Stock market and economic commentary – February 2022

“The pessimist sees difficulty in every opportunity. The optimist sees opportunity in every difficulty.”

Winston Churchill (1874-1965), British Statesman and former Prime Minister

Economic Update

The first few days of February had distinct echoes of January with the contrasting fortunes of two prominent American technology companies taking centre stage.

Facebook

The month had only just begun when Facebook’s re-christened parent company Meta Platforms Inc delivered a humdinger of a warning on its trading outlook. The big fourth quarter earnings miss dragged all major stock market indices lower in an unmitigated bloodbath. The lacklustre results gave the stock, and a broader market already on edge following January’s volatility, a further knock. It was Meta’s worst-ever single-day drop that wiped out around $250 billion in market value. To put this in context, the fall in value was equal to the combined value of Unilever and Glaxo.

Some might argue that a rout which had already affected the more speculative tech stocks was somewhat overdue. Sky-high valuations that some financial pundits have noted were “priced way beyond perfection” are under threat, especially in the context of a Federal Reserve poised to hike rates.

But several financial commentators think the fall in Meta has been overdone, with one renowned fund manager commenting that the outlook is not as bad as it seems, insisting Meta remains a “core” holding.

“It’s easy to forget amid the near-term uncertainty, that Meta remains one of the greatest businesses of all time. Keep in mind that 3.6 billion people – a staggering 61% of all people aged 15 and older on the planet – use one of Meta’s services every month, up 9% year-on-year in the fourth quarter.” For the record, Meta owns Facebook, Instagram, WhatsApp, Oculus and Messenger.

All of that translates into 20% revenue growth, an operating margin of almost 40% and free cash flow that hit a record near $13 billion last quarter, and up around 36% year-on-year, the investor added.

Amazon

On the day Meta dropped its earnings bombshell and in anticipation of its own fourth quarter trading update, the shares in Amazon fell almost 10%. Yet when the results were announced, the retail platform giant unveiled record earnings and became the first-ever company to make more than £100 billion profit in a single quarter.

In the crucial holiday period, the tech behemoth raked in more than £1 billion a day as sales rose 9% to £101 billion. Amazon’s operating profit almost doubled despite contending with higher shipping costs, supply chain disruption, higher wages and employee incentives. Of more importance to market observers was the fact that the company plans to raise prices in the US on Prime, its one-day delivery and streaming TV package, by almost 17% in a move that underscores its pricing power and highlighting Prime as a big revenue driver.

The very next day the shares rose by 15% as buyers eager for a bargain took advantage of the lower price.

It is worth noting that the Clarion funds and model portfolios had negligible exposure to Facebook whilst on the other hand, US and global index-tracking funds have significant exposure, particularly those funds which track the Nasdaq index.

Russia and Ukraine

The human tragedy of Russia’s invasion of Ukraine far eclipses the events earlier in the month and ranks as one of the most catastrophic episodes in European history. Our thoughts are with the people of Ukraine at this difficult and uncertain time. We salute their bravery in the face of such evil.

The conflict has thrown major new complexities and uncertainties into the geopolitical and macro-economic outlook. Markets had already been pricing in the possibility of escalating conflict given the build-up of troops on the Russia/Ukraine border and the continuous vocal communication about the likelihood of military action. However, since the reality of the invasion, financial markets have entered a new phase of risk and volatility.

Russia’s vast landmass and large population (144m) belie its role in the global economy. Russia is the world’s 11th largest economy, somewhat below Italy, while Ukraine is ranked in 55th position with roughly the same level of GDP as Hungary. Unlike China, which is a manufacturing powerhouse at the centre of global supply chains, Russia is a relatively minor player in global trade, other than in commodities. Russia’s annexation of Crimea in 2014 accelerated a long-term reduction in Russia’s importance as a trading partner for the EU. Russia accounts for just under 5% of total EU trade, down from over 9% ten years ago.

In terms of military power, and in particular nuclear capacity, Russia punches well above its weight. It has an outsized global role that is greater than its population or economy would imply. Peter Robertson, professor of economics at the University of Western Australia, estimates that adjusting for the relative defence costs, Russia gets more from its defence spending than the UK, France and Germany combined.

