Stock market and economic commentary June 2022

Crisis is derived from the Greek word “Krisis: a time of decision, with the possibility of both danger and opportunity”.

The next few years of rolling crises look sure to offer plenty of both.

Ukraine

The Russian military, mired in a war with no end in sight, is attempting to resuscitate its sputtering offensive in Ukraine, firing commanders, splitting combat units into smaller formations, and redoubling its reliance on artillery and other long-range weapons.

The shift comes almost four months after Russian and American officials alike predicted a quick and decisive victory for Moscow. After the deaths of thousands of Russian soldiers and an avalanche of failures since the invasion began, Russian President Vladimir Putin has narrowed his objectives in a campaign viewed as unsustainable, unrealistic — and likely unwinnable.

Russia’s attempts to take Kyiv or even the second city of Kharkiv appear to have been abandoned. Instead, they are waging a tougher and far more limited war of attrition in Ukraine’s far east and on its southern coast.

The question; was the initial chaotic Russian assault on the capital a failed strategy, or was it a tactical move to divert attention from the true intention, which had always been to establish a land bridge to the Crimean Peninsula and dominate the coast? Is Russia in fact winning, despite everything?

In a speech, Russian president Vladimir Putin compared himself to Russian Tsar, Peter the Great, claiming it was his mission to return Russia to what Russia was. Former Swedish Prime Minister Carl Bildt said it was a “recipe for years of war”.

The European Commission called for Ukraine to become an official candidate to join the EU after French, German and Italian leaders travelled to Kyiv to meet with Ukrainian president Volodymyr Zelensky.

US treasury secretary Janet Yellen said that the US is involved in “extremely active” talks with allies in Europe to form a buyers’ cartel for oil to minimise the amount of revenue flowing to Russia. However, if China continues to buy the surplus oil from Russia, this is likely to have limited impact.

A protracted war is bad for everyone, but perhaps less bad for Russia. Sanctions and a blockade could soon add up to stagflation and raise the risk of unrest over food and energy prices across the world. But it’s hard to see how this can be avoided without someone admitting a crushing strategic defeat.

Economic Update

A year is a long time in economics. Last summer there was much talk of how the end of the pandemic could usher in a period of rapid, technology-driven growth, much as happened in the 1920s. Such talk has faded in the face of soaring inflation and faltering growth. Instead of roaring growth in the 2020s, global activity is spluttering, with the OECD and the World Bank recently warning of the growing risks of a recession.

The risks are in plain sight. Inflation is eating into consumer spending power at a speed that has not been seen in decades. Weaker demand, higher interest rates, corporate cost-cutting and uncertainty inhibit growth. By undermining investment, and the ‘animal spirits’ of the business sector, a weak economy depresses productivity and future growth.

We are in a classic downturn phase of the economic cycle, driven, as so often in the past, by rising inflation. Most economists forecast a slowing or stagnation in activity with a softish, if uncomfortable landing but some think that the risks lie towards things being weaker, not stronger.

Recessions tend to cast a long shadow on subsequent growth, as they did after the financial crisis in 2008 and 2009. Yet a country’s growth potential is not solely a function of the ups and downs of the economic cycle. A host of other structural factors, including law and regulation, emerging technologies and the organisation of production, matter too.

If such structural factors shift in the right direction recessions can be followed by strong growth. The end of the first World War in 1918 saw a deep recession, driven partly by demobilisation, but this was followed by several years of strong growth as the widespread electrification of production boosted productivity. The UK suffered a severe recession in the early 1980s, but the Thatcher reforms of that period helped lay the ground for a stronger trend growth through the 1990s and the early 2000s.

So, amid the gloom about the immediate outlook it is worth keeping an eye on how the structure of the world economies might change.

One obvious driver of change is the way in which the pandemic has changed the organisation of work and where it takes place – the overnight experiment of home working saw the proportion of the workforce operating from home in the UK going from around 5% to 50%. The pandemic compressed years of digital and cultural innovation in remote working into months.

A recent survey by the Office for National Statistics found that 38% of the workforce were working from home some or all the time. Previous step changes in the organisation of work, such as specialisation by trade, the production line and the modern office, have raised productivity. Hybrid working could have similar potential.

Reorganisation of work, when coupled with the mass application of new technologies, is one of the surest ways to faster productivity growth. And innovative technologies, from AI to mRNA vaccines, gene therapy and new, cheaper satellites, are coming through.

The greatest change, however, is the energy transition. Such a phrase does not capture the scale of what is happening. What has started as a shift away from hydrocarbons seems likely to broaden into a societal and industrial revolution in much the way that the move from water to steam power did in the 19th century and the shift from steam to electricity and hydrocarbons did in the 20th.

Technological improvements have helped collapse the cost of onshore wind and solar power, rendering it cheaper than gas or coal. Last December the International Energy Agency estimated that global renewable capacity will rise by 60% by 2026 with total capacity forecast to exceed that of hydrocarbons and nuclear combined. Soaring energy prices could yet pitch us into recession, just as the oil price shocks of the 1970s did, but those shocks also led to a massive drive for energy efficiency. Today’s high energy prices, and the war in Ukraine, make the case for renewables still stronger.

