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March 2022

Market Update
Part 2

Hello and welcome to our latest investment update.  This month we're providing our latest thoughts on markets. We’re grateful to our friends at Brooks MacDonald for their help in pulling this together.

It's fair to say that 2021 was a transition year for both economies and markets. Over the coming year, we expect pandemic driven distortions to fade and this should allow central banks and governments to move towards clearer policy goals. Where these goals settle will determine whether asset allocation preferences should keep a balance which has served us well during 2021, or whether instead we should fall more decisively behind one particular investment style.

In terms of YTD, markets have had a tough few months. That began with a ‘below the surface’ rotation from growth into value with headline indices pretty robust. Although new narrative appears to be entering the market. The start of the year was characterised by ‘Omicron is fading, therefore we are off to the economic races but that means higher inflation, higher inflation means higher rates, what will get hit by higher rates?’. This caused the correlation of bonds and equities to turn positive, particularly in the growthier names (such as tech), when bond yields rose, growth equities fell.

This correlation has recently reversed with bond yields falling and equities falling, the more traditional response to an ‘economic shock’. The market is thereby introducing a new narrative. ‘Ok it seems like the Fed will continue on their hawkish path, raise rates and reduce the size of the balance sheet, but what if they are wrong and inflation fades quickly? That’s not good for growth, it could even cause a recession in 18/24 months’ time.’

Investors will be looking for goldilocks data which suggests economic demand is strong but not excessively strong given the supply chain issues being worked through currently. Fed Chair Powell’s data dependency, and the knowledge that near term inflation numbers will remain elevated, leaves the market highly susceptible to sentiment over the coming weeks and months. With US factors driving global risk appetite, we expect the US to continue to drive daily moves.

The situation in Ukraine
The Ukraine war and humanitarian crisis has already incurred a huge human cost and financial markets have also needed to price in a more uncertain outlook. The first order effects have been a broad risk-off sell-off which has most severely impacted the countries close to the invasion itself. As both formal sanctions against Russia and an informal shuttering of external activity with the country continue, supply chain impacts are filtering through to higher commodity prices, the highest profile of which has been the oil and gas market.

Such a surge in energy prices, if sustained, has significant impact on economic growth, both as it damages corporate margins but also because it squeezes consumer discretionary spending. The extent to which this surge in commodity prices continues is tied to the next stages within Ukraine which themselves are highly uncertain.

Of key importance will be how central banks respond to this crisis. As with the economic impact, we expect central bank thinking to be influenced by their proximity to the crisis. The US is far more insulated than Europe in terms of energy security, for example, and therefore the Fed is more likely to focus on its domestic inflationary pressures. That said, higher energy prices globally have a cooling effect on economic growth so central banks may be encouraged to consider the core level of inflation in the economy (which excludes food and energy) in assessing the case for the sequencing of rate rises in 2022. Core inflation is expected to naturally fall on a year-on-year basis as the comparable month last year shifts from lockdowns to a more normal level of economic activity.

Inflation and interest rates
How inflation, interest rates and economic growth progresses from here will determine the economic outcome in 2023 and 2024. Our base case continues to be a moderation of inflation coming into the end of this year, alongside slowing economic growth. We expect central banks to react to this by dialling back their monetary policy tightening language and therefore for markets to return to a low growth, low interest rate and moderating inflation narrative. That said, we are conscious that the risk of a high inflation low growth environment (stagflation) has increased recently.

The Ukraine crisis, energy security and fiscal coordination all throw additional problems towards Europe at a time when debt to GDP levels are already elevated, particularly in the periphery. Whilst rapid agreement around a fiscal package supporting defence spending and energy independence could support growth, we are yet to see the level of agreement in the region at this time.

Whilst last week proved a very strong week for risk assets, this of course needs to be compared to the volatility of March in aggregate. Technology outperformed, with reports of Chinese state support and the Federal Reserve (Fed) meeting both boosting sentiment towards the sector.

Negotiations between Russia and Ukraine continued last week which helped buoy risk appetite. Turkey’s Foreign Minister suggested that a peace deal and ceasefire was possible assuming neither side changed its negotiating demands too dramatically. The starting point, that Ukraine will agree to be a neutral country and commit to not join NATO, appears to have softened Russia’s prior hard-line approach to talks. After reports broke that Russia had requested military and economic aid from China, China has been in the spotlight over its position on the Ukraine war.

On Friday President Biden and President Xi Jinping discussed China’s position over a call and both sides concluded with hopes for a peaceful resolution which saw no further escalation. The latter comment may well allude to suggestions from US intelligence sources that nuclear sabre-rattling could recommence should the Ukraine war become protracted.

After the Bank of England and Federal Reserve both hiked rates last week, we will hear from a steady stream of central bankers this week, giving us more colour on the content of the discussions. The Federal Reserve ‘dot plot’ of interest rate forecasts showed a wide disparity of views amongst the Fed members, suggesting the speeches this week won’t be running off a shared narrative. The Bank of England warned on inflation and economic growth when it hiked rates last week, the US has taken a different approach, showing heightened inflation expectations alongside robust economic growth forecasts. How the Fed speakers address their expected resilience of the economy in face of tightening monetary policy and cost of living squeezes will be of particular interest.

The Fed are likely to come under significant pressure over the next few weeks as many economists have criticised the bullish economic growth projections as disconnected from the reality of consumer demand. Should the bond market conclude that the Fed speakers’ belief in the Fed’s own economic growth numbers is less than universal, we could see an extension of the technology outperformance that we saw after meeting last week, as markets price in the risk that the Fed will need to blink in the face of slowing growth.

It's still equities over bonds for now
Despite the uncertainties in the markets, we continue to see a preference for equities over bonds over the medium to long term. With the sell-off in equities, earnings yields have risen and, even in the event of a re-calibration of corporate earnings expectations, remain well above the yield available on government bonds. Additionally, we are keenly aware of the value in staying invested during periods of market volatility.