4 min read 5 Apr 22
Summary: Equity markets have staged a comeback since early March, with the MSCI AC World Index down less than 6% in US dollar terms year to date. We believe investors are being far too complacent about the risks ahead and should exercise caution in their Equities exposure.
The backdrop for markets has significantly changed since Russian troops invaded Ukraine in the final week of February. Prior to that, inflation was high, and appeared more persistent than the market had initially anticipated, but the outlook for global demand and economic growth remained positive. The case for equities was not as strong as in early 2021, but the asset class was still attractive from a relative valuation perspective.
In early 2022, market volatility represented a buying opportunity, and it made sense to maintain dry powder to take advantage of unwarranted price dislocations. Given companies’ varying exposure to cost inflation and yield pressure on the balance sheet, selectivity was the name of the game.
Since late February, the hand investors have been dealt is a different one, with the consequences of the invasion of Ukraine and subsequent Russian sanctions likely to have more lasting effects than other geopolitical events in recent years.
Importantly, as we discuss the broader implications of the war, we should not forget the extent of the human tragedy, and our thoughts are with the people of Ukraine and all of those affected by the conflict.
From a macroeconomic standpoint, the outcome from the current events is likely to be a binary one. Either the conflict persists and the related sanctions stay in place for the foreseeable future, or we have an early resolution.
If the conflict persists, we may be facing an inflationary spiral, which could weigh on the global economy – with elevated raw material prices feeding through the supply chain and curbing demand. This would add to the existing supply side woes and potentially trigger a recession that extends beyond the borders of Europe.
We have seen the first signs of – if not demand destruction – at least demand erosion. On recent quarterly earnings calls, consumer-related companies in the UK, Europe and the US, have been flagging softer demand in the first quarter. From home furnishing companies to sporting and fashion retailers, firms have cited weakening consumer sentiment as a driver of reduced sales volumes, and are predicting increased pressure on consumer spending in 2022 as we lap COVID-related stimulus payments, and inflation and higher prices begin to squeeze household budgets.
The Chairman of Taiwan Semiconductor Manufacturing Company (TSMC), the bellwether of the semiconductor industry, also commented last week that the company was seeing signs of a slowdown in consumer electronics demand (e.g. smartphones, PCs and TVs) amid geopolitical uncertainties and COVID-related lockdowns in China1.
Looking at weekly gasoline demand data from the US, it’s possible that we are starting to see the beginnings of demand destruction there as well.
In the slide below (LHS chart), the green shaded area represents the pre-covid five-year range and the pink line the average. Year-to-date US gasoline demand is represented by the dark blue line, where we’ve begun to see a downward trend as gasoline prices have risen in recent weeks – above the peak prices reached in mid-2008 (RHS chart).
Source: Bloomberg, March 2022
If the conflict persists, energy prices are likely to remain elevated, further eating into consumers’ incomes. The announcement of a further release of US reserves on 31 March may have a short-term impact on oil prices but it is unlikely to have a longer-term impact given the temporary nature of the supply. The two attempts at releasing strategic reserves over the past year have not had sustained success in lowering prices which, instead, are reacting to high global demand, supply disruptions, low inventories, and limited supply additions. While the Biden administration is encouraging the US shale industry to drill more, it takes a long time to physically bring production onstream. It should eventually lead to a production boost, but it’s unlikely that higher US supply will come on stream before 4Q 2022.
At an aggregate level, the OECD Consumer Confidence Index had already been tracking lower since the middle of last year as COVID-related fiscal support began to unwind and macroeconomic uncertainty ticked up. We would expect the decline to continue.
Source: Refinitiv DataStream, February 2022
On the other hand, a near-term resolution to the war in Ukraine could reverse some of the inflationary pressure and also bring some relief to global markets. Yet, we need to define what ‘resolution’ means, as an improvement from the point of view of the intensity of the conflict – which is clearly very much hoped for from a humanitarian perspective – would not necessarily lead to an immediate lifting of sanctions. This view is shared by UK, US and EU officials who have been keen to keep sanctions relief off the agenda amid peace talks.
Although recent actions have been met with scepticism in some quarters, markets have responded positively to reports of a de-escalation of Russian military operations (notably around the Ukrainian capital Kyiv) and agreed ceasefires to allow for humanitarian corridors to evacuate civilians from conflict zones. Any de-escalation in practice would be a welcome development and could bring a short-term reprieve to equity markets, but not necessarily to the global economy.
Moving forward, the key variable to watch will be inflation – what is driving it, and how are central banks responding. The risk of policy error remains real, amid further possible near-term shocks, and with multiple and competing data points feeding into decision making.
In a world of elevated inflation, historically, gold and raw materials have outperformed. However, given how far raw material prices have run to date – in March, Brent Crude reached its highest levels since mid-2008, and the wider Refinitiv CRB Commodities Index reached highs not seen in over decade – a resolution to the conflict could see a steep decline in commodity prices from current levels, although possibly still elevated versus pre-conflict levels depending on the duration of sanctions and how long geopolitical concerns will remain in place. Let’s not forget that one of the key consequences of the Russia-Ukraine conflict is likely to be the repricing of geopolitical risk. As central banks globally attempt to tame inflation and price pressure leads to further demand destruction, the risk of stagflation and/or a recession increases.
In a recession, equities tend to underperform. In that context, we would expect the US equity market to outperform on a regional basis, given the perception that it offers higher quality and greater defensiveness, and is also supported by flows of capital towards the US dollar.
In such a scenario, we would expect Europe and the Emerging Markets to underperform the US, but constituent markets could react differently. Emerging Markets are not a homogeneous asset class and we have to distinguish between countries. Those that depend on raw material imports, such as India, will be negatively impacted if the conflict endures. Alternatively, countries exporting raw materials, and those that have relatively healthy balance sheets (where ‘relative’ is the key consideration), such as South Africa and the Middle East, would likely outperform in the event of a protracted conflict.
In a scenario where the conflict is resolved in the near term – and inflationary pressures have not had time to impact demand permanently, and push the global economy into a recession – we would expect the US equity market to look comparatively less attractive versus the rest of the world given the higher valuations.
2022 is shaping up to be a very unpredictable year. Faced with binary outcomes, there are three key ways investors can look to insulate themselves:
In the near term – with rising geopolitical tensions contributing to an already uncertain backdrop, lockdowns in China raising concerns about weakening output and demand, persistent inflationary pressures challenging central banks, and rising prices starting to weigh on household budgets – markets are perhaps being too complacent in the face of growing risks. The answer, for us, is to stay selective and stay diversified.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.