Investment commentary - First Quarter 2022
As we began the new year our main areas of concern centred around rising inflation, the pace at which central banks were likely to tighten monetary policy, and the ongoing threat of Covid-19. These fears were soon overshadowed by a far more devastating event however, when on the 24th of February Russia embarked on a full scale invasion of Ukraine, setting in motion a catastrophic humanitarian crisis which continues to worsen by the day. The consequences are yet to be realised in full, but the impact will run far beyond the borders of Europe. The economic implications are numerous. With Russia being a significant producer of oil and gas and both Ukraine and Russia being agricultural producers, the potential for supply disruptions quickly sent commodity prices soaring. Having started the year around $78 per barrel, oil prices spiked with Brent Crude trading close to $140 at one point before settling back down to $108 by quarter end. Meanwhile the broader Bloomberg Commodity Index gained 25% over the quarter and gold edged up nearly 6%.
Soaring commodity prices are by no means the only problem caused by the conflict in Europe. Ukraine, for example, played an important role in the supply chain for European car manufacturers. Already we have seen both Volkswagen and BMW closing assembly lines in Germany due to the shortage of wiring harnesses manufactured in Ukraine.
Aside from supplying the European Union with around 40% of its gas supplies and a quarter of its oil, Russia also plays an important role in supporting manufacturing in Asia, as many of the finished goods exported to Europe travel via Russian transportation infrastructure. This all comes at a time when global supply chains were only just beginning to recover from the lockdowns imposed to fight the pandemic, so the potential impact on European growth is not insignificant. So far EU members have been reluctant to sanction Russian oil and gas imports and have exempted energy related transactions from sanctions on financial institutions, severely impeding the efficacy of the sanctions altogether. If these nations were to yield to pressure to do more however, this could be very disruptive for the Eurozone economy and add further to existing inflationary pressures.
Equity markets have actually remained quite calm so far this year, volatility spiked in early March as the extent of the conflict unfolded but has since subsided, and whilst equities have generally declined over the quarter, we have certainly not seen panic selling. The US S&P 500 for example only declined around 5% over the first quarter, and the pan European STOXX 600 index gave back 6.5%. Germany and Italy were hardest hit of the major European markets, down 9.3% and 8.5% respectively, but given they are particularly dependent on Russian oil and gas this seems far from an overreaction. The Russian market was obviously hit hard with the MOEX index showing a loss of just under 30% for the quarter, although the market has been closed for much of the time and is now only open to certain investors, so the true losses are hard to assess.
Looking at the UK market and the picture is quite nuanced, with the FTSE 100 index showing a gain over the quarter of 1.8%, whereas the FTSE Mid 250 index and FTSE Small cap index declined by just short of 10% and 7% respectively, reflecting the fact that the FTSE 100 has a much higher weighting to energy and material stocks which have done particularly well over the recent past whereas the mid and small cap indices have much less exposure to those sectors.
In the currency markets the pound declined 2.9% against the dollar in the first three months of the year, was broadly flat against the euro and gained 2.5% against a generally weaker Japanese yen. The dollar on the other hand strengthened against most currencies with the dollar index up 2.4% for the period, reflecting its safe haven status coupled with expectations of rising interest rates.
Looking ahead and the outlook is undoubtably challenging, the war in Ukraine shows no signs of easing and increased sanctions will only add further pressure to commodity prices and supply chains, stoking inflation which is already well beyond central bank’s target rates. The UK Consumer Price Index rose 6.2% in the twelve months to February, the highest since 1992. Household energy bills, which rose by 25% on the year, and petrol prices were the biggest drivers according to the Office for National Statistics (ONS). With the Bank of England’s (BOE) target for inflation sitting at 2% this puts policy makers in an uncomfortable position of attempting to rein in inflation without stifling growth and sending the economy back into recession. At the recent March 17 meeting, the BOE increased the bank rate again taking it from 0.5% to 0.75%. The picture is not dissimilar in the US where inflation hit 7.9% in February, forcing the US Federal Reserve to begin raising interest rates with a 0.25% increase in its target rate. The Eurozone, which saw inflation of 5.9% in February, has so far resisted increasing borrowing costs, with the March meeting of the Governing Council of the European Central Bank (ECB) voting to maintain their refinancing rate at 0% and hold their negative deposit rate at -0.5%. The situation is particularly challenging for the ECB given the Eurozone is more directly affected by the war in Ukraine and so heavily dependent on Russia for its energy supplies, placing their economies in a fragile position.
Looking at some of the forward looking data from the Purchasing Manager’s Indices (PMI), in the UK the March survey for the service sector accelerated at its fastest pace for 10 months, coming in with a reading of 62.6 (above 50 signals expansion). According to S&P Global who conduct the survey, higher levels of business activity were supported by a strong rise in new work during March. More than twice as many survey respondents (31%) reported an increase in new orders as those that signalled a fall (15%). Businesses operating in the travel, leisure and entertainment sectors commented on especially strong demand. Data for the manufacturing sector was less positive declining from the prior month but remained in expansion territory at 55.2. Survey respondents maintained a positive outlook however, with over 55% forecasting that output would rise over the coming 12 months. Data for the construction sector also remained positive with the March reading coming in at 59.1 (unchanged from February). The picture is similar in the US, where survey data also remains in expansion territory as it does for the Eurozone as well.
Turning to corporate valuations, and whilst equity prices have generally declined over the quarter, forward earnings expectations have held up, resulting in markets now trading at slightly lower levels relative to their expected earnings than they were at the start of the year. For example, at the end of March the S&P 500 traded on approximately 19 times its forward earnings estimates whereas at the end of December it was trading around 22 times estimates. Other markets have reacted in a similar fashion where stock prices have declined so far this year but earnings expectations, have thus far generally held up.
Clearly there are valid reasons why markets are trading more cheaply now than they did three months ago, inflation is pushing up input costs and for some businesses not all of this can be passed on to the consumer. Monetary conditions are tightening and as well as increasing the cost of capital for corporates, this puts a squeeze on consumer spending. More generally there is an increased level of uncertainty hanging over markets. The conflict in Ukraine is still ongoing, and the response from the west in terms of how far they are prepared to go with sanctions is still unfolding. All of this makes it extremely difficult to predict the extent to which we will see further disruption to supply chains and the subsequent impact on inflation, so an increased risk premium being priced into markets is understandable.
Although the path ahead is certainly not without challenges, there are still positive tailwinds in support of equity markets going forward. Corporate earnings expectations remain strong, balance sheets are in good shape, and survey data although off recent highs, still paints a relatively positive picture of companies order books. Meanwhile, employment is high, and although households will face increased cost pressures, historically high savings levels will cushion some of the price increases they face. Finally, the uptick in activity from economies opening up after lockdown is beginning to come through as employees return to work and consumers unable to spend in lockdown unleash pent up demand.
We would not be surprised to see spikes of volatility however, as situations develop and investors adjust their holdings to whatever style or sector they feel offers more upside in the market conditions that prevail. Investors face a dilemma in situations like this, on the one hand not wanting to take precipitous actions by selling holdings that have fallen sharply and miss any recovery, as markets quite often overreact to a change in outlook only to retrace some of the losses in the weeks that follow, but on the other hand not wishing to remain static in what is clearly a changing economic backdrop. As is the case with many things, sometimes a middle ground is the most prudent course of action. In the case of portfolios, not chasing whatever has done well of late but making calculated tactical adjustments whilst remaining well balanced and diversified.
Neil Jefferies, Head of Adroit Financial Planning