly resilient while strategic bond funds have used their flexible mandates to limit the impact of falling bond prices. Notably, the managers of the Janus Henderson Strategic bond fund have used the weakness in government bonds to add to holdings. Like ourselves, they do not see yields rising much further as the energy shock, combined with the rising cost of living elsewhere, chokes back economic growth. Finally, our exposure to long dated, high-quality bonds, held as a hedge against economic weakness and deflation, having performed well over the last two years have been less helpful in 2022 as yields have moved higher once more.
Portfolio Positioning – Growth assets
As discussed above, the equity market rotation in the early part of 2022 saw investors move away from the strong performers of recent years, preferring instead the likely beneficiaries of maintained economic growth and higher interest rates. This left our core global funds trailing the indices over the year to date. On such occasions, rather than reposition to be on the right side of short-term movements, we always re-examine our core views and re- visit the fundamentals of the key positions in funds. On the outlook for markets, our view has been strengthened by recent events; economies will struggle to continue to grow through this interest rate tightening cycle, especially now it has been compounded by a commodity price shock. On key stock positions, we have been encouraged by the strong results reported by long term growth businesses – they are continuing to deliver, and we continue to prefer these companies. As Amazon’s announcement last week of a 20-1 stock split and an additional $10bn of share buybacks indicates, such companies have great resilience and should be able to deliver for shareholders, largely regardless of economic growth – or the direction of interest rates. What is more, valuations are beginning to look increasingly attractive after the rotation.
Outlook
In summary, we maintain conviction in our positioning. In the long term, companies with the ability to grow earnings are likely to deliver attractive returns, irrespective of bouts of volatility. In the near term, such companies provide a hedge against the scenario of deteriorating economic growth – whether this is driven by the interest rate cycle or a further deterioration in the situation in Eastern Europe. Considering equity markets more broadly, investors have already endured a meaningful correction to reflect the less supportive monetary policy outlook and the risk of a deterioration in the situation in Ukraine. While there is, of course, scope for further falls should circumstances worsen, markets are forward looking and have now discounted a significant amount of bad news. Finally, we should note that the ongoing volatility is likely to create opportunities for long term investors and, subject to our judgement about the prospects for markets beyond the current dislocation, we will be looking to adjust positioning to enhance long term returns.
