While one natural catastrophe seems to be on the wane let us hope this human made catastrophe will end soon.
- Tuesday, March 22, 2022
We have been enduring a particularly difficult period in both equity and credit markets. Market concerns have moved from Covid 19 and onto the Ukrainian crisis. The eyes of the world are now on Ukraine and its brave people.
Prior to the invasion of Ukraine, Russia had built up its foreign currency reserves to US$630bn and held the West hostage over gas supply. The West has united in condemnation and imposed asset freezes and sanctions upon the Russian state, its institutions and influential Russian citizens. Russia has been frozen out of the reserves it holds in New York, London and Geneva. These sanctions have stopped Russia using much of its war chest to fund the war and finance itself through the inevitable sanctions. The restrictions placed upon most Russian banks to access the international banking payment system SWIFT has effectively weaponised the Wests financial system against Russia.
Investment professionals are collectively admitting they were not expecting or had really planned for military action in Ukraine. Commentators and analysts did not expect an invasion as a likely outcome. The economic implications of Russia’s actions were to create prior to the invasion an energy supply shock and then exasperate it further with their attack upon Ukraine. High oil and gas prices greatly benefit Russia and these exports fund their war. Western governments have reacted by either stopping purchasing Russian energy or encouraging others to reduce and stop funding the Russian war machine. Currently the EU buys 40% of its gas from Russia.
The economic hit on Russia may impact how Moscow now reacts. Oil and gas exports are by far Russia’s largest income source and it would be a desperate move for President Putin to close supplies of gas and oil to Europe but one cannot rule it out in these dreadful times.
The Russian economy is relatively small in G20 terms with a GDP of US$1484bn which is similar to Spain at US$1281bn. Inflation in Russia is currently 9.17% and interest rates 20% in order to support the Rouble which has fallen from a peak in early March of 150 RUB to 110 RUB to the dollar. Russia does however influence the energy market that allows it to punch above its weight. The combination of an energy power armed with nuclear weapons adds to the threat it offers the West.
The Organisation for Economic Development (OECD) said the impact of the conflict could cause a “deep recession” in Russia if it is sustained and the conflict could push up prices globally by about 2.5%. Prices of oil, gas, metals and chemicals essential to fertiliser production, for example, have jumped as concerns over supplies from the region increase. Although Russia and Ukraine only make up a small percentage of the global economy, they are huge producers of raw materials. Outside Russia and Ukraine, the OECD suggest that most pain would be felt in Europe, with up to 1.4% knocked off economic activity.
Sanctions against The Central Bank of Russia (CBR) has made it difficult for Moscow to make payments to overseas bondholders in US$ and that payment in Roubles would breach the terms of the bond contracts. Russia is therefore potentially set to default on US$117m of interest payments. To avoid a default that would make raising money in future far harder and more expensive, Russia will have to tap into its domestic US$ reserves as at least half of its foreign currency reserves are frozen in international banks abroad. Russian government bonds are now trading at 20% their face value as investors price in a default risk. A default on government bonds is rare and can cause problems in global markets but when Argentina defaulted in 2001 on a greater amount it was manageable.
Last week President Joe Biden banned imports of Russian gas and oil into the USA. This move was matched by the UK. The EU however did not follow suit but did state they wished to reduce their dependency on Russian energy by 65% within a year. Russia is the worlds largest exporter of crude oil and shipped 8 million barrels a day at the end of 2021. The US and UK are far less dependant on Russia for energy than much of the Eurozone with 60% of Russia’s oil going to Europe. With sanctions now biting some 70% of Russian oil is struggling to find a buyer even on discounted prices.
India is risking its reputation by opening talks with Moscow to buy Russian oil at a heavily discounted price. The deal could involve a Rupee/Rouble transaction outside the sanctions imposed by the West and by pass the SWIFT system. Prime Minister Modi has stated he wants to protect the special relationship with Russia. India buys Russian military equipment to protect its borders with China.
The investment theme so far of this conflict is the energy supply shock and the implications this has on inflation and interest rate rises. Central Banks have little control over energy prices so their only tools are for interest rates to control inflation. There are complex linkages between this war, sanctions, commodity prices, inflation and interest rates and that planning is extremely challenging.
In normal times, central banks would look through these spikes in price inflation but policy makers are behind the curve in controlling inflation while also sustaining growth. The US and UK are trying to smoothly bring inflation down from its current highs. A big concern would be hiking interest rates too late and then having to raise rates far higher later. With all that is going on the chances of a recession before the end of 2024 are real if the policy makers get this transition wrong.
