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Quarterly Wrap: March 2022

Russia’s invasion of Ukraine and concerns about high inflation and tighter monetary policies in the developed economies, especially in the US, drove financial markets over the 2022 March quarter.

       Written by George Lin
Senior Investment Manager | Colonial First State

Financial markets entered 2022 nervously, with investors concerned about the Federal Reserve pivoting towards tighter monetary policies due to persistently high inflation. Those fears were confirmed by successive US inflation data, and by February, investors had priced in a 25 bps rate increase at the March Federal Open Market Committee Meeting (FOMC). The FOMC duly increased the policy rate and delivered a hawkish communication to investors on monetary policies. Russia’s invasion of Ukraine on 24 February sharply escalated geopolitical risks. Given Russia’s status as a major commodity producer, especially energy, commodity prices rose sharply and added to concerns about inflation. Brent crude oil prices traded as high as USD 133.2 per barrel before declining to finish the quarter at USD 112.8 per barrel. Global bond yields surged with US 10 year finishing the quarter at 2.33%. Equity markets were generally weaker, with S&P 500 falling 5.0% while the Euro STOXX plunged 9.2%. The Australian equity market, supported by commodity prices, was one of the strongest performing developed equity markets in the quarter with the All Ordinaries rising 0.1%. The Australian Dollar also benefited from higher commodity prices and rose from USD 0.709 to USD 0.751.

Russian Invasion of Ukraine

Russia invaded Ukraine on 24 February and quickly sent global equity markets into a dive. The invasion was widely expected to be fast and brutal with a quick Russian victory, culminating in the capture of Kyiv and the probable installation of a pro Russia regime. The battle has not gone according to plan and Russia has not yet managed to capture any major Ukrainian cities. The western democracies, in particular Europe, also surprised Russia with the severity and speed of their economic response. Most Russian financial institutions are frozen out of SWIFT, the global payment system which links financial institutions worldwide. Trade with Russia has been severely impacted as most major western corporations quickly withdrew from Russia. Sanctions were also imposed on the Russian central bank. Russia has accumulated a massive foreign exchange reserve of around USD 630 billion and its sovereign wealth fund holds another USD 175 billion, in anticipation of a confrontation with the Western democracies and economic sanctions. Apart from around 20% of FX reserves held in gold sitting in Moscow and St Petersburg, Russia’s central bank now faces varying levels of difficulties in accessing its reserve, in particular the 50% of reserves held in Western currencies, mainly Euro. This makes it very difficult for Russia to defend the value of the Rouble.

While Russia is a reasonably large economy (ranked around 11th largest in the world by the size of GDP), its significance to the global economy rests on its status as a major commodity exporter, especially in energy. In particular, Europe is extremely dependent on Russian oil and natural gas exports. and imports around 30% of its natural gas from Russia. This average figure masks considerable variability across different countries - Germany and Italy import around 40% of their natural gas from Russia, the figure for Poland is more than 50% and even higher for eastern European countries such as Hungary and Finland. Petroleum products are the other major Russian exports to Europe, with Russia providing 20% of Euro area’s petroleum imports. In addition, Russia is a major producer and exporter of several metals (aluminium, titanium and nickel) and agricultural products (seed oils, barley and wheat). Given that Ukraine is in its own right an important exporter of seed oils, barley and wheat, the Ukraine crisis is a significant negative supply shock to the global economy and will exert further upward pressure on inflation.

The direct results of the invasion of Ukraine are sharp rises in commodity prices, especially energy. Energy prices have already increased since mid-2021 due to a combination of recovery in demand as economies reopen, the lack of new supply as OPEC refused to increase oil production significantly and the Chinese energy crunch in 2021. The Ukraine crisis aggravated the price shock. Brent crude oil traded as high as USD 133.2 per barrel immediately after the invasion, before declining to finish the quarter at USD 112.8 per barrel. Natural gas prices also spiked as the Henry Hub natural gas price increased by 46.7% over the March quarter. Strong price rises were also seen in a number of metals, such as aluminium and nickel, and agricultural commodities such as wheat.

