“In many ways, the stock market is like the weather in that if you don’t like the current conditions, all you have to do is wait a while.”
Louis A Simpson, CEO and President of US Government Employees Insurance Company and close friend, confidante and adviser to Warren Buffett of Berkshire Hathaway.
Russia’s invasion of Ukraine continues to take its toll. Most tragic are the terrible loss of life and human suffering but the material destruction is also enormous. Before the war, the IMF forecast an increase this year in Ukraine’s gross domestic product of as much as 3.6%. Now the Economic Intelligence Unit predicts that will drop in real terms by an alarming 47% whilst the Russian Finance Ministry is forecasting “about a 10% contraction” in Russian GDP this year.
According to Ukrainian Prime minister Denys Shmyhal, considering the damage already done and the expected fall in production in coming years, the losses will exceed $1trillion, of which the destruction in infrastructure amounts to $150 billion. Sadly, by the time you read this commentary, those figures will likely be many millions more.
In the current phase of the crisis, humanitarian and military aid is most urgent but a time will come when the bombing eventually ceases. The day after, both immediate help and long-term support will be essential.
Who will pay the price? To support Ukraine’s reconstruction, the EU have said they will create a special long term financial vehicle – a European fund for the “Reconstruction of Ukraine”. Launching such a fund will not be easy and will prove far more expensive than supplying weapons to fight the Russian Aggressor.
The second instrument of aid for Ukraine is likely to be deep cuts in its foreign debt, currently around $60 billion, a large chunk of which is held by multilateral institutions such as the IMF and World Bank. Either way, Russia has more to answer for than the loss of life and human suffering.
How will it all end?
There are equal chances of a seriously terrible or a genuinely positive outcome, but there is also an equal probability that the conflict will turn into something more like World War 1, stuck in stalemate for years and years to come. The current attitude in financial markets seems to be that this can then be safely ignored, much as the grinding conflict in Afghanistan came to be known as the “Forgotten War”.
We continue to hope and pray for an early and peaceful solution with the avoidance of further suffering and loss of life but, sadly, this is looking increasingly unlikely; and history is against us. Only time will tell but we pray for a good outcome, for all our sakes.
Predictions for world economic growth in 2022 were recently revised downwards by the IMF to 3.6% from 4.4% at the start of the year. UK’s economy is now expected to expand by 3.7% compared to earlier predictions of 4.7%.
Immediately after the IMF report was published the price of oil fell by almost 5% adding weight to the adage that “the best cure for high oil prices is high oil prices”. Eventually, oil prices get to such a level that usage starts to fall in a process of “demand destruction”.
It is understandable that the economy is showing signs of stalling from its remarkable pandemic recovery, given the sense of foreboding which arose from mid-February as Russian troops massed on the Ukraine border and then the commodity shock unleashed by the invasion hit sentiment.
Despite worries about consumer and company resilience, this snapshot is unlikely to push the Bank of England off its path of raising interest rates this year. Attempting to tame increasingly wild inflation is still set to be the priority. However, the IMF report does indicate the UK economy is showing more signs of fragility than the US, where economic growth is still running “hot”.
The saving grace, for now, is the piles of lockdown savings that many consumers were able to build up during the pandemic, which are now a soft pillow to land on as the headwinds of higher prices whip up, but this cushion will flatten as the year progresses. So, UK policymakers are likely to hold off on mirroring the Federal Reserve’s much more aggressive stance in terms of tightening monetary policy.
The biggest and most broad-based impact of the Russia/Ukraine conflict is through higher energy and commodity prices. Russia and Ukraine combined are crucial sources of both food and energy. Russia supplies around 10% of the world’s oil and 40% of Europe’s gas whilst together with Ukraine, the two countries produce 30% of the world’s wheat.
Immediately after Russia’s invasion, economic sanctions by the West and, in some cases, voluntary self-sanctioning by firms, led to a sharp rise in fuel prices. Although markets have steadied since the initial shock, the price of crude oil remains about 8% above mid-February levels and the price of natural gas in Europe is up 50% over that period.
Rising energy and food prices are one of the main factors pushing inflation towards the 8 to 10% mark but also the reason interest rate rises will remain ineffective in bringing inflation down to the desired target of 2%.
Interest rate rises are not the right medicine for these external forces. Rate hikes can of course do some good by suppressing price rises elsewhere, but tightening must be done carefully given the potential to tip the economy into recession.
While those rate hikes are slowly dripped into the market, inflation could yield wins for some parties – shrinking the real value of debt and increasing the government’s tax take due to frozen thresholds. And it might also hasten the reduction of our usage of polluting fuels.
But mostly inflation is damaging. It erodes our purchasing power, devalues our savings, lands us with extortionate energy bills and can lead to weaker real returns from our investments.