Russia also plays an outsize role in global commodity markets. Russia and Ukraine jointly account for about a quarter of global exports of wheat, with Middle Eastern countries and Turkey being the main markets. Russia accounts for 40% of the EU’s natural gas imports (about half of German and Italian imports and almost 100% for Eastern European EU members) and 26% of the EU’s oil. About 40% of gas reaches Germany via the Nord Stream 1 pipeline under the Baltic; 30% comes through Ukraine and just under 30% comes via Belarus to Poland and then Germany.

It is impossible to say how long Russia’s current first move will take or what its outcome will be. Russia appears to be looking for an annexation of at least part of Ukraine and a regime change in Ukraine, even if the short-term economic cost to Russia through sanctions is damaging to its people. The political will in Russia to achieve this goal appears to be much greater than the ability of Ukraine to resist it or the resolve of Western powers to block it.

The key questions for investors are how the invasion will play out, how far the Russian incursion will go, and what response the Ukrainian government, military and most important population will have. Russia may win the War, but will it win the Peace?

The outcome and timing will have an impact on how sharp the short-term reaction will be in terms of energy and other commodity prices, what impact this reaction will have in turn on inflation and policy responses by the central banks, and how great the risk is of a significant further escalation or a prolonged period of great uncertainty which could materially undermine the current expectation of global economic recovery and strong GDP growth in 2022-23.

A scenario could be that annexation/some regime change will occur in Ukraine quite soon. Russia would effectively take control of the Eastern part of the country including further valuable access to ports on the Black Sea. If active hostilities calmed down during this period, markets would increasingly view it as a regional conflict with limited impact on global growth. The immediate mood of heightened risk in markets would dissipate and the focus would return to the economic costs, increased inflation and the likelihood that energy prices would steadily fall back as market conditions normalise, supply increases and supply chains realign.

In this scenario, markets are likely to remain volatile but avoid a prolonged downturn, as in many industries and countries the impact will be manageable. Countries with lower levels of self-sufficiency in energy and companies with high input costs in energy, minerals and agri-commodities would be squeezed the most. Many companies would see limited impact on their operating environment or profitability. Quality and resilience will be the key to survival and prosperity.

In a different scenario of a prolonged conflict of six months or longer, or if other countries including NATO members decided to get involved directly in the conflict, the impact on markets would be more significant. However, while that more problematic scenario would likely have greater short-term volatility, it would not necessarily lead to a more substantial impact on a medium-term view of one to two years or more.

We must be careful with precedents, but previous geopolitical events of this nature suggest a time-limited downturn in markets. For example, after Iraq’s invasion of Kuwait in 1990, the S&P 500 was 13% down after six months, but 10% higher after 12 months. On a smaller scale, when Russia annexed Crimea in 2014, the S&P 500 was 3% higher after three months and 15% higher after 12 months.

The greatest economic pressure to come out of the Ukraine situation is likely to be a broader short term inflationary pressure which will include energy, materials and agri-commodities. The question will be how central banks respond to inflation that is up to 2% higher than previous estimates. Will the Fed, the ECB and Bank of England lift rates further and faster than current expectations, raising the risk of choking the economic recovery? Or do they fear a potential recession more than inflation, and will they adopt a more measured approach?

It is likely that policymakers will see recession as the greater current risk given the geopolitical situation, the still uncertain recovery from the coronavirus pandemic and the potential for polarised political outcomes in domestic elections in many countries this year, in particular, the US mid-term elections and the French presidential elections.

Inflation

Inflation has been incredibly low since the financial crisis, yet a pound held in 2008 is worth only 67p today. Prices have risen around 19% in the past five years alone. Imagine what even slightly higher inflation will do to the purchasing power of cash over the coming decade.

Across the West, inflation is hitting multi-decade highs. US inflation rose from just 0.1% 18 months ago to 7.5% in January, a 40-year high. In the UK and Euro area inflation is running at over 5.0% with further to go. The Bank of England expects Britain’s inflation rate will reach 7.25% in April.

These sorts of inflation rates pose an increasing threat to the economic recovery, arguably more so than the pandemic and possibly even more than a war in Eastern Europe.

The real problem is not a temporary surge in inflation, the sort that was seen in 2011 on the back of rising commodity prices. The current bout of inflation is worse than expected, but most economists continue to think it is driven by temporary factors, particularly disruption caused by the pandemic, and that price pressures will ease later this year. If this thinking proves to be correct central banks will want to tighten policy, but probably not enough to derail the recovery.