The invasion of Ukraine is a massive wakeup call over energy supply and its sources. Germany is reluctant to cut off Russian gas but will now like many other countries work to reduce dependency and switch supply to other providers and other forms of energy. The impact on the German economy prevents such immediate action but by next winter reliance could fall by 2/3rds. If as is now expected, Europe moves to diversify and improve its own sources of energy and invest into wind, tidal, wave, nuclear and build new terminals for shipment of LNG, then the longer-term economic impact upon Russia will make Vladimir Putin’s action very short sighted. He has uniquely united the West, make neutral countries such as Finland and Sweden want to join and therefore strengthen NATO as well as turn his key customers away permanently.
According to all sides in the peace talks between Russia and Ukraine there was significant progress made on a 15-point plan. The deal includes a ceasefire and Russian withdrawal from territory captured since 24th February when Russia troops crossed the Ukrainian border. In return Ukraine will declare neutrality, agreeing not to join NATO and end hosting of military bases. The biggest sticking point is over Russia’s demand to recognise Russia’s 2014 annexation of Crimea and the future independence of the Donbas region as separate states. Critics of Russia say that Russia is not committed to peace and is stalling for time to regroup their battered forces.
Since these positive comments were made, Russia has continued with its siege bombing of major cities and tested the resolve of the Ukrainian people. President Zelensky has sought face to face peace talks with Vladimir Putin but the Russian response has been to ‘educate yourself first’ before any talks can start. There are estimations that up to 8 million people will eventually flee Ukraine and create the West’s biggest refugee crisis. Peace seems a long way away and that the threat of an escalation in bombing or even chemical weapon attacks seems just as likely.
The greatest tragedy is the innocent deaths in this conflict. So far 1300 Ukrainian soldiers have died along with 847 civilians. These figures are rising daily. Equally upsetting is the fact that 10,000 Russian troops have been killed so far in this unnecessary and unwanted war which surprisingly includes five Russian Generals.
Global leaders have been working behind the scenes for a settlement including Beijing, Jerusalem and Ankara. Putin will need to save face and with recent arrests within the Kremlin hierarchy, Putin may be already seeking out scapegoats and fall guys.
Global investment markets had a period of recovery over the past week with oil prices falling back from US$130 pb to US$100 pb. As a result, the S&P gained 6.4%, the FTSE 100 gained 3.5%, the Euro Stoxx 50 was up 3.7% and Japan’s Nikkei 225 up 6% over the same period. Markets have dropped back slightly as oil is now trading at US$115 pb. It is not just oil prices that have declined recently, so has gas and other hard commodity prices. Wholesale gas prices are down 16% over last week. Any decline in energy prices will ease pressure on inflation.
Both the Bank of England and the Federal Reserve raised their base interest rates from 0.5% to 0.75% last week. Markets were expecting this as a step by step move to control inflation. The Fed announced that markets can expect another seven rate rises this year. We can therefore expect a 0.25% hike each time the Fed FOMC committee meets every six weeks through the rest of 2022. This is the fist time that the Fed have risen base rates since December 2018. US inflation is currently 7.9% and unemployment 3.8%. As the US is self sufficient in energy it is less effected by energy cost spikes as compared to Europe.
The Bank of England’s Monetary Committee have over the past three meetings increased base rates. UK inflation is currently 5.5% against a BoE target of 2%. Looking ahead inflation in the UK is now expected to raise above 8% in April-May and could go even higher at the October price fixing of the OFGEM price cap. UK unemployment is 3.9% similar to pre pandemic rates. However, the vacancy to unemployment ratios now stands at the highest levels since 2001. There is plenty of work but vacancies are not being filled.
Both the BoE and Fed FOMC 0.25% rate rises were expected and taken positively by the markets. However, the longer an energy price shock as we have experienced for the past nine months continues, the more these rises will be embedded into inflation expectations and so turning what was once considered transitory price rises into more structural inflation. This is why the BoE and Fed are tightening gently and not causing market upset. The future employment market will be closely monitored over signs of tightening further.
The ECB are likely to be later in starting interest rate rises but would like to get out of their current negative interest rate position as this policy has not really worked. A concern for the Eurozone is that the ECB may get behind the inflation curve and have to hike rates more aggressively in future to have any impact upon inflation. The Eurozone inflation rate is 5.9% not dissimilar to the UK, but its unemployment rate is 6.8%. This factor is holding the ECB back from rate rises until unemployment falls further.
On the back of US interest rate rises last week, the 10-year US Treasury yield rose to 2.28% the highest 10-year yield since May 2019. With further rate rises to come yields are expected to rise further despite the conflict in Ukraine. Longer duration fixed interest often a safe haven in times of uncertainty hold considerable duration risk in these times of inflation and interest rate rises. For this reason, the large majority of our portfolio fixed interest securities are primarily short dated and inflation linked.
