Stock market and economic commentary March 2022

“Be happy for this moment. This moment is your life.”

Omar Khayyam (1048-1131). Persian astronomer, historian, philosopher and poet.

The Russia-Ukraine Conflict

Russia’s invasion of Ukraine is first and foremost a humanitarian tragedy and we hope for a peaceful solution although the prospects are finely balanced. It is difficult to imagine what a ‘fair’ peace settlement would look like, or rather the difficulty lies in envisaging the Kremlin agreeing to what the rest of the world would see as a fair deal.

Everyone is convinced that peace talks are simply a way for Putin to buy time and boost his chances of victory. In the meantime, we have the relentless bombardment of Ukrainian cities and innocent civilians, unprecedented economic sanctions and a huge energy and food shock.

The West will undoubtedly feel significant pain in the short term from a new oil and energy shock but in the longer term it will drive speedier adoption of renewables, “the energy of freedom” as German finance minister Christian Linder put it.

Despite the pressing needs, we should try not to abandon everything achieved in the past 3 decades. We are not at war with ordinary Russians who simply hope for a better future. On the contrary, in the long term they may prove our allies. Sanctions need to be targeted, as far as possible. The future of trade and other peaceful exchanges will depend on how this crisis unfolds. But at least we now have a mobilised and united west. A new world is being born.

Please refer to The Clarion Investment Diary for a real-time summary of the key points discussed at the Investment Committee meeting held at Margetts Fund Management Offices in Birmingham on 10^th March. Click Here.

Economic Update

Whenever there is trouble in the world, the price of oil soars. It happens at least once a decade, and sometimes more, such as during the 1970s when wars and revolutions in the Middle East led to a collapse in oil production in the region.

Once the extent of the Western reaction became clear it was inevitable that Russia’s attack on Ukraine would cause wild spikes in oil and gas and other commodities. Crude oil prices hit $140 a barrel shortly after the invasion, the highest level in 14 years, and gas prices surged.

Energy is at the heart of the economic relationship between Russia and the West. That relationship is now changing, with huge implications for both sides. The US, EU and the UK have made it clear that they want to reduce their dependence on Russian energy.

Oil is Russia’s main export earner, accounting for a third of its total export revenue. Put another way, Russian crude is the seventh bestselling export in the world, exceeded only by the likes of Saudi/UAE crude oil, Chinese audio-visual equipment, German cars and Taiwanese microchips.

Halting all exports of Russian oil and gas to the West would blow a hole in Russian government receipts and would hamper the funding of the war in Ukraine. But how feasible is it for the US, Europe and UK to cut off Russian oil and gas?

The US has announced a ban on imports of Russian oil and the UK plans to phase Russian oil exports out by the end of the year. Neither country, however, is a significant user of Russian oil.

Europe is far more dependent on Russian energy and in relation to gas, Chancellor Olaf Scholz said last week: “At the moment, Europe’s supply of energy for heat generation, mobility, power supply and industry cannot be secured in any other way. It is therefore essential for the provision of public services and the daily lives of our citizens.”

Whereas there is a global market for oil, gas markets are more localised and are only loosely linked. Gas is mostly transported by pipeline with limited global capacity to ship gas in a liquefied form. This means that local and regional factors can loom large in determining gas prices. Thus, in the last year while European gas prices have risen seven-fold those in the US have risen by “only” 60%.

High oil prices are likely to be here to stay for some time. Last Friday it cost $94 to buy a barrel of oil for delivery in January of next year. That is below the current level of around $110 – which suggests that markets assume that price pressures will ease – but well above the $78 a barrel seen at the start of this year.

The war will give a powerful impetus to global inflation and will dampen the recovery from the pandemic recession. Countries in central and eastern Europe with close ties to Russia in terms of energy imports, trade and financial exposure, are particularly exposed. Among major Western European economies, Germany is the most vulnerable because of its heavy reliance on Russian gas and an auto sector that is suffering from renewed supply chain disruption because of the war.

Economic growth, especially in Europe, will be weaker. The average forecast for Euro area growth this year has been revised down to 3.2% with Germany being downgraded to 2.4%. The UK is less exposed, and the average GDP forecast for 2022 has dropped by 0.7%, to 3.6%.

Inflation

Over the past three decades, there has been a tendency for investors to concentrate on a single data point. In the 1980s, this was balance of payments deficits. In the 1990s it was budget deficits and unemployment rates. More recently the focus has been on quantitative easing announcements and ‘dot plots’ that provide ‘forward guidance’ on future interest rate rises. Today there is little doubt that the number in focus is inflation.

Soaring commodities prices and disruption to supply will add significantly to already high inflation rates. Economists see Euro area inflation this year running 1.8% higher, at 7%, because of the war, while UK inflation is expected to come in 1.3% higher at 8% or more. This is not only a European phenomenon. In energy-rich America, which has weak trade and financial ties with Russia, the war is expected to add 1.4% to inflation this year. For many Western countries, inflation is likely to hit levels last seen more than 30 years ago.

