Worst may not be over, but uncertainty should be peaking

Chief Investment Officer's team
07 March 2022
Worst may not be over but uncertainty should be peaking
A week of war ended with peak uncertainty as the US considers en embargo on Russian oil


  • A week of war ended with peak uncertainty as the US considers en embargo on Russian oil
  • The US may be able to afford it, but such an escalation could trigger unpredictable responses
  • High uncertainty is widely priced-in by markets now, but not the worst-case scenario.

We wrote it repeatedly: a material disruption in the supply of Russian energy to the world would mark a critical escalation in the stand-off between the West and Russia. President Putin’s speech on February 24th didn’t just announce the war, but contextualized it as “a matter of life and death” with the West, not Ukraine in itself, being the threat. “No matter who tries to stand in our way or all the more so create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history”. The Biden administration now considering the banning of Russian oil imports could be seen by Russia as such a threat.

Financial markets are reacting to the immediate consequences with oil prices surging, stocks collapsing and safe havens being supported. Our base case scenario remains for a de-escalation, in which case the upside potential is now very material. However, the path will be erratic and it could get worst before it gets better. In the meantime, the global economy will slow, with much higher headline inflation, which also adds uncertainty with regards to central banks’ action. To that extent, extreme tightness in the US labor market was only confirmed by last week’s job report, with 678k new positions being created in Feb, way above forecast.

Looking forward, we expect volatility to remain extreme and markets to be as unpredictable as ever. Fundamentals won’t matter much and the worst-case scenario is so terrifying that it can’t really be priced-in. Under our central scenario, even discounting slower growth, higher inflation and persisting uncertainty, expected returns are positive for the medium term.

Stay safe.

Cross-asset Update

Who would have thought that markets in 2022 would face one of the fastest transitions from a post-covid deflationary boom to what could become an inflationary bust if the geopolitical situation continues to unravel? It is worth remarking, though, that the war in Ukraine is only exacerbating pre-existing price pressures, driven by a decade of underinvestments in the old economy, alongside strong aggregate demand and supply bottlenecks following the pandemic. A record number of commodity markets is in backwardation, which in financial jargon simply means that they are very tight. The proponents of the thesis of the commodity super cycle, higher prices of basic resources for years to come, see a decade of scarcity after one marked by efficiency, that is technological progress. And they could be right, as inflation seems to be a policy choice, driven by relentless stimulus and the pursuit of a green economy which requires massive investments, hence commodity consumption.

But now that US policymakers have got too much of what they wanted, will they be able to fight inflation without causing a sharp slowdown? Probably not, said in a recent interview Lawrence Summers, ex Treasury Secretary, who sees the Fed’s central scenario of inflation falling below 3%, longer-dated yields not much above 2.5% and unemployment below 4% as wishful thinking. From this point of view stagflation, the threat of low growth and high inflation, is a short-term issue, which should abate somewhat alongside geopolitical risks, yet requires tighter monetary policy. But Summers, in a previous interview, also focused on the long run, speaking about a new scenario, a “struggle ahead”, following a new world order of tighter bonds between Russia and China, where the United States should shift efforts from supporting corporate business abroad to defence and global security, as well as supporting the role of the dollar as the global currency. In between the lines, we can understand that this would be a world where multilateralism and globalisation take a back seat, one where countries are more inward-looking, hence a backdrop more conducive to rising price pressures as well. From this viewpoint inflation is a longer term issue, whereby secular forces like demographics and technological progress tend to be more than offset by scarcity and deglobalisation.

As we transition from the decade of efficiency to that of scarcity, investors should adjust their portfolios accordingly, increasing their focus on cyclical and commodity-related companies, the ones providing the materials, the basic resources, the expertise necessary for the build out of the greener economy, or more directly benefitting from the commodity supercycle. Also, in times of higher price pressures, when valuations no longer expand and returns are more uncertain, high-dividend paying stocks have historically outperformed. It is not a coincidence that within equities above-market dividends are also a distinctive feature of cyclicals and materials.

Fixed Income Update

The dynamics of the fixed income asset class have been turned on their head over the last couple of weeks. The correlations between different segments of the asset class have come down, showcasing the difference between the haves and the have-nots. Selectivity in such a scenario is of paramount importance. The Geopolitical tensions support the rationale behind our call at the start of the year to follow a diversified asset allocation even within Fixed Income. A clear example of this is the relative performance of safe-haven assets versus riskier segments before 20th Feb and post that. The returns of developed market treasuries and investment-grade were in line with underlying yield movements, and the returns of these safe-haven assets were between -2.5% and -4.5% till 20th Feb. The riskier segment returns were not far-off, with Global HY and EM Debt returns around -3.7% and -4%, respectively. However, post that the risk-off sentiment has resulted in a significant divergence between these two types of broader segments. While Developed Market treasuries have rallied and gained roughly 1% since 20th Feb, High Yield and EM Debt have lost approximately 2.5% and 4.5% in the meanwhile. The only asset class with positive YTD returns has been China Investment Grade local currency debt with +1.3% performance till date.

