State Of The World

Economic commentators are highlighting a number of factors that have come together which create uncertain times for the global economy:

“Inflation remains the biggest threat to stock prices both directly (in terms of hurting corporate earnings) and indirectly (in terms of the steps the Fed [Federal Reserve] would have to take to deal with it). Inflation creates an entirely different market dynamic than markets faced in decades. Comparisons to conditions over the last decade are misleading; the Fed no longer enjoys the luxury of letting inflation run “hot” because it is already boiling over. Inflation is embedded in the economy due to structurally higher energy prices and labour prices, exorbitantly higher debt levels, and pricing structures created by years of lax antitrust enforcement. Inflation from supply chain disruptions will likely burn off over the next year or so which will help. And commodity prices could ease from lower demand driven by higher prices, but we need to see how that works out. But monetary policy is well behind the curve even if pricing conditions ease.” Michael Levitt, The Credit Strategist

 

 

State Of The World

Economic commentators are highlighting a number of factors that have come together which create uncertain times for the global economy:

“Inflation remains the biggest threat to stock prices both directly (in terms of hurting corporate earnings) and indirectly (in terms of the steps the Fed [Federal Reserve] would have to take to deal with it). Inflation creates an entirely different market dynamic than markets faced in decades. Comparisons to conditions over the last decade are misleading; the Fed no longer enjoys the luxury of letting inflation run “hot” because it is already boiling over. Inflation is embedded in the economy due to structurally higher energy prices and labour prices, exorbitantly higher debt levels, and pricing structures created by years of lax antitrust enforcement. Inflation from supply chain disruptions will likely burn off over the next year or so which will help. And commodity prices could ease from lower demand driven by higher prices, but we need to see how that works out. But monetary policy is well behind the curve even if pricing conditions ease.” Michael Levitt, The Credit Strategist

2020 marks secular low for inflation and yields – third great bear bond market under way; prior great bears were 1899 to 1920 and 1946 to 1981; deflation to inflation, globalisation to isolationism, monetary to fiscal excess, capitalism to populism, inequality to inclusion, US Dollar debasement… long-term yields >4% by 2024. +10% return from US stocks and bonds of recent decades likely to fall to <3% to 5% long-run returns at best; higher volatility in bonds, currencies and stocks. While the “geography of capital” favours US stocks near-term (investors grappling with a shrinking geographical opportunity set as countries and asset classes to invest in confidence of safety and liquidity), technology is the new secular sell-into-strength (likely worst performing sector of 2020s) as bond yields rise over the medium-term and Central Bank liquidity shrinks.” Michael Hartnett, Bank of America

The last few months have been a contest over inflation, combined with a re-pricing of Central Bank reaction functions. That may no longer matter – markets are now exclusively about geopolitics. Just as WWI mattered for reasons beyond the slaughter of millions of people, the conflict in Ukraine could mark a lasting change in the way the World economy works. When the guns fell silent the leaders at the time tried to restore the old World order of free trade and liberal harmony and comprehensively failed.” James Aitken, Aitken Advisors

“It is rare to see any one of the three stool legs of the policy framework, fiscal, monetary, or geopolitics, be completely restructured. Yet, all three are being completely upended at the same time. Borders are changing in Europe following Russia’s attack on Ukraine with a new China / Russia / Saudi alliance forming. No longer is the Fed trying to prevent inflation; the Fed needs to crush inflation. That has not happened since 1982. And after unprecedented fiscal policy during COVID-19, budget deficit reduction this year will be the largest since 1947. These events are all happening in an election year, historically a volatile year for stocks, which tend to rally into the November election. Interestingly, the first quarter drawdown in stocks looks eerily similar to the S&P 500 in 1982, the last time we were dealing with inflation, Russia, and midterms elections at the same time.” Dan Clifton, Strategas

What this means for the behaviour of stock markets over the next year is far from certain:

 

 

 

 

 

 

 

 

 

The table above highlights what is regarded by most market participants as the best indicator for the probable onset of a recession in the US – so called yield curve inversion. The implication is that when yields on long-dated US Government bonds fall below those of short-dated US Government bonds this is because of the impact of the Central Banks raising interest rates, which pushes up the cost of borrowing (even for the US Government) and engendering a slowdown in the economy via lower aggregate demand. In turn, this should bring down inflation – meaning holders of longer dated bonds require less compensation in the form of the bond yield than was the case preceding the interest rate hiking cycle.

