Where Does it Go From Here?
What a difference a quarter makes. The end of 2021 saw markets rise and an air of cautious optimism prevailed for 2022. The markets were looking forward to economies reopening with COVID restriction firmly in the past. There were issues to be tackled, namely inflation, but projections were optimistic. I would normally provide a narrative for the portfolio over the year to December 2021, but that growth has been lost and I believe it is more important to explain where we are now and the outlook for 2022.
Geopolitical events have dominated the first few months of 2022 and, unsurprisingly, global stockmarkets suffered significant falls in January and February 2022 as the markets anticipated a Russian invasion of a sovereign European country for the first time since WWII. The severity and the gratuitous violence of the actual invasion was not only repugnant on a human scale but caught the markets by surprise.
The volatility of the first months of 2022 were polarised across geographical regions, asset class and sector. Russian stock took a precipitous decline, falling between 60-99%. Most of the portfolios have no direct exposure to Russian stock. The portfolios however were not immune from the extreme volatility and, with the tech-heavy NASDAQ down 27.71% as I write, the S&P 500 down 18.20% and even the FTSE 100 currently down 0.89% year to date (18 May). All portfolios have suffered.
This volatility is both unwelcome and uncomfortable as valuations fall. However, corrections are not unusual and the nature of investing in equity means that volatility is an acceptable risk for longer-term growth. In times of volatility, it is key to remain focused on the objectives of the portfolio, which is longer-term growth. It is important, therefore, to remain invested and let the fund managers manage through the short-term volatility. Volatility and corrections provide fund managers with the ability to buy into quality companies at reduced prices. Although past performance is no guide to future performance, the adage of “its time in the market, rather than timing the market” has never been more apt. The fund managers are working hard to analyse both economic and market data so they can position their funds to ride out this short-term volatility. However, with the current headwinds and uncertainty, volatility is likely to remain in the short term.
Portfolios invest in a diverse set of asset classes and geographies. This diversity normally works in reducing volatility, and hence risk, and provide a smoother return than simply investing in stockmarkets. So why have portfolios been subject to a perfect storm from an investment perspective?
When inflationary issues are added to geopolitical risk you get the perfect storm of both equities and fixed interest falling at the same time. Index linked gilts have proven as volatile as equities in the first quarter 2022, when these two asset classes should be non-correlated. Government Bonds should be a safe haven and were often called a “Risk Free Return” although, due to inflation, this has reversed to a “Return Free Risk”. In the UK, a 10-year Gilt is offering a nominal 1.6% gross yield or minus 4.6% in real terms. UK Gilts and US Treasuries have declined in real terms by over 5%.
The War in Ukraine and subsequent sanctions has caused supply side inflationary issues. Ukraine is a major producer of wheat, cooking oil, potash as well as metal ores. Production and export of these commodities has been severely restricted since February. Russia obviously produces oil and gas and the sanctions imposed by the West have led to an energy crisis all too evident in all our bills. China has continued to pursue a zero Covid policy, shutting down whole regions at the smallest outbreak. All these factors produce supply-side issues and shortages of supplies leads to inflation.
Inflation destroys economic growth and therefore Central Banks will look to engage fiscal and monetary measure to control inflation, even at the expense of economic growth in the short term. As UK inflation hits 9% today, interest rate rises are surely on their way. However, there is a ray of hope not quite yet above the horizon. Interest rates are likely to rise over the next few months with the general view that they may get to 3% this year before coming back down in 2023 when inflation is under control. Central Banks have to tread a skilful line controlling inflation without creating a recession and they will be acutely aware of this dilemma. A good indication of what the markets are predicting are the fixed rate mortgage rates: 2-year fixed rates are higher than 5 year rates which are higher than 7 year fixed rates. This implies that rates will rise in the short term before falling back to the long-term average. Let’s hope the analysists are correct. A rate of 2-3% is actually a return to the norm, it’s just we have got used to interest rates at 0.5% or below after the financial crisis of 2008. To put 3% in perspective, I’m old enough to remember my first fixed rate mortgage at 12.5% back in 1991.
ESG/Sustainable Portfolios
The energy crisis and Ukrainian War will have a short-term impact on ESG/Sustainable portfolios. The current supply squeeze has led to energy and mining companies significantly outperforming other stocks since the turn of the year. The US energy sector has risen circa 40%, European 20% and the UK 25%. Defence and armament companies have also risen. This has led to a lag in performance for ESG portfolios since the turn of the year. This underperformance is likely to continue in the short term, as the world moves away from Russian gas and oil, spiking demand from other sources and driving oil shares higher. To put this into context, the FTSE 100 has performed relatively well since the start of the year as it is heavily biased towards oil (BP, Shell), Mining (Rio Tinto), Armaments (BAE systems) etc. However, if these sectors are excluded from the figures, then the FTSE 100 would actually be showing a more significant loss. ESG/Sustainable funds negatively screen out these sectors and, therefore, the likely scenario is that ESG/Sustainable funds will underperform the average balanced sector through 2022, or until the energy crisis and War has abated. On a positive note, the dependency on Russian gas and oil has brought forward the focus on alternative energy sources, such as the green/renewable agenda, specifically transferring to a carbon neutral world by 2050. ESG/Sustainable funds are likely to benefit over the medium term as sustainable alternative energy sources are found, although this will take several years to implement.
Outlook
As the world becomes over exposed, and therefore sanitised to the horrific scenes in Ukraine, the markets turn to the fundamental economics rather than reactions to new atrocities. Ultimately, it is always economics that drive markets. We are expecting the next few months to prove challenging from an investment perspective as the War in Ukraine looks unwinnable by either side, and it’s difficult to see how Putin can ride back across a golden bridge to Russia claiming any sort of victory. Indeed, Russia is likely to become a pariah state for many years to come. There are few alternatives at present as selling out of a portfolio locks in the short term loss and misses a potential recovery whenever that comes. Cash pays nothing and is indeed negative against inflation. We have experienced difficult trading conditions before, such is the nature of the beast. It’s time to remain invested and wait for the world to return to some form of normality but I suspect that may be a few months yet.
Marcus Maisey