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Chief Investment Officer's team, 28.02.2022
Russia shocked the world last week with a broadly unexpected full-scale invasion of Ukraine. Commodity prices surged while all other asset classes took a hit. Within emerging markets, stocks fell -4.8% while bonds lost -2%. Within developed markets, the MSCI World ended the week down only -0.1%, thanks to a sharp +3% rally on Friday led by Europe and the US. The entire fixed income asset class was in the red, and so were hedge funds. Visibility is low, and volatility extreme.
We said it repeatedly: 2022 should reward reactivity over proactivity. Last week, we added to stocks from developed markets across profiles, as the S&P 500 fell way below the 4,300 threshold we had set. We added respectively 1%, 1.5% and 2% to our Cautious, Moderate and Aggressive allocations, funded by cash. This is slightly less than what we had sold earlier in January - at much higher prices- when we cut our large overweight to stocks to prepare for a “Year of low visibility”.
We are not geopolitical experts. The global economic impact is about energy, and the duration of the war, with probably slower growth and more inflation in the coming months. There are strong incentives to de-escalation. On one hand, the world needs Russian oil and gas. Supply was already struggling to meet demand before the invasion, and elections are coming in the West. For Russia, the multiple costs of occupying Ukraine are stellar, economic sanctions are very serious, especially on the central banks and lenders, and China’s support doesn’t look unconditional. The situation is terrible for the world and dangerous for markets, which will remain volatile. However, assuming some reasonable level of de-escalation, global growth should remain robust and support positive medium-term returns. Stay safe.
Traders thriving in volatile market conditions may be getting more than they are willing to bargain for in these times. The West has upped the ante following the Russian invasion of Ukraine by adding to sanctions and deciding to provide the country with further funds. Although the new sanctions have not hit energy transactions, higher levels of uncertainty are anyway being discounted with an upward shift of the crude oil forward curve. In this environment there is two different repercussions to be taken into account.
A first-round effect is persistent market volatility. Safe havens and dollar assets in particular will again be sought after. Russian banks that cannot access the SWIFT system could see people flocking to withdraw money, undermining the stability of the country’s financial system. Alexei Kudrin, Russia’s ex-finance minister, said that Russia’s GDP could shrink by 5% a year on a SWIFT ban, which as of today is still highly selective. But there could be collateral damage for the West as well. To be on the safer side oil traders could steer away from Russian crude, and in case OPEC were unable to meet the additional demand given scarce spare capacity, WTI prices would eventually come under extreme tension. Meantime, havens like US treasuries and the dollar will be in demand, and US equities would be expected to resume outperformance, being Europe more directly affected by the conflict, also as a major energy importer. The UK has high energy dependency as well, and the large weights of the euro and the pound sterling in the dollar index basket go some way in explaining rising odds of renewed dollar strength. Apart from dollar-centric assets, we could see some resilience in Asian markets too, now that China is back to injecting liquidity in the system. Considering tame valuations, the case for significant EM asset outperformance when tensions abate seems to be reinforced to us.
A second-round effect of the ongoing crisis is the impact on central bank policy. The Fed in particular is unlikely to be deterred from tightening. Price pressures on commodities only reinforce the need for less stimulus and so far it seems that above-trend US growth could be relatively unscathed, if anything because the SWIFT ban has been devised in such a way as to minimize repercussions on energy trade. A 50-basis-point hike looks unlikely but not impossible in March, but unless financial stress spills over from the Russian market, the direction of travel should be towards less stimulus. On the other hand, the ECB will have most likely to hold back on the removal of liquidity for some time to come, as inflation from steeper energy bills will come with a hit to economic growth.
The known unknown of Russian cyber-attacks is always lurking in the background, which brings our mind to the very recent attack on Ukraine’s government websites, or to the hack in April last year of the networks of the largest fuel pipeline company in the US. With such a fluid situation, one could be tempted to double down on gold exposure. We would advise against that, as the Fed’s tightening even as the economy slows should see upward pressures on real rates, a net negative for gold, all the more so if the crisis blows over.
Fixed Income Update
The fixed income markets had a lousy week across most of its segments last week. Since we had added to our Treasury exposure in the previous week, the US Treasury 10-year yields have not closed above 2%, reflecting a flight to quality and risk-off sentiment. The moves in the Core Euro Area treasuries have been nothing short of dramatic, with German Bund yields down by 14 bps after hitting a high of 0.3% on 15th February. The market is repricing the ability of the ECB to take a hawkish stance under the current uncertain scenario. The probability of a 50-bps hike in FED’s March FOMC meeting has drastically reduced according to the latest probability indicators compiled by Bloomberg.
