Are we out of the woods? Sitting here in Hong Kong it’s hard to believe that most of the world has almost left the pandemic behind, having found a way to deal with the health risks and move on. Only in China is the fight ongoing, but even here a change in mindset is noticeable. This is a solid positive for the global economy.
It’s even harder to believe the images of the human tragedies in Ukraine that we are seeing on our screens every day as innocent civilians are killed and refugees flood out of the country. What’s going on in the financial markets pales into insignificance compared with the terror of the invasion. But it’s our job to consider what it all means for investors.
As it stands, the world is faced with a geopolitical crisis that looks set to wipe out some of the benefits that have accrued since the end of the Cold War in 1989 as a result of globalization, cost efficiencies and international trade flows. This is clearly a negative and is resulting in considerable uncertainty for investors.
The Western (NATO) response to the war is very much through economic sanctions, so prices in the financial market give us a good sense of the implications of war in today’s interconnected world, and also what the implications for corporates may be from further deglobalization and higher commodity prices.
Of course it’s not easy to set out a three-month outlook when we don’t even know what next week is going to bring. To suggest that you should prepare yourself for more volatility is not particularly insightful, but it’s probably the best advice anyone can give at present.
For now, financial investors are mostly feeling the impact of events in Ukraine through higher input prices in general and commodity prices in particular. The big question is what the combined impact of higher inflation and higher rates will be on economic growth and profitability. At the end of 2021 it looked like earnings could remain strong, but in the first quarter we have already seen some companies signalling that pressure on their margins could dent their profitability. And let’s not forget that corporate profitability is the linchpin that supports the global equity markets.
As well as lower margins, earnings may come under pressure from the slowdown in real economic growth that’s likely to result from the prevailing uncertainty. This is particularly the case in Europe, where markets have suffered the biggest hit.
The low interest rates that have been in place for over a decade have muffled a lot of volatility. But this era is coming to an end. Monetary authorities all over the world are longing for normality, just like ordinary citizens were longing for normality during the dark days of lockdown. The Federal Reserve has already started hiking rates and the ECB feels its hand is also being forced by what is viewed as scarily high inflation in Europe.
The situation in Asia is very different because in its biggest economies – China and Japan – increases in input prices have not yet resulted in much higher consumer price inflation readings. Historically, Asian equities have struggled under a tightening US dollar rate environment but this time may be different. Asian equities lagged during the liquidity-driven rally of the past few years, but will have less to fear from the Fed’s moves because Asia’s central banks don’t need to tighten much in 2022.
As ever, our analysts and portfolio managers are carefully collecting data on prices and margins to make a call on where to reduce their exposures and where to remain invested. It looks to me that commodity producers have the most pricing power, but there is also plenty in the technology sector, where shortages are proving persistent.
The healthcare sector may also be able to display its pricing power now that demand for treatment is normalizing and as governments look set to become more willing to provide funding having been confronted with the importance of a well-funded health system during the pandemic. Quality – the ability to generate returns above the cost of capital for a sustained period of time – is likely to remain an important determinant of success, and it will be defined by pricing power.
Although I have been taught by our quant researchers that timing factors is nigh on impossible, I still like to think that value-oriented strategies will receive further support from higher bond yields in the second quarter. Bond yields are always important for equity investors to consider as they drive the discount rates used in stock valuation models – faraway cashflows are worth less when the discount rate rises.
As yields creep higher in Europe and Japan, it seems a good idea to tilt portfolios towards shorter-duration stocks – in other words, value stocks. Personally, I would add telecoms to the list too as these are firms with strong (albeit regulated) pricing power and are benefitting from very steady demand as they head into a phase in which less capex is required as most of the necessary investments in 5G have already been made.
What began in 2020 as a scarcity of containers in Asia to ship goods to the West had by March 2022 morphed into a series of supply chain disruptions. Aggravated by the recent run-up in oil and gas prices, these problems have resulted in a rethink about global interdependencies, with politicians clearly moving towards the need for national self-sufficiency. This trend started in the Trump era, when the US wanted to reduce (so far unsuccessfully) its dependence on Asian products – especially those from China.
Governments are now talking about the need to develop their own computer-chip supply chains and of course to become less dependent on imported energy. This has shifted the focus from the long-term green transition to short-term energy security. It now seems likely that natural gas and nuclear energy are going to remain important fuels, at least in the medium term, to help us navigate the green transition to net-zero by 2050.
The vilification of some energy companies looks likely to stop, and we must focus on those that are actually contributing to the transition by making investments in cleaner energy, including gas. Our engagement efforts are clearly paying off in this respect.
The US scores well from the perspective of energy independence thanks to the shale oil revolution. What’s more, American growth looks less vulnerable than Europe’s at present, so the US seems a good place for equity investors to allocate to.
Within Europe, France has been relatively insulated from the energy shock as most of its energy comes from domestic nuclear plants, and this insulation should help President Macron’s chances of re-election in April. Meanwhile, German Chancellor Olaf Scholz has been making a good impression with his mediation efforts in the Ukraine conflict. Strong and stable political leadership in Europe is welcome during tough times.
China is likely to be hitting the headlines in the second quarter. It has tried to stay out of the conflict and focus on its own internal battle against Covid so far, but can President Xi maintain that position? China siding with Russia would be explosively bad news for the markets, whereas any harmonization of China’s relations with the US would leave Russia isolated. This could lead to a quick resolution of the conflict in Ukraine and possibly a breakthrough in the protracted trade war between the US and China at a later stage. That really would be good news for the world.
With plenty of uncertainty around, investors may be thinking about looking for safety in the fixed income markets, but as bonds’ nominal returns remain very low, they need to remember that allocating to the asset class will not generate enough returns to pay for one’s pension. Equities remains thus the place to be, we believe.
The ‘rally of everything’ that we spoke of last quarter clearly ended very early in 2022. Investors will need to be more selective, but we are not downbeat about equities’ prospects. Stocks retain their appeal as equities are backed by real assets, which tend to move in line with inflation to a certain extent. What’s more, companies generate a margin from these assets and adjust their prices when inflation bites.
In the following pages you can find more detailed views from our fundamental equity teams. These are challenging times in many respects, but rest assured that we are here to help.
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