Source: Factset
Source: Factset
Source: Factset
Source: Factset

Key economic developments

The main developed economies were already experiencing significant inflationary pressures even before the Ukraine driven surge in commodity prices. Among the developed economies, US, Europe and the UK all saw significant rises in inflation. The epicentre of global inflation is the US which saw three consecutive higher than expected monthly inflation data in 2022. Headline inflation rose to 7.91% year on year in February, while core inflation, which excludes food and energy, accelerated to 6.42%. Both readings are significantly higher than the Federal Reserve’s target of 2 to 3% annual inflation. The details of the price data also revealed a broadening of price pressures, with inflation driven not only by supply side disruptions but also by services inflation, often associated with labour shortages and strong wage increases.

US economic indicators were largely positive for the March quarter. In particular, the US labour market continued to generate robust job growth. The US generated an average 582,000 new jobs in the three months to February 2022 while the unemployment rate fell to 3.8%, the lowest level since March 2020 before the start of the pandemic. The one US labour force variable which has not recovered to its pre pandemic levels is the participation rate which, after a tepid recovery, remains stuck at around 62% compared to a pre pandemic level of 63.4%. The result of robust employment growth and lower labour force participation is labour market shortage and higher wage growth, with private sector average hourly earnings now firmly growing at a trend of around 5.0%.

Source: Factset
Source: Factset

Given the Federal Reserve’s dual mandate of targeting average inflation of 2 to 3% and maintaining a strong labour market, it has little choice but to play catch up with market expectations of tighter monetary policy. The “pivot” started in December 2021 FOMC announced an acceleration in tapering (reduction in asset purchase) and flagged an earlier than expected reduction in its balance sheet (without releasing any details). The Federal Reserve also shifted its rhetoric from describing inflation as transitory to admitting that inflation is too high and has to be managed by tighter monetary policy. By early February, financial markets “priced in” a rise in the target Federal Funds rate of 25 bps at the March FOMC.

When the Federal Reserve duly delivered a 25 bps rate hike on 23 March, investors were not surprised by the decision but shaken by the hawkishness in the communication. The FOMC members’ median forecast for Federal Fund rate now implies six rate hikes by the end of 2022 and a Federal Funds rate of 2.75% by the end of 2023. Furthermore, seven members of the FOMC project Federal Funds rate higher than 2.0% by end of 2022, suggesting that this is a real possibility if inflation does not slow significantly over the next 6 months. The median forecast for core inflation is now 4.1% by the end of 2022, compared to a forecast of 2.7% at the December FOMC. Chairman Powell was hawkish at his post meeting press conference, stating that the “committee is acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that”. He also said that “there is a very, very tight labour market – tight to an unhealthy level, I would say.”

While Australia is not immune to the global trend of rising inflation, the inflation dynamics are different from the US and financial markets do not expect the same aggressiveness in the pace of monetary tightening. The Reserve Bank of Australia (RBA) has stated reportedly that it has two key conditions for a rate rise: firstly, sustainable core inflation above its target range of 2 to 3%; secondly, wage increase of more than 3.0%.

Sustainable inflation above target inflation is widely interpreted as several consecutive readings of underlying inflation of between 2 and 3%. Headline CPI rose 1.34% over the December quarter to bring annual inflation to 3.67%, the highest reading since September 2008. The Reserve Bank of Australia’s (RBA) preferred measures of core inflation rose by around 0.95% over the December quarter to bring annual core inflation rate to 2.63%. Importantly, this is the second consecutive quarter of underlying inflation achieving the RBA’s inflation target of 2 to 3%. Arguably, the inflation target has been achieved but markets expect the RBA will “play safe” and want to see at least one and possibly two more readings of around 2.5% core inflation before raising the policy rate. The wage price index rose 2.29% annually in the December quarter, the second consecutive quarter of greater than 2.0%. Although the RBA has not yet achieved its wage growth target, survey based data is pointing to continuing improvement in the job market and hence stronger wage growth in the near future.

Other Australian economic indicators pointed to a strong recovery in the March quarter following the Omicron induced slowdown in the last quarter of 2021. Retail sales rose strongly in February for the second consecutive month. As a result, markets now expect the RBA to start raising the cash rate in the second half of 2022. This shift in sentiment is implicitly acknowledged by Governor Lowe who, after months of insisting that he does not expect a rate rise until 2024, admitted that a rate rise before the end of 2022 is plausible.

