Commentary on February 2022
Global investment markets took a turn for the worse with the tragic events in Ukraine. Whilst insignificant in comparison to the suffering of Ukrainians, the job of investors was to focus on the implications for economic growth and inflation. Commodity prices ratcheted higher, sending share prices lower. The immediate effect on fixed interest bonds was to see safe-haven buying driving yields lower, but subsequent fears of higher inflation for a prolonged period led to a reversal of fortunes.
At the end of February, stock-markets were between 1% and 2% lower, but the escalation of events saw shares fall by a further 2-3% in early March. The exceptions were those companies that benefitted from the production and supply of commodities. The UK government bond index registered a fall of over 7% since the start of the year. Emerging markets in both bonds and equities suffered further.
Economic data, which reflected a world before the invasion, confirmed continued growth with unemployment falling and some easing of supply bottlenecks. Inflation remained a problem with further price rises exceeding expectations; headline inflation in the United States hit 7.9% whilst the United Kingdom and European Union reported 5.5% and 5.8% respectively. A range of sanctions against Russia increased concerns that rising fuel and commodity prices would drive inflation even higher and quite possibly for longer than previously anticipated.
February featured rhetoric, rather than actions, from central bankers, and this had been expected. Members of the US Federal Reserve indicated a general, though not unanimous, preference for a 0.25% rate increase at their next meeting but remained open to a 0.5% rise at some point during the year. At March’s European Central Bank meeting, members recognised the stagflationary headwinds by revising their growth forecast for the year down from 4.2% to 3.7% but boosting their inflation expectations from 3.1% to 5.2%. Investors were surprised by the hawkish tone which suggested members were prepared to raise rates earlier than previously expected.
Events in Ukraine have thrown the world into turmoil and we have to re-assess previous assumptions. Inflation will remain an issue, being driven in the near-term by the parabolic rise in fuel and some commodity prices, but if the conflict prevents the planting of wheat crops in Ukraine then that could have significant ramifications for global food supply and further price rises.
The task of central banks has been made trickier. Current levels of inflation cannot be ignored but it’s not clear that raising rates will provide the solution to a voluntary (through sanctions) shortage of commodities. We think that some rate rises are inevitable but that central bankers will be watching second round effects like wage rises, and whether companies can pass on higher costs to consumers, in considering the extent of future rate rises. If higher prices lead to a wage-cost / price spiral, then we will expect higher interest rates to be needed to push growth below trend. If demand subsides, leading to slowing growth and rising unemployment, then we would anticipate a more cautious approach to interest rate policy.
Market traders are increasingly pricing in a fear of stagflation (an unhealthy combination of rising prices but slowing growth). This has been very noticeable in the fixed interest yield curve where short yields have been rising more rapidly than those on longer-dated bonds, reflecting an expectation that slowing growth will force rates to fall again within a few years.
Clearly these are worrying times and stock-markets are in a period of higher volatility. But in these times we need to separate the emotions of human tragedy from cold analysis of the investment process. History shows that remaining calm and invested during such periods produces the best long-term returns. Cash and bond returns will remain below inflation for some time, diminishing the real value of savings. We remain of the view that a diversified portfolio, favouring equities over bonds, remains the best way of producing inflation-beating returns over the long term.
How are we currently positioned?
We have identified levels that we think present good entry points for long-term value and will be monitoring these over the coming weeks with a view to investing if opportunities arise.
We are likely to remain underweight fixed interest for the foreseeable future as yields still offer little reward for the potential risk of capital loss. In the portfolios that require bond exposure we favour those funds linked to inflation or rising interest rates and with limited exposure to rising yields.
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Some examples of these ‘alternative’ assets are funds invested in gold & silver, infrastructure, agriculture and absolute return strategies.