Market Update – March 2022
Chris Brown, CIO, 11th March 2022
When Covid hit, we wrote to clients that the fight against the pandemic was a bit like a war. Wars normally go on much longer than people think at the start and have a much higher human cost. But eventually, we thought we would win the war against the pandemic. The right thing to do was to keep our eye on the longer-term prize and make sure we profited from the eventual recovery when it came. This proved to be the right approach for 2020/21. Well, now we have an actual war. The human cost is already tragically high and rising every day. The economic cost is coming through in the shape of higher energy and food prices. What is the right approach today?
The first message is pretty standard financial advice. As with the dark days of Covid, if you have a financial plan, now is the time to stick to it. We run risk-controlled portfolios aligned to your requirements precisely to weather these sorts of geopolitical shocks and nasty surprises. By themselves, geopolitical events normally cause short and sharp reactions in markets that are over in 6 months or less. Table 1 gives some context of previous geo-political events and the (US equity) market’s reaction to them.
The problem here is that the war came at a time when the market was also suffering from an inflation shock coming out of Covid. War is inflationary and inflation, which was expected to be peaking around now, will now keep climbing higher in the short term. This double inflation shock has led to the sharp falls in equities (and bonds) we have seen so far this year. The challenge we face as investors is to judge how far this inflation spike will go and the impact it will have on the broader economy and interest rates.
Risks and Opportunities
One risk (from an investment perspective) is that the war ends early. Any kind of retreat from Ukraine and/or renormalizing of relations with Russia would see European assets in particular rise sharply. Though this is not what we expect to happen, we need to make sure we have enough exposure to recently distressed assets that we can catch any positive surprises should they happen.
That said, European banks, for example, have now fallen over 30% from their February highs. Is now a time to be brave? We think it is still too early. The most likely scenario is that the war grinds on. Putin needs to be able to show a victory and his only leverage is to start reducing Ukraine to rubble so he can earn concessions to make him stop. Though the military campaign has so far been inept, Russia has risked too much to pull out now. In this scenario, the US looks the best place to weather a longer term ground war in Europe. It is both broadly energy independent and the home of many of the technology giants (such as Microsoft and Google). Technology as a sector is less exposed to the sort of cost-push inflation pressures that more energy intensive businesses face. We have slowly increased our US equity exposure over the last few years. This looks a market that is well placed to weather the current geopolitical storm.
For the broader economy, the risks today look balanced to our eyes. Net/net higher energy prices are a bit like a tax rise and leave less money for people to spend elsewhere. In the longer run this should slow growth down and be deflationary. However, in the short run inflation is already high and due to rise again as energy and food price rises kick in. This will keep the pressure on central banks to stick to their current plans to raise interest rates. Our view is that inflation remains the bigger risk for the rest of 2022. This pushes us to own, as much as we can, real assets. These include both equities that benefit from higher inflation and also our listed trusts which own assets (such as renewable energy investments and specialist property) that generate attractive inflation protected returns. Within equities, energy producing companies look well placed to produce very healthy returns if inflation remains high and we may look to add more to our investments if energy prices remain at elevated levels.
That said, we are reluctant to make major changes to our portfolios while the economic situation remains as fluid as it is today. Our focus as always is on the longer-term investment opportunities which crises like these inevitably throw up. Our aim is to profit from them and we will continue to update you as and when we do.