Quarterly Investment Review – April 22
The Russian invasion triggered a risky assets sell-off
The pandemic is not even over as the latest lockdowns in China illustrate, and the war in Ukraine started. It is putting global supply chains through another test. Distortions in supply because of the destruction of war and disabled supply chains, sanctions, and voluntary self-sanctioning all hit trade.
Although Russia and Ukraine’s global trade share in exports and imports does not exceed 2%, both countries are crucial commodity exporters. In addition to energy exports, Russia and Ukraine export agricultural products such as wheat, corn, and sunflower oil and large amounts of industrial commodities such as steel palladium, platinum, and nickel, amongst others. Delays and congestion suggest longer-lasting problems for supply chains.
The Russian invasion has triggered a sharp spike in volatility and risky assets have collapsed
Global equities (MSCI World) have experienced a fall of c. –14% between early January and early March. Concomitantly, safe even assets have spiked. Gold price has jumped by +16%, and the USD by +4%. Energy prices have benefited from geopolitical tensions and sanctions to reach new highs: oil and natural gas up by +65%, industrial metals by + 40% and agricultural goods by +25%.
Since March 8th, risk appetite has resurfaced. Most of those segments have dropped from the highs.
More surprisingly, the US treasury bonds failed to be the asset of choice. Given high realized and expected inflation, the US yields have strongly moved up to 2.40% form 1.50% on the 10-year. The US government bond index has delivered its worst quarter since 1980. European bonds have followed and printed their worst quarter since the launch of the EUR. 10- year German and Swiss yields are back into positive territory for the first time since 2019 and 2018.
Fed tackling inflation head on
In March 2021, the Federal Reserve told us that inflation was largely transitory. It was primarily the result of postpandemic re-opening frictions, and in an environment of significant labor market slack, it would not need to raise interest rates before 2024.
Fast forward 12 months and the story could not be more different. The economy is now 3% larger than before the pandemic struck, the unemployment rate is below 4%, and inflation is proving to be far more durable, running at 40- year highs and still rising.
The Fed has just started its tightening monetary policy cycle with a 25bps rate rise at its March meeting and signaled that 50bpswb rate hikes are firmly on the table at upcoming meetings.
All equity markets and segments are equal
In such a complicated environment, the US equity market has once gain outperformed peers. The Dow Jones dropped by –4.1%, the S&P 500 by –4.6%, and the Nasdaq has lost –8.9%. The latter being more sensitive to interest rates moves. Euro equities have lost –8.9% and Japan –4.3%. The UK market has been the most resilient given its exposure to pharmaceuticals, oil & gas and metals & mining companies, which have been the main gainers in this context. It was up by +2.9%.
Currencies – Q1 2022 performance
Currencies have had a bumpy ride. Within developed countries, the EUR is the big loser due to its geographical exposure and its energy and food dependence on Russia and Ukraine.
Within emerging currencies, performance was very balanced.
Bonds – Q1 2022 performance
Nowhere to hide. The vast majority of bond segments posted negative performances. The reason is the sharp surge in inflation and the aggressive response from the US Federal Reserve.
Once again the Chinese sovereign market demonstrates its diversification characteristics.
Equities – Q1 2022 performance
After a sharp correction at the beginning of the Russian invasion, developed markets have recovered. They are slightly down given the context. Europe underperforms the US.
Emerging stocks were the biggest losers. China is the big loser.
Commodities – Q1 2022 performance
Unsurprisingly all commodities have delivered strong performance, whether food, energy or metals. The current conflict having a significant impact on the supply side.
Developed world growth slows
Inflationary pressures were sustained, with the number of manufacturing firms worldwide reporting higher prices for raw materials nearly four-and-a-half times higher than normal. A fresh series record of higher prices was reported for semiconductors, while reports of rising energy prices were also at a record high amid surging gas prices.
In the wake of the Russian invasion of Ukraine the cost of energy became especially volatile, with the benchmark for global oil prices exceeding $130 per barrel at the start of the conflict. Moreover, given the dependence of European economies on Russian gas and existing price and supply pressures, reports of rising energy costs and strained supply are likely to continue throughout the year.
Pandemic-induced supply shortages ease but remain a driver of global inflation
As has been the case since 2021, manufacturers globally reported severe disruption in electrical components amid stronger demand. Semiconductor and electrical item shortages have plagued the global manufacturing sector recovery. While there were tentative signs of easing pressures at the turn of the year, the rise of Omicron variant has forced a renewed rise in the number of
companies reporting shortages.