It is easy to draw conclusions from the past. Some are pointing to a repeat of the 1970s, when the UK RPI rose to a peak of +26.9% in August 1975. But such comparisons are too simplistic and potentially dangerous. As the Wall Street Journal suggests, 2022’s inflation is more reminiscent of 1946-1948. The post second world war inflationary episode was due to supply shortages during peace time refits of manufacturing plants, rebounding demand for consumer goods, elevated levels of savings and soaring money growth.

This sounds a lot like today. As for how the 1940s inflation ended, supply and demand came back into balance and central banks slowed economies by curbing money and credit growth. Price increases slowed rapidly in 1948 and declined in 1949. A brief mild recession ensued, and stock markets trended upwards.

Today’s inflation is the product of some unique circumstances, many of which will not endure. Inflationary pressures may abate once economies normalise, and supply chains settle back towards a more balanced equilibrium.

In the meantime, many expect central bankers to ride to the rescue with tighter monetary policy. The Federal Reserve and the Bank of England recently increased interest rates by a quarter of one per cent. Financial markets expect the Fed and the Bank to keep on raising rates this year, with UK and US rates predicted to reach the 2/2.5% mark by the end of the year (US rates currently stand at 0.5%, UK rates at 0.75%). Even in the Euro area, where the knock to growth from the war will be greater, financial markets see the European Central Bank raising interest rates this year for the first time since 2011.

Central bankers are, however, ‘in a trap of their own making’. Interest rates have stayed so low, for so long, that debt has been allowed to balloon to over 100% of GDP in countries like the UK and the US, matching post World War II levels.

Simply put, interest rates are unable to rise above the current level of inflation without triggering defaults and a recession, which central bankers would wish to avoid at all costs, meaning financial repression will worsen and cash deposits will continue to lose purchasing power.

Stock Markets

The implications of inflation for investors comes in several forms. The first is the prospect of a rising cost of capital. This may take time to take effect as interest rates remain low and are negative in real terms. However, companies whose value rests upon cash flows discounted far out into the future are vulnerable to those earnings becoming less valuable as discount rates rise.

Previous bouts of inflation have led to a reappraisal of the price that investors are prepared to pay for future earnings, preferring a bird in the hand over two in the bush. This explains the recent falls in the more speculative parts of the stock market during the first few weeks of 2022.

Nobody knows the answer to the inflation conundrum, but we need to be alert to all potential outcomes. Are we now entering a new regime? Nominal returns, although positive, may be more volatile while real returns are likely to be harder to achieve.

How do we position investment portfolios for these circumstances?

Companies with higher gross margins (those with a lower cost of goods as a proportion of sales) are better insulated from the vagaries of rising input costs and wages. A 5% margin business would be far more vulnerable to gas prices doubling than a 25% margin business. The former’s profits are precarious, as a result, harder to manage and, by definition, harder to value.

Lowly valued capital-intensive companies may be just as exposed to rising inflation as more highly rated growth stocks. There is no easy escape for investors, and it is not surprising that market volatility has picked up of late as investors attempt to digest the implications of higher inflation and rising interest rates.

In recent years we have been through many challenging periods; the global financial crisis, the covid-19 pandemic, and, to a lesser extent, the uncertainty over Brexit. At all times we have continued to focus on the long-term attractions of the funds in which we invest.

The good news is that corporate profitability has recovered well from the worst of the pandemic impact and dividend announcements have been positive. The UK, European and Asian stock markets are reasonably priced compared to long term averages, the US whilst slightly more expensive, is more attractive than at the start of the year, and many sound companies are trading on attractive valuations, from which we believe they can deliver strong shareholder returns.

It is important in times of uncertainty to maintain a focus on risk. The Clarion portfolios have good exposure to “value’ stocks”, such as those in the energy, financials and industrials sectors, which have consistent earnings but lower growth prospects than stocks such as those in the technology sector. This strategy has provided some protection against recent market falls as value stocks tend to be more predictable during periods of market uncertainty.

We continue to believe that investing in quality businesses with strong balance sheets, low levels of debt and high-profit margins is the best way to protect the purchasing power of hard-earned wealth. Investors should avoid companies with no pricing power and low gross margins. Quality, diversification by geography and a broad mix of sectors are paramount.

These are the criteria Clarion use when we select the fund managers for the Clarion Portfolio funds and model portfolios.

As always, we thank you for your continued support and we look forward to updating you regularly throughout 2022. We invite you to get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

March 2022

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Risk Warnings

The content of this article does not constitute financial advice and you may wish to seek professional advice based on your individual circumstances before making any financial decisions.

Any investment performance figures referred to relate to past performance, which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.