The wider price pressures over inefficient supply chains have reduced as inventories have grown and business adjusted. This will however likely to still be affected by the zero Covid policy of the Chinese Government. Large areas of China are currently in lockdown. The Jilin Province in North East China, home to 24 million citizens is where most new cases of Omicron Covid have come from. The Chinese authorities have taken swift action to lockdown the province. The containment policies have been less effective to Omicron but the real problem is the quality of Sinovac, the Chinese vaccine. While according to the Chinese National Health Commission 88% of the population has had 2 vaccines, it is far less effective than the Western alternatives. Beijing is unlikely to admit this but progress on a better vaccine must be a priority. Hong Kong is now in the middle of a full-blown epidemic and sadly 60% of the over 80-year-olds are not vaccinated at all.
Avoiding lock down is certainly positive for growth and this is now a top priority for Beijing having last week announced they would take measures to boost the economy in the first half of the year. On these announcements the Hang Seng rallied by 9% last Wednesday in one day’s trading. Commentators are now expecting a considerable policy of economic support in China.
Despite this, Beijing has just published its lowest official target for economic growth in three decades. Speaking during one of China’s most important political gatherings of the year, Premier Li Keqiang said that China would target GDP growth of 5.5% this year. This indicates that the housing slump, stringent Covid controls and global risks will continue to curb demand. Analysts consider this to be very ambitious and a target of 4% would be more realistic.
Investors are concerned that China could get dragged into the Ukrainian conflict and then have Western sanctions imposed. Beijing is likely to want to avoid this and potentially be the peacemakers. Interdependence remains high between China and other nations as China’s share of world exports stands at 14.2% as compared to Russia 2.2%, while imports stand at 10.5% and 1.2% respectively. China is heavily dependent upon the West to purchase its goods.
Global banks are not expecting a recession this year but growth is likely to be slower, not helped by the general cost of living crisis. Consumers have saved money through Covid lockdowns and this is likely to be seen in the economy as life returns to normal and previous spending patterns return. Governments are expected to step in and support consumers from the full effects of the cost of living rises and particularly energy inflation.
While there may not be an expectation of a recession this year. The crunch time could be next winter if energy supply has not been eased. Any worsening of supply and heightening of prices will not just be an inflationary problem but an economic production one too. Unfortunately, Boris Johnson’s visit to Saudi Arabia last week on behalf of the West was not particularly fruitful, but this may be the start of a longer diplomatic exchange to encourage OPEC to produce more oil.
War does not often bring about stock market corrections. In many occasions, markets have stabilised after an initial shock. Uncertainty is not the friend of markets but we can already see the world taking action on planning supply chain security, energy supply, defence and military expenditure and infrastructure planning. Public opinion has shifted post COP 26 towards home grown energy supplies such as North Sea oil and gas rather than imports, fracking and nuclear power alongside wind, solar, tidal and wave energy sources. This is likely to mean higher costs and taxes to fund such projects.
Clearly peace talks are the outcome that the world at large wants to see happen. Progress over a cease fire, humanitarian routes out of the country, medical and food aid delivery and the start of meaningful peace settlement would bring about a real relief in tensions in the world economy. Gold has had a very good run as a safe haven asset. We have been pleased to hold gold funds in our portfolio but the prospect of peace may reverse its appeal. No one can be sure about the course of this conflict. However, it is clear that the innocent people of Ukraine live in fear for their lives and the innocent people of Russia will see years of economic hardship forced upon them, while their rulers live in opulence.
If a peace deal is forthcoming then European equity markets are likely to be the main beneficiaries. If there is escalation then US equities are better placed. No one can be certain at this stage and that is why a diversified portfolio makes sense.
We have been very pleased with the performance of our portfolios over the past month. The changes we made in January were designed to protect capital from inflation and uncertainty even before the conflict and took a more defensive stance. We included such assets as gold, infrastructure, energy, natural resources, hedge funds, property, index linked bonds, short dated bonds and sustainable energy funds. These selections have held our portfolios up very well compared to the national averages. Across all six portfolios we are showing positive gross returns for the past one month ranging from 0.67% for our Cautious portfolio to 1.98% for our Speculative Beta portfolio.
It is difficult to look beyond the tragedy unfolding in Ukraine and how and when this may end. Equity markets have started to recover. The high levels of vaccination and the low virulence of omicron is a welcome development that brings forward the move to ‘normal’ living for much of the world. While one natural catastrophe seems to be on the wane let us hope this human made catastrophe will end soon.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.