Pre-Bank Holiday Briefing Notes

Briefing Note - June 2022

I have purposely avoided issuing too many briefing notes as the world is dealing with the war in Ukraine. Whilst it is hard to keep pace with what is going on, the television coverage and media reports have been heart-breaking, and the peril suffered by ordinary Ukrainians is in thanks to the unjustifiable action of Russia. As is typical in these situations, the headlines disappear as the media finds other salacious stories for its readers. The conflict in Ukraine is a serious problem for the West and the whole world at large. Although the Ukraine army seem able to hold their own against the Russian forces, the longer it goes on, the more instability there will be in markets. We can only pray and hope, Russia comes to its sense sooner rather than later.

As we near 100 days of the war, markets seem to have settled and factored in as much as possible with a push for business as usual. With that in mind, I think there are some issues worth commenting on.

This year, so far, has tested the resilience of many investors. The environment has been inundated with geopolitical uncertainty and inflationary figures not seen for decades. Central banks promising to fight inflationary pressure while withdrawing liquidity, fuelled strong asset price growth over the last few years and China’s zero covid policy has led to significant slowdown of one of the world’s biggest manufacturing hubs. Subsequently, equity markets and bond markets suffered as they tried to work out if recession is around the corner and what the ‘new normal’ will look like.

Dollar

A key measure of global investment risk is the dollar. When people are risk-averse, they tend to pile into the US. According to the experts this makes them feel a little safer, but in turn, makes life worse for anyone needing to buy dollar-denominated commodities or repay US currency debt. However, the broad ‘dollar index’ is beginning to look as if it is turning. For the first time since the initial week of the Ukraine invasion it has dipped below its short-term (50-day) moving average.

Whilst this does not prove the inflationary wave is over or that we have nothing more to worry about, it does provide good reason to hope the Fed will not have to hike rates too far, and inflation fears may have been exaggerated. It also provides a good excuse for a ‘risk-on’ respite after a brutal start to the year, which is what we are seeing just now.

The Federal Reserve’s rhetoric remains hawkish, and many investors fear it will push the US into recession. Currently, our investment teams are hopeful the central banks can respond effectively to bring about a slowdown in demand to control inflation nearer to a more sustainable level going forward. A normalisation in supply chain dynamics, relief from surging commodity prices and a shift in consumer behaviour from goods to services could help to bring down the year-on-year relative rates. With this in mind, we believe the rush to the safe-haven dollar has gone too far and our managers are hedging US dollar exposures.

Inflation

I would advise caution here as there may be a limit to how far this can go. An inflation scare can easily morph into a growth scare, as central banks do more to keep price rises under control. This raises hopes both equities and bonds can rise together (as they have done recently) but is not greatly helpful for the future.

Yet there are still two big geopolitical issues that need to be resolved. How will Russia’s invasion of Ukraine be concluded and with what impact on future trade flows? And how will China emerge from its shutdowns to combat Covid-19, and with what permanent impacts on its economy? Either could conceivably tip the balance into either inflation or deflation.

Annual inflation in Germany reached 7.9% in May, the highest in almost half a century. The country’s statistics agency blamed the war in Ukraine for rising food and energy prices, which are up by 11.1% and 38.3%, respectively, since May 2021. Spain’s year-on-year inflation also increased in May to 8.7%, up from 8.3% in April. Inflation is hitting multi-year highs around the globe and in discussions with our fund managers, we have asked what action have they taken within the portfolios to protect investors capital from the damage of inflation?

Generally, our clients have benefitted relative to our peer groups, in that they have been bearish on bonds for a long period of time and have preferred to allocate the traditional fixed interest weighting towards absolute return funds. This action has protected investors and shown resilience in volatile markets.

Interest Rates

The month of May has seen a reset as investors factor in the likelihood the Fed will be unable to tighten as much as it wants. This has eased pressure on currencies and credit around the world and could have its own self-reinforcing reflexivity. But let us not take things too far, during a short week with plenty of macro data.

Two months ago, the European Central Bank (ECB) was expected to be stuck with negative rates at the end of this year. No longer. Markets have sped to price in an aggressive tightening campaign. That in turn helps strengthen the euro, and weaken the dollar, as U.S. rate expectations have been stable for a month now. That does help those who want to get ‘risk-on’ again. But it is driven by decidedly risky developments.

Our investment teams are being questioned about their expectations for interest rates and when they expect to see inflation starting to peak. The expectations for monetary policy have seen the market pricing in interest rates of over 2% for the UK and US by the end of the year with the Eurozone nearer to 0%. Our managers expect inflation to be peaking near term and have seen commodity prices coming back from peak levels earlier in the year. However, the outlook is still uncertain and very dependent on how long the Ukraine/Russia conflict continues, and the outlook for manufacturing production in China (and the impact on supply chain) with continued lockdowns and whether there is a stimulus package from the Chinese Government. The later points will continue to push the price of oil ever upwards!

Environmental, Social and Governance (ESG)

Many observers have commented that the war in Ukraine, the subsequent sanctions, climbing inflation and its impact on Growth Assets, combined with a desire by the West to wean itself off Russian oil and gas has highlighted short-term risks and long-term opportunities of ESG portfolios. As with all investments currently, the uncertainty has driven a large sell off in growth stocks and those with long lead times for real earnings per share upgrades have been significantly punished due to reaching stretched valuations on near term earnings potential.

Some of the companies and themes within ESG, particularly on renewable energy creation, have suffered from an overstretched valuation perspective. However, fundamentally many of these are long term very attractive businesses.

Our managers are focused on protecting the capital values of ESG investors over the short term but must maintain some exposure to assets that should benefit over the medium to long term. Within our ESG portfolios, our managers have researched in depth to find alternative funds which are committed to the ESG framework and provide an ‘absolute return’ type of performance. Additionally, investment in infrastructure and real estate investment trusts, which provide diversifying asset allocation, have also been used in these portfolios.

Geopolitical Issues

The war in Ukraine has highlighted the overdependence of the West on Russian energy supplies. Investors have asked what impact do we see this having on our portfolios? It would be impossible to ignore the significant price rises in energy and commodities so far this year. The market was already grappling with high oil and natural gas prices from late 2021 on the back of market forces rebalancing after the impacts of COVID, and the significant impact from the Russian invasion has led to further price increases.

The energy crisis exacerbated by this war will move governments to accelerate their energy transition plans, creating significant opportunity in the obvious beneficiaries from such a transition. The European Commission has already announced ambitious plans to reduce imports of gas from Russia by two-thirds before the end of the year via more diversification, energy efficiency and by accelerating investments in wind and solar power plants. The EU has put in place a plan to use more liquified gas shipped in via container from US, North Africa, and the Middle East. This will have an impact on Asia as their supply will be affected by this new European demand.

The likely effect from this will be further coal usage in Asia and impact on zero carbon goals from COP. Wind supply will be a key new growth area, but the lead time is 3-4 years. Similarly, so will solar energy, with China being the biggest potential supplier. Interestingly, we already have a key holding within this theme in our ESG portfolios (managed by Apollo). The Trium ESG Emissions Impact fund and the Schroder Energy Transition Fund are well positioned and already held. If you have a spare moment, they are worth a look at.

Summary

I think that is enough for now, but should anyone have any questions, concerns, or worries, please do not hesitate to speak to your Prosperis adviser.