Firms have reported surging price pressures for these inputs have led to sharp rises in costs. Moreover, price and supply pressures for semiconductors especially has had a knock-on effect across the global manufacturing sector. This is most prevalent in key sectors such as automotives, as car production has become increasingly reliant on semiconductor technology.
The outlook for global inflationary pressures appears skewed to the upside due to escalating energy prices and renewed disruptions to international supply chains. While COVID-19 restrictions have been lifted across much of the world, supply chain disruption is expected to continue feeding into purchasing prices.
The pace at which price and supply pressures return to stability will be contingent on how quickly logistical disruptions are resolved and capacity is rebuilt, or in some instances “re-shored” to help resolve supply and demand imbalances.
Landing with sticky inflation
It is a painful reminder: in Q121 the Fed expected average (transitory) inflation in 2021 to range around 1.5%! Twelve months later, even the slightly more realistic G7 central bankers (such as Canada and the UK) are eating their hats and seriously increasing the pace of monetary tightening. They have little choice if they do not want to lose control and the little credibility they have left!
Fortunately, Hyper-inflation is not around the corner.
A global recession is not a base scenario, though its odds have become significant lately (say 30% in 2022, 50% in 2023). But still, removing the ¨patch¨ when the economy decelerates will prove a very delicate path. Even more so considering the unpredictable trajectory of commodities’ prices. If history is any guide, energy shocks of the current magnitude, when they last a couple of quarters, have irremediably provoked hard landings…
Investors’ consensus has rapidly acknowledged for the deterioration of growth perspectives. According to recent surveys, the consensus now expects a macro framework comparable to 2008/9, 2018/20. Interestingly, the wave of pessimism started long before the Ukraine conflict. A geopolitical risk premium has built lately. Fears of nuclear war in Europe have pushed oil and gold to
A premature end of the business cycle is as likely as a soft-landing scenario. Still, negative real rates will prevail. Risk premia will continue to progress, as markets will endure contracting global liquidity. Policymakers have no choice but to tighten financial conditions, until ¨something tentatively breaks¨.
The global landscape for financial markets is becoming gradually more adverse. Uncertainty and volatility will prevail. A lot is already discounted by investors, though a ¨full capitulation¨ did not occur.
Fed hawkish repricing is no longer the trigger
Past price actions have demonstrated that this is not necessarily good news for the USD. In 4 out of the past 5 tightening cycles, the USD has appreciated in the 6 months before the first rate hike. However, it has only once continued to strengthen in the 6-months after. This reflects the fact that the Fed has not always delivered on expectations of promised tightening cycles. The nearterm inflation threat may mean 2022 is different, but at the same time the hurdle to beat current expectations are high, they have already risen above the neutral rate.
For now, all is about inflation, central banks’ exit strategies and yield expectations. All those factors are at the benefit of the USD, but the real economy developments could become more of a driver in the year.
Surprisingly, this could support EUR bulls. The US economy will experience a net fiscal tightening this year while the European Union will get another boost from budget spending. A significant help will come from the EU Recovery Fund. It is expected to boost GDP by 0.5% in 2022 and 0.6% in 2023 and 2024.
Excessive USD strengthening
When the pandemic hit the world in March 2020, the major currencies were all close to their fair values. But the recovery has been very uneven. The USD is at its most expensive level in at least 6 years according to purchasing power parity (PPP) metrics. PPP is an economic theory that compares different countries’ currencies through a “basket of goods” approach. Two currencies are in equilibrium when a basket of goods is priced the same in both countries, considering the exchange rate.
The USD is now more than 25% overvalued against the JPY and almost 10% against the Euro.
The GBP is fairly valued.
Only the CHF is stronger.
Negative yielding bonds have vanished on aggressive tightening talks
Such aggressive pricing Fed tightening in terms of speed and magnitude has never happened. The market expects the Fed to hike rates up to 2.75% by June 2023, in line with the Fed own expectations for 2023, and above the median long-term dot (2.4%). The terminal rate pricing (2.75%) is already above the previous Fed terminal rate (2.50%) and close to the previous market expectations peak at 3.0%. This time the market believes the Fed will have time to reach restrictive area.
