Monthly Investment Review – 14 March
Long-term macro regime. Prepare for shorter and brisker cycles vs last decades
Imbalances, debt, sticky / resilient inflation, and geopolitics argue for more cyclicality and variations in economic cycles
Financial conditions will continue tightening. After plateauing T421, global liquidity has started to contract in 22 because of central banks, higher oil prices and sanctions on Russia (pressuring European banks B/S)
Economic recovery will broaden as pandemic eventually becomes endemic. Growth-flation is likely in the US, and possibly in Europe if it can escape an energy crisis. China trajectory is uncertain, as politics dominate (Zero-Covid, deleveraging)
Geopolitics is back with vengeance. The war in Ukraine is a wake-up call for complacent investors. It imposes the installation of a risk premium
Erratic capital flows into financial markets. Speculative investors face higher cross-assets’ volatility. Long only investors did not panic, as wider spreads and oversold conditions refrains massive selling, while uncertainty prevents buying
Unstable equity-bonds correlation, but no regime shifts. Negative real rates will remain in force in 2022. Growing risks of a hard landing restores appeal of risk free / duration rich assets
A succession of risk-off / on periods ahead. A cocktail of complex events is unfolding. Geopolitics, irritating inflation (and a maneuvering Fed), as well as likely delicate US politics in H2 (controversial mid-terms)
War in Europe – The Geopolitical framework has shifted from bad to perilous in just a couple of weeks. Obviously, guessing at this stage the outcome of the Ukraine war is impossible. Still, after one week, experts think that the odds of a ¨Blitzrieg¨ are lower than at first thought. Ukraine’s resistance is raising the bar for Putin. Contrarily to his expectations he coalized the West / NATO against him and restored European unity and its will contemplate – finally – a solid common defense. Indeed, even Germany reversed its longtime policy of not supplying deadly weapons to countries at war and plans to raise defense spending to 2% of GDP.
Did Putin overplay his hand / underestimate Ukrainians’ determination?
At best – i.e. in case of a brief conflict and relatively low impact of sanctions – broad-based shortages of natural resources would prevail for some months. At worst – i.e. in case of a major conflict spill-over – incalculable casualties (human, economic, financial, etc.) would ensue, putting the stability of the whole European financial system at great risks. Most probably, the actual outcome of this crisis will lie somewhere between these two extreme scenarios. But where? In any case, its costs will be of large magnitude, if not of long duration. In a nutshell, Europe is the most exposed, global inflation (cost / input) is reinforced and prolonged, trade / growth will be impaired. For sure, there is no magic formula to predict recessions. But let’s face it, most of them have been preceded by a) a tightening cycle (featuring a policy error) and b) an energy crisis.
Asset allocation conclusion – Suddenly, geopolitics makes its shattering return. The recklessness of investors, especially those who have ¨abused¨ of the largesse of central banks – thus of free money – is undergoing multiple, adverse, restoring forces. The evaporation of liquidity, the prevalence of volatility, the deterioration of the geopolitical context and of the macro are imposing themselves, in the long run. The mantras that have been in vogue for nearly two years – alignment with central bank purchases, buy on dips, FOMO, TINA, etc. – are going out the window. The investment environment is less supportive.
Since the end of January, we are underweighted equities in the wake of the upcoming interest rate hike and the shrinking of the Fed’s balance sheet. We still remain invested in the asset class. The volatility will last.
Rates will remain negative in EUR and CHF. Short USD rates still do not compensate for inflation. We remain overweighted on the US dollar and to commodities, mainly gold and oil.
Forget the fundamentals, geopolitics has taken over – It has been a long time since conflict has not been the primary driver of currency markets, but the tide has turned. The Russia-Ukraine conflict has become the overwhelming currency market driver. Market participants can forget the usual drivers of the post-Covid world outlook, growth prospects and central banks tapering strategies for now. Increased USD exposure in a global risk-off market context, and at a time when Europe is particularly exposed to the Russia/Ukraine predicament, makes sense. But the USD is not the only short-term winner. The CHF and JPY safe-haven virtues have been confirmed, as well as resilience of commodity related currencies.
Positioning alone cannot determine a currency’s fate, but extremes can exacerbate price action when sentiment changes. The speculative data from CFTC confirm an exponential increase in USD longs in early 2022. As of mid-February, almost 70% of contracts were long USD, close to recent years tops. The overweight positioning means exacerbated downward USD price action as those contracts unwind, but we could see further extreme USD long positioning first. Europe’s high dependence on Russian gas and Ukraine’s geography leave it particularly exposed to the situation. The EUR should remain vulnerable to the drop in risk appetite and disproportionately weak European risky assets. The more hawkish than expected February ECB did provide some support but this faded as officials recently clarified that a rate hike remains some way off. With the Fed and other central banks still expected to hike rates over the coming weeks, the EUR looks at risk.