A glimmer of hope emerged from, of all places, China, which in recent data reported a 50pc decline to 9.1pc in wholesale price inflation in January and a much more benign 0.9% rise in consumer prices. The West is still heavily dependent on China for a wide range of goods, so it is comforting to see that as post-Covid supply chain problems ease, goods price inflation is tumbling. Energy prices in China are also beginning to fall.

Protecting capital in an inflationary world

The hurdle for protecting the real value of capital is being raised and, while many commentators do not anticipate progressively higher inflation from here, there is clearly a greater risk of this outcome due to the financial and monetary “solutions” to the Covid crisis.

Shares in quality businesses are one of the best ways to protect capital over time. This however is only true if you pay the right price to acquire those shares. As Warren Buffett once famously observed, “price is what you pay, value is what you get.” Owning high-quality companies with sustainable growth is a winning strategy over the long term and has been shown to work over several economic cycles. Buying high-quality businesses at the right price is a simple recipe for success.

But what do we mean by “quality”?

High margins and pricing power are critical to maintaining and increasing profitability in an inflationary age. Companies with superior pricing power can raise their prices in line with (or even beyond) inflation, without losing too many customers in the process.

But pricing power is only part of the story. Companies that have high gross margins and low raw material costs also have an advantage. A high gross margin means that the uncontrollable external costs of running the business are comparatively low when compared to the revenue. Inflation has a higher impact on businesses with a lower gross margin.

The “Holy Grail” of inflation-busting companies is the ability to combine a high gross margin with superior pricing power. A “double whammy” which means they are less affected by rising costs, whilst also being able to increase their prices to outpace inflation.

It is these companies that should benefit in an inflationary environment. We, therefore, believe inflation should be seen not as a headwind to long term investment performance, but potentially as a boon to the performance of those companies that can prove their mettle during inflationary times. What an investor needs to avoid, are those companies that have a low gross margin, with little or no pricing power.

Stock Markets

Global equity markets have had a shaky start to 2022 falling by circa 10-12% so far this year, with technology and so-called growth stocks, the big drivers of rising equity markets in recent years, being particularly hard hit.

Low interest rates and quantitative easing have been the fuel for the long equity rally, but the revival of inflation has raised concerns that the era of easy money may be coming to an end. Higher interest rates reduce the value of future earnings when discounted back at higher rates. Lower growth companies are less affected by this phenomenon which is why we have seen a rotation out of high growth companies into so-called value stocks. The problem is that not all value stocks are quality companies. Higher rates also dampen growth, and future profits, creating an additional headwind for stock markets.

Throw the Russia/Ukraine situation into the mix and this is a more challenging environment for equities, and different markets and industries have performed differently this year. But it is far too early to call time on the equity market rally. The last 12 years have been punctuated by equity sell-offs that then recover.

An optimist would argue that with the bad news on higher interest rates already priced into markets, inflation likely to moderate later this year and good growth in prospect, why shouldn’t stock markets make further gains after the current bout of volatility settles down? Besides, what’s to fear from peak interest rates of 2.0%, far lower than the post-war norm?

The situation in Ukraine is a dark cloud on the near-term horizon but capitalism will survive, and quality companies will continue to prosper as they have done many times before.

Walking the Dog

Fortunately, how to respond to recent turbulence in financial markets is not a problem that should concern Clarion clients who have the safety net of a sound, structured, long term financial plan in place. The expensive lesson that markets keep teaching us, but most keep forgetting, is that flitting in and out in response to rallies and routs is usually foolish….and expensive.

Investors can be prone to panic and often sell out when markets are volatile but then miss the big rebounds that often follow. Simply missing out on the top 10 days of equity market bounces would on average, halve an investor’s annual return.

Imagine a dog walker crossing a field, their dog wildly zigzagging around them. We could relate the companies in which our chosen fund managers invest to the walker, clear in direction and making steady progress across the field. The daily stock market price is like the dog, moving back and forth quite randomly. The current economic storm may send the dog cowering for cover but given enough time the dog and the walker will ultimately leave the field together. In a similar way, we also know that the price and value of a quality company will eventually come together again.

Stay invested, focus on the long term and block out short term noise. Enjoy the journey difficult as it might be from time to time.

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

February 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.