In our last commentary we stated that Central banks in the west had taken the first baby steps towards normalisation of interest rates. Whilst the actual moves made to date are indeed small, investor expectations have moved on since then to expect a canter and now a gallop towards normalisation. This has happened as already spiking inflation was exacerbated further by a surge in commodity prices following Russia’s invasion of Ukraine.
Investors are now dreading the prospect of stagflation as the erosion of real wages and consequent decline in consumer confidence is expected to slow demand in the face of rising prices.
Chart 1. UK real wage growth (top) and UK retail sales and consumer confidence (bottom)
Corporate confidence is also waning as rising input prices, persistent component and staff shortages as well as a war on Europe’s doorstep all erode the outlook for profit growth. However, leading up to the invasion there was significant evidence that Western economies were performing very well. US retail sales and industrial production in January were examples of this, as were UK and European Purchasing Managers Indices (PMIs). UK and European retail sales were also good early in the quarter, in keeping with those in the US.
As we will expand upon below, the short term gloom could easily give way to a sunnier mid-term outlook given the inherent strengths within western economies, ongoing policy easing in China and a belated post-Covid re-opening in Japan.
Commodities and commodity related markets up, everything else down, is a fair summation of the quarter. I would also add it is the first risk off period in my memory when bonds actually underperformed equities instead of offering their usual diversification benefits amidst geopolitical upheaval. Indeed, one could argue amidst the pincer movement from rising rates and geopolitics, equity markets could have fared worse than they actually did. The table below displays performance of several key assets in the quarter.
Table 1. Performance of assets in Q1 2022 (all figures in base currency)
As can be seen, for once the FTSE 100 was one of the better performers as its high commodity weightings helped. The same could not be said for the FTSE 250 and Berenberg observe that the recent underperformance of UK Mid-caps is now on a par with the 2008-09 period of financial crisis and exceeding the poor run that followed the Brexit vote. Underperformance of small caps was not confined to the UK and is normal in risk off periods.
Elsewhere, the US and the UK kicked off their rate hiking cycles, pushing yields higher over the quarter whilst the Fed’s hawkish pivot continued in earnest. At one point as many as nine interest rate hikes were anticipated by some, before expectations somewhat moderated as growth became threatened by war in Eastern Europe.
As yields moved higher, the first 7 or so weeks of the year were characterised by long duration assets selling off. Speculative growth and non-profitable names were hit particularly hard, at one point roughly 40% of the stocks in the Nasdaq were down 50% or more from their 52 week high. However, there was some respite following the onset of war as stagflation once again became the market narrative. Nonetheless, the Nasdaq ended the quarter down over 9%.
Volatility stayed high in China as Omicron began to spread and policy was eased. Although there were tentative signs that monetary and fiscal stimulus was beginning to have a positive effect, markets suffered as Tencent was dragged into the regulatory spotlight, property market fragility remained evident and localised lockdowns crimped growth. The government restored hope at the end of the quarter by announcing that the worst of technology regulation was over and that they would step up support for financial markets and the real estate sector. There are some signs that Covid cases are peaking, if not plateauing, and we would expect further policy support throughout the rest of the year.
Activity & Positioning
In line with our long-standing practise of foregoing incremental upside in order to protect on the downside, we trimmed our slight overweight in European equities back to market weight as Europe is most exposed to the negative consequences of the war and attendant energy price spike. We recycled the money into some US Mid-caps. The fund we went into should be better insulated from the Ukraine situation than the fund we sold and should not be as exposed to the impact of higher US interest rates as many of its US peers.
Also in keeping with our long-standing policy we used the extreme weakness in Chinese Mega cap companies to pick up a Chinese equity ETF at what we expect to be a very attractive price.
Chart 2. Nasdaq Golden Dragon tech index today versus Nasdaq in 1999 (Source; Bloomberg)
We remain overweight equities and underweight bonds although we do expect a contra trend rally in the latter to ensue at some point in the coming quarter. Given how volatile most financial markets have been in recent quarters this could be quite spectacular.
This is not to say we are not cognisant of the (very well discussed) risks those with a bearish disposition can point to currently.
One is the near term inversion of the 2 to 10 year yield curve. This means that currently the yield garnered for investing two years out is at or above the yield for investing ten years out. This is very unusual and market observers look at this closely as over the past sixty years such inversions have been followed by a recession every time but once, although often with a meaningful lag.
Another warning that is flashing red is the soaring oil price. Some economists believe that every US recession has been preceded by a spike in oil prices. And that we have most certainly had. Just remember, two years ago this month the price of West Texas Oil was very briefly negative due to the technicalities of that particular market. That was a time when the world didn’t think it needed hydrocarbons anymore! How times change!
Our analysis is that a sharp economic slowdown will occur for about three months and then recover unless the Ukrainian situation deteriorates further.
As can be seen below the price of European gas has already fallen precipitously and hopefully some of the more hysterical predictions about Autumn price rises will be scaled back. Consumers have excess cash and rising wages. There is pent up demand for services so all is not lost. In this respect the chart below is very illustrative. It shows current orders for European automobiles is currently running at about twice the prevailing rate of production! This is an important part of the European economy which looks set to rebound dramatically as the fog of war lifts. Beneath that you will see the often shown depressing chart about business investment in the UK. It is currently 24% behind pre-2016 trend so this catch up is another important driver of future growth.
Chart 3. Mind the gap: Eurozone motor vehicle production versus orders (Source: Berenberg)
Chart 4. UK real business investment – catch up potential post Brexit and Covid (Source: Berenberg)
Any consumer names, including UK house builders and retailers have already suffered share price declines of over 30% and now trade at very attractive valuations, even if there is some near term earnings risk. Similarly, as it can be seen below, Emerging Market valuations are now at levels from which they have invariably recovered from over the last decade.
Chart 5. MSCI Emerging Markets are at a valuation discount to the MSCI World (Source: Liberum)
So in conclusion, the volatility we alluded to in our last report has manifested itself across many asset classes. This has thrown up opportunities from both a valuation and re-acceleration perspective. As ever, we look to take advantage of such whilst keeping an eye on the ever changing risks, be they financial or geopolitical.
Chief Investment Officer
11 April 2022
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|Small Cap||Small cap stands for small capitalisation and is a term used to group stocks and shares. Sitting below large- and mid-cap stocks, small-cap stocks generally have a valuation, or market capitalisation, of less than $2 billion.|
|Mid Cap||Mid cap stands for middle capitalisation and is a term used to group stocks and shares. Sitting between large- and small-cap stocks, mid-cap stocks used to have a valuation of between $1 and $5 billion but more recently are defined as having a valuation of between $2 and $10 billion.Some stock index providers have mid-cap indices. For example, the FTSE 100 is a large-cap index, while the FTSE 250 is a mid-cap index and the FTSE Small Cap is as the name suggests a small-cap index.|
|Large Cap||Large cap stands for large capitalisation and is a term used to group stocks and shares. Sitting above mid-cap and small-cap stocks, large-cap stocks generally have a valuation, or market capitalisation, of more than $10 billion.|
|Risk-off||The alternative to a risk-on environment is called “risk-off.” This happens when investors are reducing risk and investor sentiment turns bearish. Investors start selling risky assets and focus on protecting their assets.|
|Price-to-book (PB)||The ratio of the market value of a company’s shares (share price) over its book value of equity.|
|Return on Equity (ROE)||The return on equity is a measure of the profitability of a business in relation to the equity.|
|Price-to-Earnings (PE)||The price-to-earnings ratio (PE ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).|