There are dispersions even within high yield and emerging market debt. Pan-European High Yield had outperformed US High Yield by 100 bps till the above date. Post that, there has been a dramatic shift in the performance with US High Yield gaining 25 bps while Euro Area HY has lost 100 bps, resulting in slight outperformance of US HY versus Euro HY ytd. Our central scenario to date is that the conflict will deescalate. While it is difficult to put a time horizon to it, we believe we might see a mean reversion where European HY would beat US HY in case of a de-escalation. Within European HY, we continue to like consumers, energy, and sub-ordinate debt of the banks that have more global footprints. We also prefer to be up in quality within HY with a liking for solid BB names.

Emerging Market Debt has seen similar dispersions, with high-yield commodity importers being punished while HY commodity exporter spreads have been very stable with soaring commodity prices. GCC and LatAm HY sovereign issuers stand out. We recommend clients keep holding GCC HY names in their portfolios. While broader EM Sovereigns have lost roughly 10.3% YTD, GCC Debt has lost only -3.5%, and LatAm Debt has lost only -6.5%. On the contrary, HY names such as Egypt, Turkey, and Pakistan have seen their spreads blowout by 300, 120, and 150 bps, respectively. While we still believe the risk of default from Egypt remains low, we will see a lot of volatility in the short term. Strong Investment Grade commodity importers have seen the lesser impact with CDS spreads widening by only 25 bps. We currently like BBB-rated sovereigns and their GREs, including India and Indonesia, within Commodity importers.

To summarize our view, selectivity remains key to benefitting from such dispersions, and broader beta risk-takinbg is not advisable.

Equity Update

Global stocks closed lower -2.7%, at the end of a turbulent week, however European markets were much worse down 10% (in USD). The flight to safe haven assets continues as the timing of resolution in Ukraine remains uncertain. US Treasuries extended a weekly rally, and the U.S. Dollar added to a recent upswing. Oil prices continue to rise. Palladium and copper are trading at record highs. Markets are also reacting to more troops being deployed to NATO member states that border Russia. The U.S., EU and other global allies have broadly condemned Russia's invasion with sanctions aimed at destabilization of the Russian financial system. Russian equities have been removed from major global indices and local trading of Russian equities has also been halted. The LSE has stopped the trading of shares of Russian companies.

It was a second straight month of stronger-than-expected U.S. labor data with the testimony of Fed Chair Powell, who said he would propose a 25 bps hike at the next meeting, providing a degree of certainty to policy and support to the US markets which fared better than Europe with the S&P 500 down 1.25%, but the Nasdaq down double that last week. Our recent addition to US equities was opportune, but we reiterate the uncertainty of markets and reaction to day to day escalations in Ukraine. Markets in Asia last week saw the MSCI China fall 4.3%, India 3%. The exception in global markets is the GCC, which continues to see gains with both the Dubai and Abu Dhabi indices up over 5% last week and the MSCI UAE Index gain 8%. The KSA Index was up 3.8% last week. We are overweight UAE equities and expect markets to hold up on the back of higher oil prices. Whilst we would also add to energy stocks we recommend consistent and growing dividend payers as a defensive play.

The impact on global economic growth could increase if there is a change in sanctions yet to target Russia's exporting activity of energy, materials and agriculture. Russia is the world’s third largest oil producer. The inflationary impact from rising oil, gas, wheat, sunflower oil and essential components such as palladium for autos, of which Russia is a key supplier, is yet to be measured. Whilst we began the year with reasonable expectations of growth, the impact to earnings and margins from increased supply chain constraints and higher energy prices are starting to be felt. Our stance for the year is to be reactive, take advantage of troughs and whilst still constructive on fundamentals, sentiment could well rule markets shorter term. We will also closely watch growth metrics and inflation readings for future direction.

Impacting revenue and profitability of some large global corporates is the withdrawal of business/ products from Russia. This includes Visa, Mastercard, Samsung, Apple, the major global automakers, European oil companies. The exits reverse 30 years of investment by foreign businesses as sanctions, the closure of transport links and the financial restrictions on SWIFT and capital controls have made it difficult for many companies to make payments and deliver goods to and from Russia.

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