Inflation and a tightening cycle add to uncertainty about the future and depress economic activity as businesses become nervous about investing and about consumer spending. Even if inflation has been under control for years (a recent study by Credit Suisse shows that between 2014 and 2021, out of 21 countries, 17 had inflation below 2%), no one can afford to ignore the threat it poses.
However, many economists believe that inflation will moderate over the medium term and are not worried about rising inflation and higher interest rates over the long term. Many of the supply chain frictions caused by the pandemic will resolve in time. Rising prices will raise capacity, increase supply, and crimp demand. As pent-up consumer demand for goods dissipates and spending on services normalises, goods price inflation is likely to ease.
There is also some comfort to be drawn from recent data from the US. Core inflation driven by supply chain hold-ups is cooling, supported by the fact that the price of Brent crude oil has slipped back to the $100 mark. According to energy expert, Mike McWilliams at the Centre for Economics and Business research, the price of fuel at petrol stations will fall later this year, but the cost of heating our homes will stay high for years rather than months.
In a recent survey conducted by Deloitte, according to the Chief Financial Officers of the UK’s largest companies, geopolitical uncertainties following the invasion of Ukraine and high inflation mean that the external risks facing businesses are greater today than at any time in the last seven years. Geopolitics and inflation now far eclipse Brexit and the pandemic, which has dominated the list of CFO concerns in recent years.
The 13 years in which the Deloitte CFO Survey has been running have been a period of unimagined risk with a succession of shocks, starting with the financial crisis, through Brexit, geopolitical tensions, deflation and inflation, the pandemic and now a war in Europe. For CFOs, external uncertainty is a fact of life that has to be managed and mitigated.
But the survey revealed that despite the risks facing business today, CFOs remain upbeat about the prospects for revenue growth, with three-quarters expecting revenues to be higher in a year’s time. Introducing new products or services or entering new markets remain the top priority. And, while expectations for capital spending are down from the all-time highs seen last year, they remain well above the long-term average.
Tragedy, volatility and confusion. The world changed dramatically in the first three months of 2022 and conditions for investors have seldom been more challenging; nor the six o’clock news so dispiriting.
But for now, global equity markets have proved to be remarkably resilient in the face of higher inflation, rising interest rates and the economic disruption caused by Russia’s invasion of Ukraine.
Many companies and industries are benefiting from a cyclical recovery in demand post-Covid and for those companies with a global footprint, a manageable exposure to direct energy costs and (critically) with pricing power, the outlook for their profits and cash flows is still robust. This position across many global companies, with a particular boost for energy and mining stocks, and a recognition that equities are the largest and best asset class through which to gain insulation from inflation, have combined to drive the MSCI World index up by over 6% from its low point in February.
April has been something of a curate’s egg for investors with an increasing list of worries to focus on – whether it be Ukraine and its potential escalation, inflation, China’s covid-related lockdowns, fears over errors by policymakers, and the risks of recession whether caused by energy costs, broader inflation or over-enthusiastic monetary tightening.
The correction in the US bond market has been one of the sharpest in many decades with the yield of 1.7% on the US 10-year Treasury on 1st March increasing to 2.84% on the 19th of April. As yields rise, the price of the security falls with long-dated government bonds, hitherto considered a safe investment, falling by more than 20%.
This has reflected a swift change in mood from safe-haven status to one with greater emphasis on the Fed’s US updated GDP forecast of 3.8% in 2022 (still well above the 20-year trend rate) and the prospect of ‘higher for longer’ inflation and the associated policy response.
The effect of inflation on equity prices is also worth noting. A recent study by Credit Suisse found that in deflationary times, equities deliver much higher gains compared with inflationary times, but they still outperform bonds and cash savings during the latter.
Tightening cycles also have an effect. The researchers found that in the UK, equities delivered an annualised real return of 1.2% during rate rise periods compared with 8.5% during periods when interest rates are falling. They also found that in tightening cycles there was a relative outperformance from defensive companies versus cyclicals and from large companies versus small caps.
These findings are based on long term averages spanning many different economic conditions, which conceal considerable difference between cycles. Encouragingly during almost half of US interest rate hiking cycles, equities performed better than during the easing cycles that followed them.
In conclusion, we share this comment from the Financial Times on March 28th, 2022, regarding the recent Berkshire Hathaway $11.4billion acquisition of insurer to toy manufacturer, Alleghany.
“Warren Buffett buying now in the face of all the uncertainty – the geopolitical, economic and interest rate uncertainty – is a real vote of confidence in the US and global economy. He is telling us that he believes there is value and that you can buy companies that will do well and will deliver more value than cash.”
We expect that this year will continue to be a difficult one for investors to navigate and while we do not consider our role to be that of making precise macroeconomic or geopolitical forecasts, we at Clarion share Warren Buffett’s vote of confidence in the future.
Please refer to The Clarion Investment Diary for a real-time summary of the key points discussed at the Investment Committee meeting held at the Clarion offices on 7th April.
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
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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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