For now, defensive FX plays could boost the USD and safe currencies
Renminbi, an alternative to the USD – Yuan lack of stress on Russian actions renewed the case for medium-term yuan globalization. The renminbi is holding up exceptionally well and its credentials as a reserve currency continue to grow. Notably, SWIFT payments denominated in CNY rose in January to a 3.2% share of global transactions, breaking out of a multi-year 1.5-2.5% range and outpacing the JPY for the first time.
Sanctions over Russia should amplify the move
A delicate exercise – The Central banks moving into tightening mode has been a key theme for months. The Russian attack has put central banks and investors off their guards. Policymakers are now in a more difficult position. They must balance an upward supply shock on inflation and a negative demand shock on the economy (increasing the stagflation risk). Market inflation expectations have been pushed up again, but the uncertainty about the economic impact of the war is significant.
The tightening monetary policy outlook jolts fixed income markets – Central banks decisions will remain an important theme and on the top of the agenda. With US 10-year yields recently breaching 2.0%, one wonders how far they might rise if the Fed is determined to get inflation back under control. However recent developments and FOMC minutes suggest that the Fed has no pre-determined path for rate hikes. Given the backdrop of high inflation, geopolitical uncertainty, the timing and size of rate increases, and the potential quantitative tightening, 2022 promises to be challenging.
Money market rates have soared (even if they have receded somewhat) together with short-term government bond yields. As long-term yields rose more steadily, yield curves flattened. Several central banks have continued to tighten their monetary policy despite geopolitical tensions and sell-off in risky assets. The Reserve Bank of New Zealand and the Hungarian central bank made tightening move and sent aggressive signals.
The ECB and the Fed are scheduled later in the month. A lesson from central banks that have already embarked on a tightening cycle is that they tend not to inflect it. The context is unlikely to alter tightening by the Fed. The Fed is already “behind the curve” and its favor inflation metrics that high that it can no longer delay its tightening without risking seeing its credibility definitively ruined.
The Ukraine situation will largely affect the ECB reaction function. It will be complicate to adopt a more restrictive stance to fight inflationary pressure while the economic outlook is worsening. Furthermore, European banks exposure to Russian bonds, loans and businesses will significantly weaken banks. The ECB could be forced to innovate again, like buying financial subordinated debts a sort of recapitalization or pushing for EU banks mergers.
Central banks will balance the higher inflation and geopolitical uncertainty and the impact on the economy and financial sector
We will not be surprised to see further drops in government yields in the near term. Yield curve flattening dynamic will prevail
Unloved credit – Well before the conflict, the credit market was already under pressure. The high yield market has its worst start of the year in more than 3 decades driven by higher bond yields and wider spreads. Risk-off stance spurs an acceleration in net outflows from credit markets. Even before Russia/Ukraine tensions reached a new peak, investors had already turned increasingly defensive.
The recent HY credit spreads widening – like Investment Grade ones – did not discount a lot of risk. Since the Q3 2021, HY spreads have increased by only 100bps, while in 2014 following the Crimea annexation they widened by more than 200bps. Furthermore, they remain well below their long-term average.
The specter of higher, stickier, and synchronized inflation is bringing the era of relentless monetary easing coming to an end. Central banks and their asset purchasing programs are no longer the buyers of last resort. Still way too early to come back into HY bonds.
China, an exception in the EM world – The PBoC has been active with liquidity injection and greater net purchases of foreign reserves to shore up the economy. Credit conditions continue to show signs of easing. The PBoC moved towards net liquidity injection throughout 2022 unlike last year. PBoC Governor Yang explicitly stated that support will be maintained, and it would keep monetary policy flexible and appropriate. Admittedly, the PBoC did keep interest rates unchanged in February, but with inflation slipping to 0.9% in January, there is scope for further easing.
Most emerging markets have been strongly hit by the risk aversion mindset. The sell-off in the emerging assets has been reinforced by the series of sanctions against Russia. The only island of peace is China. Chinese government bond yields have remained anchored around 2.8%.
China has gained its badge of honor
The Russian invasion in Ukraine – Risk on profit growth and major changes in energy and defense policy in Europe – Profit growth and margins in Europe are obviously at risk with the geographic, trade and financial proximity to Russia. European chemical companies and foundries have warned that results will decline in 2022 due to rising energy costs. Bruno Lemaire, the French Minister of Finance, was clear: support for Ukraine and massive sanctions against Russia will have a cost for Europe. Russia is a key supplier of fossil fuels (oil, gas, coal) to Europe. The United States will probably be better immunized.
The war could create disruptions in some production and supply chains in metals and wheat, adding pressure on prices. Ukraine provides 90% of the world’s needs for neon, a noble gas essential for the manufacture of semiconductors, and Russia accounts for 40% of the world’s production of palladium, also used in the manufacture of semiconductors.