The Australian Federal Budget for 2022-23 was largely a “non-event” from a financial market perspective. The main theme in the budget is the use of improved tax revenue to finance short term measures to alleviate cost of living pressures. The main initiative is the halving of the 44.2c per litre fuel excise tax for six months until 28 September. While the Federal Treasury believes this will reduce headline inflation by a quarter of a percentage point in Q2, the Reserve Bank will see this as a one off reduction which will be ignored in deliberation of monetary policy.

In contrast to the developed economies, China is at a different stage of the economic cycle. China is struggling to lift its economic growth and is in the middle of a policy easing cycle. While some leading economic indicators such as industrial production and fixed asset investment are pointing to a mild recovery, the strength of the economic recovery has disappointed investors due to issues in the critical real estate market after the collapse of Evergrande in 2021 and the rolling lockdowns in major Chinese cities. Since December 2021, a number of Chinese cities including Xian, Shenzhen (China’s Silicon Valley as well as a major port) and Shanghai (China’s most populous and economically significant city) have all entered lockdowns. The latest lockdowns, driven by Omicron, are particularly damaging due to the size of the population affected (more than 50 million) and concentration in the most prosperous and economically advanced regions such as Shanghai and nearby areas, and Guangdong province next to Hong Kong. The lockdowns are hampering both business and consumer confidence and holding back growth in the services sector. Premier Li announced a growth target of “around 5.5%” for 2022 at the National People Congress in early March. The target growth level is low by Chinese standard and the language also seems to suggest some doubts in achieving the target. More accommodative policies are expected as China attempts to achieve 5.5% economic growth.

Key market developments

The most noticeable financial development over March quarter was the massive rise in global sovereign bond yields. The US 10 year bond yield rose from 1.51% at the end of December to 2.33% at the end of the March quarter, a level last seen in mid-2019. The Australian 10 year bond yield had an even greater rise over the period, from 1.67% to 2.83%. Other developed market bond yields followed the lead of the US bond market and rose sharply over the quarter. Concerns about rising inflation, reinforced by the sharp spike in commodity prices, are the main culprits behind the rise in long term bond yields. Markets have also rapidly repriced the expected path of central banks’ policy rates, in particular that of the Federal Reserve. As a result, yields on shorter maturity bonds spiked. The US 2 year bond yield rose from 0.73% to finish the quarter at 2.29%, a rise of 156 bps over 3 months. Those moves resulted in a “bear flattener” in the US Yield curve, with the 2 year versus 10 year slope of the US yield curve collapsing to a mere 4 bps. Given that a negative 2 year versus 5 year slope is historically a reliable leading indicator of US recession, talks of a US recession are starting to surface.

Source: Factset
Source: Factset

Equity markets had a very volatile March quarter and mostly finished the quarter lower. Equity indices came under downward pressure from early January as bond yields rose on the back of higher inflation. Growth stocks performed worse than value stocks. Equity markets then stabilised before suffering another correction of between 5% to 10% immediately after the Ukraine invasion. Markets then recovered in the last two weeks of March as the worst fears of investors (a direct military confrontation between Russia and NATO) receded. Overall, most developed equity indices ended the March quarter lower. S&P 500 fell 5.0% while the technology dominated NASDAQ fell 9.1% in the March quarter. Euro STOXX plunged 9.2%, due to fear about the economic impact of a reduction in Russian energy exports to Europe. Greater China equity markets had a particularly volatile quarter. The Hang Seng fell by close to 22% at one point in mid-March before staging a strong recovery to end the quarter 6.0% lower.

The Australian equity market was one of the best performing developed equity markets in the March quarter due to surging commodity prices and returned 0.1%. Resource stocks performed well with the All Resources Index returning 16.4% in the March quarter. Industrials fell 2.8% - a respectable performance relative to most developed equity markets.