Since the start of the year, our advice has been to add to safe-haven assets through exposure to Multi-asset funds or aggregate bond funds to protect against such volatility in case direct exposure to the developed market treasury is not possible. Chinese local currency IG debt also provides a good way to allocate to safe assets. However, we must admit that the attractiveness had declined compared to June 2021, when the spread differential between the 10-year US and China treasuries was over 150 bps. Nevertheless, they do provide some form of diversification to investor portfolios.
It is also impertinent to keep an eye open for mispricing of risk or oversold segments under such a scenario. We are not talking about the Russian rate or credit here since we did not have any Russian bonds on our recommended list and are not planning to look at them under the current sanctions regime. However, Pan-European HY seems to have been punished after the conflict with the Bloomberg Barclays European High Yield index OAS spreads crossing 400 bps last seen during December 2018 and March 2020. As mentioned above, the ECB would be reluctant to turn hawkish, which would provide some tailwinds to the asset class. We must also remember that the rising inflation would put the margin of the high yield issuers under threat. Such high spreads could provide a good opportunity for investors with a longer time horizon of more than 12 months. But we have to be cognizant that markets are ruled by sentiment more than fundamental factors in the short term.
Nothing can be more evident than the impact on Emerging Market Debt. The Bloomberg EM Debt Index has lost -2.6% last week alone. The spread widening is stark when we look at EM Corporate (+ 25 bps) Vs. EM Sovereign (+68 bps) over the last month, even though EM Sovereign has only 1.9%, Russia exposure and EM Corporate has 2.9% Russia exposure. Moreover, the EM Sovereign index is titled towards commodity exporters (six out of the top seven issuers are commodity exporters accounting for 40% of the index weight) while EM Corporate index is tilted towards more commodity importers, with only three out of the top seven countries being commodity exporters that sum up to 25% of the index. Therefore, even though EM Sovereign has a longer duration, relative value-wise, it makes more sense to move into EM Sovereign now.
While Ukraine is the major issue dominating market movements currently with oil and natural gas prices adding to already high inflation, and growth forecasts in question, the broader global backdrop remains supportive for equity performance. Europe naturally faces the largest fallout due to the geographic proximity and dependance for natural gas on Russia, but the high oil prices also affect oil importers such as India. Last week saw some extreme volatility with global equities having a rough start to the week. Emerging market equities fell -4.8% last week while developed markets, were flat supported by a late week rebound in US equities. We still see 2022 as a year of growth, albeit with an accelerated monetary policy tightening cycle. Uncertainty around growth, inflation, policy and geopolitics will continue but should moderate in Q2 as the Fed gives direction in its mid-March meeting. The ECB is unlikely to change stance till Ukraine issues settle and some EM counties are already on a tightening path.
Valuations across the board are much below where they began in 2022. With the addition to DM equities last week we have an overweight position overall for equities. The trigger level for adding was 4,300 for the S&P 500 with the forward P/E at 18.5. Whilst the Index closed above on Friday at 4384, volatility both intraday and weekly is going to be a norm short term and sentiment more key than fundamentals and expect big swings in both directions for global indices. Thursday saw the Nasdaq Index open down -3% and close up +3%. Our outlook for the longer term is constructive at a 4950 fair value for the S&P 500 at year end. So we would add at troughs but be cognizant of sharp moves and keep to the asset allocation grid.
On a granular level we remain overweight US equities in preference to Europe. On the EM front our two overweight positions the UAE and India were outperforming the market till recently. UAE equities should continue to trade in line with profit and valuation metrics with oil prices adding to positive sentiment. However, we shist to a neutral stance for India as oil is a significant contributor to inflation. To play the oil price rise beta, the energy producers, the KSA and the UAE should provide continued upside. The GCC and the UK are amongst the few regions with positive YTD performance with the Eurozone now the worst performer amongst large markets. Energy is the only global sector positive YTD with financials close to flat.
Indian equities fell 4% last week and the MSCI India is trading at 20.3x one year forward P/E almost 12% down from 23x at the start of the year. India has outperformed the Asia region during past geopolitical risk spikes and during the 2014 annexation of Crimea, however growth and corporate margins will feel the impact of the higher oil prices. A GS report estimates “oil-sensitivity of India’s macro parameters from a $10/bbl increase (from US$90 to US$100/bbl avg.): GDP: 20bp (lower), CPI: 30-35bp (higher), CAD: (50bp higher), Earnings: -3pp (1-2 qtr. lag).”
Our stance for the year is be reactive, take advantage of troughs and whilst constructive on fundamental parameters for equity returns, sentiment could well rule markets short term.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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Heated by the sunshine of a vibrant recovery, the magic liquidity is evaporating, and turning into fog for investors. While growth remains robust, markets may not be ready for the new uncertainties around central banks, inflation and interest rates, to name a few. We are getting prepared to navigate tactically, in a year of ‘low visibility ahead’.Know More
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