Remember that stock markets do not rise when corporate profits fall. In addition, an inflationary regime weighs on stock market valuations with lower PERs. We will most certainly see a downward revision to earnings growth in Europe given the relatively large revenue exposure to Russia/Ukraine/Belarus and the energy impact. We monitor Russian and Ukrainian assets held by some banks/insurers, thinking of Raiffeisen International, Erste Bank, Société Générale, Fortum or Unicredit where risks must be assessed not in relation to total balance sheets, but in relation to equity (see financial crisis 2008)! Others will “benefit” from it such as Eramet or ArcelorMittal with the difficulties for Polymetal, Evraz and Severstal. Conversely, the earnings exposure of US S&P 500 companies to Russia and Ukraine stands at 1%. Now it remains to be seen what the central banks are going to do in the current geopolitical situation, fight against inflation or support the economy; it could provide support to financial markets.
This situation reinforces our conviction to overweight the energy and metals sectors. In Europe, defense and energy transition are making a strong comeback. Total change of doctrine in Germany: increase in military spending with a target of 2%+ in relation to GDP (1.4% today) and end of dependence on Russian gas with investments in renewable energies and in the import terminals of liquefied natural gas (LNG); in the meantime, Germany will be forced to massively use its coal-fired power plants and perhaps extend the life of the last three nuclear reactors. LNG imports from the United States, Qatar and Canada will accelerate. We prefer the US domestic oil and gas companies (Cheniere Energy, Devon Energy, Marathon Oil, Hess) to European companies which will be penalized by their capital links with Russian groups. BP, Shell and Equinor have announced the sale of their stakes in Rosneft and Gazprom, while at the time of writing TotalEnergies, one of the most affected companies, is reluctant to exit. Accounting, we do not yet know the impact. Exxon Mobil, Trafigura and Vitol are other large groups exposed to Russia.
Germany, Sweden and Finland have decided to abandon their export bans on lethal weapons – a policy of neutrality dating back to 1945! – and the two Scandinavian countries are even considering joining NATO. Germany will invest €100 billion in defense in 2022 and increase the share of the military budget in relation to GDP to more than 2%. We are buying European defense stocks, whose share prices have risen sharply on this new doctrine. Germany will increase its military budget to more than €80 billion, which is considerable. On a global level, annual military expenditure fell between 2010 and 2016, but since then it has continued to increase to flirt with $2,000 billion. 62% of military spending includes the US, China, India, Russia and the UK.
The UK stock market, posted a clear outperformance. It benefited from the composition of the index with a weighting of 19% for basic consumption (10% in the other indices), 12% for energy (3%) and 10% for mining and metals (3%). But the FTSE 100 was already outperforming at the start of the year, with investors betting on the exit from the Covid, an improvement in relations with the EU and the sterling.
Oil, Russia is a key supplier for Europe – The massive sanctions against Russia are obviously negative for Europe in particular and for the world in general, since Russia is among the 3rd largest producers of oil (11 million barrels/day, including 5 million for export), with the US and Saudi Arabia, and the world’s leading gas producer.
Russian oil and gas are gradually being embargoed by traders, tanker companies and refineries, while they are not (yet) affected by Western sanctions. Trafigura is getting rid of its Russian oil shipments at a significant discount. International traders want to avoid negative publicity. 70% of Russian oil is frozen. If we do not know all the international sanctions against Russia, stakeholders no longer want to touch Russian oil. If this situation were to last, it would not only be hard on Russia, but also on consumer countries and Europe in particular.
At its March 2nd meeting in Vienna, OPEC+ confirmed its policy of gradually increasing production, ignoring the soaring prices that are worrying consumer countries. The alliance is also ignoring the Russian invasion, which is massively sanctioned by much of the world, keeping Russia in the enlarged alliance. OPEC+ considers that the current volatility is not due to changes in fundamentals, but to geopolitical developments. The geopolitical premium is around $20 a barrel, but we could indeed see the price of Brent go beyond $120 if the positions were to harden between Russia and the West.
Faced with such large volumes, the use of strategic reserves of Western countries and a possible agreement between Iran and the West will only have a limited impact. Saudi Arabia and the United Arab Emirates could increase their production by 1 million barrels/day each, but it would take one to two months to achieve this. The situation was already tense before Ukraine with rising demand and producers who were unable to achieve their objectives as for Nigeria and Angola. OPEC’s strategy is gradual and renewed from month to month; in April, production will be increased by 400,000 barrels/day and the next meeting will take place on March 31st.
Stagflation risk benefits to gold – The slope of the US yield curve signals a risk of an economic slowdown or even a recession. With high inflation, which will last longer than expected with the Russian madness, the risk of stagflation has increased significantly. By listening to European politicians, Europe is heading for low growth and high inflation. In stagflation, gold is the best asset. Gold also benefits from its safe-haven character with the war in Europe.
If the Fed engages multiple increases in Fed Funds to fight inflation, gold’s progress will be slowed, but the trend will remain bullish.
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION Investment Adviser.