Source: Factset

Forward-looking views

The major driver of the short term outlook for financial markets is the course of the war in Ukraine. If one looks through the fog of war, there are three possible paths on Ukraine – the status quo of a military stalemate, de-escalation and escalation. Those paths and their implications are listed in table 1. It is impossible to assign a precise possibility to each scenario given the factors involved, the geopolitical forces behind the conflict and the very nature of the battlefield which is fluid and dynamic. Market consensus, for whatever it is worth, is that the status quo is the most likely path for the near future. This points to increased financial market volatility in the coming months as investors react to news but critically, no massive price shock in commodities. The “pre-Ukraine crisis” drivers of financial markets – surging inflation in developed economies and the Federal Reserve playing catch up in monetary policy tightening, will likely reassert themselves. It is also important to emphasise that inflationary pressures have been exacerbated by the one-off shock to commodity prices.

Table 1: Likely short term course of Ukraine Invasion
  De-escalation Status quo Escalation
  A negotiated ceasefire. A continuation of hostilities with no clear military victory. Russia chooses to escalate – use of weapons of mass destruction (biological or nuclear) in Ukraine or striking military targets in NATO.
Commodity prices A sharp fall in commodity prices, especially energy prices. Commodity prices stay high and remain volatile but no sharp price rises Another sharp rise in commodity prices, especially energy as Europe will be forced into an energy embargo of Russia
Equity markets Positive as geopolitical risk premia will decline. Neutral overall but sector specific impact (e.g. energy). The Fed will be the main driver. Major equity correction. Europe will likely enter stagflation.
Bond markets Yields will fall initially but upward trend in bond yields will remain due to inflation. Upward trend in bond yields will remain due to inflation. Yields will rise sharply as inflation rises.

Source: Based on research provided by Wellington

The global economy started transitioning from the COVID-19 world of low inflation with massive monetary and fiscal stimuli to a world of higher inflation and more restrictive policies, especially monetary policy, since mid-2021. Ukraine is a negative aggregate supply shock which will likely result in higher prices globally via the commodity price channel and a lower level of output concentrated in Europe. The higher commodity prices will make it more difficult for the Federal Reserve, which is already “behind the curve” to balance between higher rates and economic growth. Currently, markets expect the FOMC to increase the policy rate after every single meeting in 2022 to bring target Fed Fund rate to 2.0%. We broadly concur with this view and believe the risks are to the upside for several reasons. Firstly, there is so far limited evidence of a slowdown in inflation in the US economy. In particular, the US labour market is still running too hot with the level of job openings around 10 million and wage rises accelerating. The recent shut downs in China may also delay the expected normalisation in global supply chains. Secondly, the spike in energy prices will likely feed into prices, both directly via higher petrol prices and indirectly via workers asking for higher nominal wages to protect their level of real wages. Given the tight labour market, now is as good a time as any for US workers to ask for wage rises. Thirdly, inflation expectations have started to “deanchor” and drift upward over the past few months. Implied inflation from US TIPs (inflation protected bonds) has risen significantly, especially in the 5 years segment. This places the Federal Reserve under immense pressure to raise policy rates more aggressively in order to protect its inflation fighting credibility. Arguably, the best path for the Federal Reserve is to “over kill” in rising rates, bear the pain in the near term in the hope of not having to raise policy rate as much in the long term.

We are sceptical of the durability of the recovery in equity prices over the last two weeks of the March quarter. While some of this improvement can be justified by the worst case scenario in Ukraine (an escalation by Russia) not being realised, the overall macro environment has turned significantly less supportive of equity markets since the start of 2022 due to higher bond yields. This vulnerability is reinforced by the expensive valuation in equity markets, despite the corrections in 2022. Using forward 12 month price earnings ratio as the metric, S&P 500, NASDAQ and, to a lesser extent, ASX are still above their long term medians. Lower bond yields are often used to justify higher equity valuation. The challenge is bond yields are now normalising. While we do not believe bond yields will increase back to pre-2008 levels, there is a strong possibility of developed bond yields going back to their peak in 2019 and arguably more to compensate for higher inflation. If this is the case, some further normalisation of valuations should be expected, especially for US equity indices. Admittedly, some equity markets are better positioned. Australia should benefit from higher commodity prices as well as the inflation hedging properties of commodities. European equities are also better supported by fundamental valuation provided that the situation in Ukraine does not deteriorate further (a big if).

Source: Factset
Source: Factset
Source: Factset

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