Historically, market expectations tend to overshoot what the central bank eventually delivers. This happens in late cycles, and terminal rate expectations tend to peak when the end of rate hikes is in sight. The market is now pricing the end of the Fed tightening in a little more than a year.
Challenging credit environment not over yet
Emerging Credit markets saw some respite after the first Fed Fund rates hike, due to some buying activity, driven by investors comforted by more clarity on rate hikes and the Fed’s decisive action against surging inflation. This relief is expected to be short-lived as uncertainty to engineer a soft landing will weigh on the riskiest part of the fixed income universe.
The current situation shows default rates are very low. Moody’s default study indicates only a mild deterioration in the next 12 months, the US default rate will rise just above 3.0% by January 2023. Their base case looks a bit optimistic. A worst scenario is more likely given the large increase in the CCC-rated bonds.
The bigger issue now is what second-round effects from higher inflation, rising energy costs and supply chains disruptions. We are already seeing some effects. However, we also believe that central banks and governments are much more proactive now than in the past when it comes to supporting the market amid external shocks.
In the current context (war, sanctions, disruptions), HY default rates are set to rise much closer to 2016-2018 levels. Credit spread will follow.
Despite a hostile environment stock market indices are holding up
The stock exchanges have been resilient with corrective phases and rapid rallies because of the algorithms, which are removing the emotional character of investors. The market is efficient: since March 2021, the start of the inflation recovery, the indices PE ratios have contracted by 30%. Now, there remains the profits development. The US yield curve flattening signals a risk of an economic slowdown .
Data from the Dow Jones Market (see chart below) shows that the S&P 500 rises 13.5% on average in the 12 months following an inversion of the 10yr-2yr curve. Some analysts point out that the 10yr–3m curve has a better ability to predict recessions and today we are far from inverted. Historical analysis shows that stock markets can rise up to 18 months after the yield curve inversion.
2022 begins with record US share buybacks, a sign of corporate health and expectations that business conditions will remain supportive.
In terms of seasonality, we are entering a more favorable period. There are 4 periods:
- The January/February period is statistically themost unfavorable.
- Mid-March to June-end is favorable with Aprilbeing the best month of the year.
- A pause between July and mid-October.
- And a favorable period from mid-October toDecember-end.
In 2022, the United States will vote for midterm, which usually is a source of higher S&P 500 volatility, particularly between May and October. The US stock market behaves less well when the president is a Democrat. Most of the time (18 of the last 21 midterms), the president’s party loses seats in Congress. It is therefore likely that the Democrats will lose the majority in Congress with Republicans led by Donald Trump, reigniting the divide, political aggression, and conspiracy theories.
But history also shows that the S&P 500 rebounds strongly after the midterms: +15% over 1 year vs. +7% in a year without a midterm.
The Russian war will decisively change the energy market
The timing coincides with an already tight oil and gas market. The damage is done, Russia will lose its first customer and Europe will give up its first supplier of fossil fuels.
The European shift will be quick: Germany wants to do without Russian coal from autumn 2022, Russian oil by 2022-end and Russian gas by 2024-end. It signed contracts in early March for the construction of LNG terminals. The United States and Europe have set up a task force to ensure Europe’s energy security and significantly reduce its dependence on Russian fossil fuels, mainly with the increase in US LNG exports (doubling in 2022) and the acceleration of the energy transition. Europe will have to reorganize by building LNG terminals for regasification.
The big winners from the Russian shock will be liquefied natural gas, US oil and gas, Qatar, energy transition, and possibly Algeria, Norway, and Australia. The United States is in the process of becoming the 1st LNG exporter in the world.
The war in Ukraine and the massive sanctions against Russia have exacerbated the already existing supply shock due to the pandemic. The problems are not only related to Russian production, but also to the domino effect on all global production and transport chains.
Russia is a major producer of nickel, palladium, and platinum, a little less for gold, silver, and copper. On the other hand, Russia is a major producer of (semi)finished metals such as steel and aluminum intended mainly for Europe. As with oil and gas, Russia was THE supplier to Europe. Of course, in the short term, European countries will suffer from such dependence. Neon gas, of which Ukraine accounts for 70% of global production, could cause significant stress in the semiconductor manufacturing process.
For many metals, supply deficit was already the case before the pandemic.
The price of gold follows the evolution of real interest rates. Gold is a good decorrelated asset in this current macroeconomic (inflationary) and geopolitical (war) situation. Will it follow the same path like in the 1970s?
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