Market Commentary – 25th February 2022
In light of the recent terrible news that Russia has invaded Ukraine we thought it would be timely to provide an update on what has been happening in financial markets and to try to help clients navigate a path through the uncertainty.
Investors will remember that despite the emergence of the omicron variant, 2021 was a strong year for financial markets, with the MSCI World index generating a return of almost 23%. So far in 2022 it has been a very different story, with a sharp increase in volatility driven by investors’ concerns about rising inflation, Central Banks being forced to raise interest rates to combat it and geopolitical tensions. Commodity prices have already risen sharply and with Russia a major supplier of energy, the oil price soared to $105 per barrel on Thursday for the first time since 2014. The MSCI World index had fallen just shy of 10% by the middle of this week and whilst the oil dominated FTSE 100 had proved more resilient, Thursday’s decline of almost 3.88% (its worst daily fall since June 2020), has pushed it into negative territory for the year so far. Similar falls were seen across Europe, and the US, although there markets actually closed higher, perhaps reflecting that at least some of the uncertainty had already been priced in.
Whilst the human cost of what is happening in Ukraine must not be overlooked, it seems likely that the global economic impact will be less significant than the disruption caused by the pandemic and the impact of lockdowns. Russia and Ukraine account for a small proportion of global GDP and their assets represent a correspondingly low percentage of global stock markets. However, there is the serious risk of spill over disruption given Europe’s reliance on Russia for its energy and many other commodities, particularly in the form of higher inflation which has been spooking markets for some time now.
There is clearly a danger that the conflict may worsen and delay the peak in inflation, not least because Russia accounts for one third of the world’s crude oil supply and 30% of global wheat production comes from Russia and Ukraine combined. However, inflation, per se, is not as big a risk as it may seem. During the oil shock of the 1970s which led to a painful and prolonged period of stagflation, food and energy accounted for 20-25% of total household spending in the US and UK whereas now it is a much more modest 10%. Furthermore, despite the media headlines of a cost-of-living crisis (which let’s be clear is very painful for some sections of society), in aggregate households are in good financial health as a result of low levels of unemployment, generous furlough schemes and enforced saving from lockdowns. Higher energy prices will tend to dampen consumer demand in other areas thus putting a cap on inflation.
The more pertinent risk therefore is that central banks panic and increase interest rates too aggressively thereby causing a recession. Whilst there is certainly scope for a policy error of this nature central banks are unlikely to act unless they start to see one of two things. The first is significant second round effects from inflation, namely a big increase in wages which leads to inflation becoming embedded in the system in the form of a wage-price spiral which forces them to engineer a downturn by increasing interest rates. The second is evidence that market participants have lost faith in their ability to manage inflation. There have been two key changes since the 1970s – the unions are much less militant and powerful than they were, which has curbed wage demands and central banks became independent in the early 1990s giving them more scope to manage inflation effectively. Current data from the labour market shows that wages are rising in the US and UK but little to worry about in Europe where the labour market is less tight. Data from the bond market shows that inflation expectations remain anchored, with the yield curve fairly flat meaning longer dated bond yields have remained fairly low relative to shorter dated bonds. In other words, bond investors are not demanding a higher yield for longer dated bonds to compensate them for higher inflation in the future. The implication is that the Central Banks have not lost the market’s credibility in being able to control inflation and that their fairly hawkish rhetoric suggesting that they will do what they need to will have the desired effect without having to raise rates.
However, until we know the extent of Russia’s ambitions and the West’s response it will be difficult to time the bottom of the market. That said, it is always difficult to time markets and it is important to remain level-headed. Selling at the right time is one thing, but it is arguably even more difficult to time re-entry given human psychology and the disproportionate power of risk aversion. Sitting in cash in a negative real yield environment (when inflation is higher than interest rates) is guaranteed to erode purchasing power.
It is also worth remembering that previous sharp falls in markets caused by geo-political events such as the Cuban Missile Crisis, the Iraqi invasion of Kuwait, and 9/11 have tended to be quite short-lived. Even the aggressive sell-off precipitated by Covid-19 and the ensuing two-year hiatus to economic activity did not prevent stock markets from reaching all-time highs during that period. Volatility, though, is likely to remain elevated and there will, no doubt, be periods of extreme pessimism as this crisis plays out and concerns around inflation and recession hold sway.
As always, we would like to remind clients that the best way to achieve their investment objectives over the longer term is to remain invested in portfolios that are diversified across different asset classes, geographies and investment styles and which are commensurate with their capacity for loss and appetite for risk.
February 2022
RiverPeak Wealth Limited