Economic systems are vastly more complex and unpredictable than the models that seek to mimic their behaviour. There are times in economic history when the pendulum swings, as it did in the late 1960s, from low to high inflation, and in the early 1980s, when it swung back again to low inflation. Today’s inflation looks more like the product of massive external shocks and supercharged global growth, forces that should fade. This will take time but may happen quicker than many economists predict.

In the short term the economic cycle is everything, and on that yardstick the outlook is darkening. But momentous changes in the structure of the world’s economy are coming, driven by technology, the climate transition, and the changing nature of work. These forces keep alive the hope that the twenties, while spluttering now, could yet roar.

Stock Markets

I am allowed to say this because I come from farming stock myself. Farmers complain and worry constantly, and about everything. Too wet, too dry, too hot, too cold, etc, etc

Investors are not so different.

The opening months of this year brought an inflation panic. Bonds prices dropped hard because they are allergic to inflation, which eats into their already skimpy fixed pay-outs.

Stock markets also fell because fund managers and investors decided that the US Federal Reserve would dish out interest rate rises like sweets at every meeting throughout the year to try to pull down inflation. The “everything rally” unravelled and left many fund managers and investors with nowhere to hide. The horror of it all!

Now, after recent readings, the inflation panic is right back at centre stage, with the added fear that the only cure will be a serious slowdown in economic growth or even, in a worst-case scenario, a full-blown global recession. Kindly adjust your stock market seat belts.

For the last 15 years central banking has been about supporting growth and heading off deflation. Today they face the opposite problem – too much growth and rising inflation. The Federal Reserve broke the last great surge of inflation, in the early 1980s, by raising interest rates to 19%, in the process inducing a recession. Today’s situation is different, not least because inflation rates are lower and, unlike the 1980s, inflation has been well behaved for years. However, there are enough similarities – soaring energy prices, tight labour markets and industrial unrest – for the 1980s experience to be relevant and unsettling today.

Central banks, like economists and journalists, have been slow to appreciate the scale of the inflationary threat. Last summer it seemed likely that interest rates would stay at ultra-low levels for years to come; an early tightening of monetary policy was widely seen as posing a major threat to the recovery.

That has changed. Earlier this month the Fed raised rates by 75bps, the largest increase in 28 years, with an implicit acknowledgement that the pace of rate hikes so far had been too slow. Christine Lagarde, head of the European Central Bank, confirmed that euro area rates would increase in July and went further by saying rates would probably go up again in September and beyond. The Bank of England raised rates at the meeting on 16^th June, the fifth consecutive meeting at which they have hiked. On the same day the Swiss central bank raised rates for the first time in 15 years.

The message from central banks is that inflation is rising faster than they expected – and that they are determined to bring it back to target. No wonder financial markets expect a barrage of interest rate rises in the next six months. Markets see UK rates rising from a current 1.25% to around 3.0% by the end of 2022 before peaking at about 3.5% in 2023. US rates are forecast to rise from the current 1.5%–1.75% to 3.5% by the end of 2022 with euro rates rising from minus 0.5% to almost 1.25%. If markets are right, 2022 will witness the sharpest tightening of monetary policy since the 1980s.

Equity markets have been rocked by recent news. At one point the US S&P index of major stocks had lost 10% of its value this month and a total of 23% since the start of the year pushing the market firmly into bear market territory. The sell-off in technology and consumer discretionary sectors has been fiercer still. The price of cryptocurrency bitcoin is down over 50% on the year. Investors have been left with nowhere to hide.

The problem is that central banks are limited in their ability to tame the type of inflation from which we are suffering. Interest rate rises cannot put an end to China’s lockdowns, produce microchips or manufacture peace in Ukraine. Unless central banks can fix that third issue, they are unlikely to pull down energy prices and by extension, temper workers’ perfectly reasonable requests for higher pay.

To bring inflation under control central banks need to do something about the demand for labour, since they cannot do anything about the supply. So, they need to induce a slowdown which brings the risk of tipping the economy into recession.

However, no government has ever won an election on the promise of slower growth. It is clearly not what incumbent politicians want, it is not what businesses and households want after an already testing couple of years. Policymakers want to engineer slower growth to take the sting out of inflation, but they also want to avoid tipping the world into a recession.

It is easy to see why the thought is taking root with investors from several angles. Just like the Farmer who worries and complains about it being too hot or too cold, too wet or too dry, so investors are going through a period of panic amid the uncertainty of how it will all end. When central banks set out to crush runaway inflation recessions often ensue. That outcome is not preordained today, but it is now in the range of possibilities.

We are back in the zone where bad news on economic growth will be good news for equity markets as it means less upward pressure on interest rates.

If you can stomach the volatility – and secretly love to complain – this is the perfect combination. As we used to say on the farm, if you can’t see the Langdale’s because of the rain, do not complain or worry, fine, brighter days will surely follow. They always do. And in the same way, at some stage in the future, equity markets will again feel confident enough to look beyond the current mayhem and see secure times ahead. But first, inflation must be tamed, as it surely will be.

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

June 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.

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