As the saying goes, history doesn’t often repeat but it does rhyme. This means that whilst this measure for the prospect of a future recession is a good one, it is not guaranteed. The table shows that historically there is a large dispersion between the yield curve inversion in prior cycles and the time before the start of a US recession. In addition, US equity market returns (SPX in the table above) following an inversion fall into a wide range, but on average are positive up to the market peak ahead of the ensuing recession.

The 1970s is currently the go to historical market analogue, given it was the last time we saw stagflation, triggered by the 1973 oil price shock. At the time the so called investing playbook saw relative equity market winners led by “hard assets” like commodities, real estate, and “defensives” with pricing power, like healthcare, utilities, and consumer staples. Software could do well a as “new defensive” technology segment. Relative equity losers are those exposed to “squeeze consumers”, like car makers, durable goods manufacturers, and technology hardware. Financial stocks are also hurt by Government bond yield curves flattening or inverting.

The aftermath of this Russia-Ukraine crisis, layered on top of all the other global supply challenges lingering on from the pandemic, is filled with many complexities. The implications are that of a World that is going to be smaller and more localised than before. For investors, this means a heightened “uncertainty” premium across the asset classes and a generally more volatile market environment.

The rise in energy prices will have a different impact on the US and Europe. Research by Goldman Sachs estimates that a $10/barrel rise in the real oil price subtracts around 0.15% from growth via higher inflation and lower household real income. While consumer spending on energy items accounts for a larger share of GDP in Europe, higher taxes and the reliance on natural gas imply that European energy inflation rises less with oil prices. Despite this, a $1.4trillion rise in energy costs equals 10% of EU GDP and a 10% hit to the average net salary. Higher energy prices are, therefore, likely to weigh more heavily on European economic activity than the US.

The combination of Russia attacking Ukraine and China imposing COVID-19 lockdowns adds further pressure to supply chains and inflation, which in some areas is approaching 40 year highs. These high inflation levels have focused minds at Central Banks which, led by the Fed, have developed a resolve to raise interest rates quickly. The US Central Bank is now forecast to raise interest rates aggressively this year, and it should be noted that currently the US economy remains strong.

Nevertheless, higher inflation also challenges growth via a squeeze on real incomes (massive energy bill increases in the UK is one such example), so Central Banks face the risk of continuing to increase interest rates as the global economy slows. From here, it will likely take clear evidence that labour markets are slackening and inflation coming down before Central Banks are deterred from tightening. In such a situation, despite the best efforts of Central Banks to attempt a so called “soft landing”, achieving that economic outcome may be challenging.

As we transition into the second quarter of 2022, ongoing market volatility over the next three months cannot, therefore, be ruled out. That said, we may receive greater clarity around the events which are causing some of this volatility. Firstly, it remains a possibility that Russia and Ukraine reach a diplomatic solution, which is the priority for all Ukrainian civilians in the middle of this war. Regardless of this, it seems a line has been drawn in the sand regarding the Putin regime’s participation in the global economy, particularly as Europe desperately attempts to wean itself off Russian gas and oil, meaning a swift decline for energy prices is unlikely.

Secondly, we will see just how much Central Banks are committed to controlling inflation expectations, acknowledging they cannot directly deal with supply shocks with interest rates in isolation, with the Fed also committing to quantitative tightening. It will be interesting to see just how much further US Government bond yields move up as a result, and if the market increasingly expects a recession as a result.

Thirdly, corporate earnings are likely to highlight which sectors and geographies are facing margin pressure because of inflation. The forthcoming earning season will provide evidence for those theories that a focus on companies in sectors previously flagged above is the optimal portfolio solution as we transition through this high inflation period.

When setting about constructing a balanced portfolio cash is usually treated tactically, particularly when interest rates remain low, but the size of that weighting can vary depending on the wider backdrop of market conditions and we would judge now as one of those times. With rising interest rates, Government bond yields are also increasing, which sees the price of a bond fall. Holding a large allocation to bonds to counteract equity market volatility is unlikely to provide adequate protection.

In fact, we appear to be in a period when both bond and equities are positively correlated (move up or down together) rather than being negatively correlated (bonds move up when stocks are down and vice versa). As an active manager we will utilise cash judicially, as we move through the balance of the year, given it is uncorrelated to both bonds and equities. The expectation is this will afford us access to what are likely to be an array of tactical opportunities that market volatility will present us as we transition through this new economic landscape.