Bedrock’s Newsletter for Friday 1st April, 2022




“Inflation is taxation without legislation.” 

Milton Friedman

Friday 1st April, 2022

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Global equity indices have now recovered the lion’s share of the losses sustained in late February and early March following the Russian invasion of Ukraine. The war is ongoing, and it remains a source of considerable market uncertainty, of course. But the chance that the conflict spreads to NATO member states, such as those in the Baltics, or to Moldova, now seems slim given the severe impact of Western sanctions on Russia’s economy and the scale of Russian losses since the conflict began (of troops, hardware, international standing, and soldiers’ morale). Russian stocks are trading once more; indeed, the MOEX Russia Index is up c.15% since the (partial) re-opening on the Moscow exchange last week. However, Western investors are not among those looking to ‘buy the dip’… cheap Russian assets look set to stay that way for some time to come.
 


In the midst of the carnage, there have been some positive war-related headlines in the past two weeks, and the outline of a negotiated peace agreement does appear to be taking shape in Turkey. However, the future status of the Donbas and Crimea remain major sticking points. Ukraine will not cede territory easily, not least when it has just beaten the odds by keeping Russian forces out of Kyiv, but the Kremlin also needs something tangible which can be sold at home to conceal the wider strategic failure. On this last point, the poisoning of negotiators from both sides (reportedly in early March) shows the extent of the resistance from hardliners within the FSB to anything that smells like a Russian capitulation in talks (and reveals the high stakes for Putin and his cronies). Although markets initially responded positively to Russia’s decision this week to ‘drastically reduce’ attacks on Kyiv so as to focus on Donetsk (including Mariupol and the Sea of Azov coast), this looks more like an effort to create ‘facts on the ground’ in Eastern Ukraine, rather than a conciliatory gesture designed to build trust and bring positive momentum to talks. Indeed, the change in tack is a worrying development in many ways. An attempted land grab in the East could well result in a military stalemate and a costly frozen conflict for many years to come. Still, with so much uncertainty about the trajectory of the conflict in Ukraine, we will refrain from making any further predictions about how events will evolve from here. Instead, we simply note that inflation and interest rates could surprise to the upside in Europe and the US given the commodity supply chain dislocations caused by the war, and we will construct our portfolios accordingly. This means maintaining exposure to diversified commodities, low duration fixed income, and less rates-sensitive equity sectors, alongside beaten down growth stocks that we believe are attractively valued at current levels. Portfolio diversification combined with a barbell approach in equities makes a lot of sense in our view.
 


Beyond the war in Ukraine, the other big news moving markets this week is the inversion of the 2-year and 10-year points on the US treasury curve. Front-end yields in the US (and Europe, albeit to a lesser extent) have been rising rapidly throughout 2022 as markets digest a raft of disconcerting inflation data and price-in an ever-increasing number of policy rate hikes. According to Federal Funds futures prices, investors now foresee >8 further rate hikes before the end of 2022 and believe that the US policy rate will finish the year above 2.4%! In February, markets predicted just over 5 rate hikes (including the one we had in March), which shows the speed at which expectations are moving. While short-end rates have risen, so too have long-end rates, both due to changing inflation expectations and amid QE tapering. Until this week, the moves had prevented the 2s10s slope from going negative; but no more. Why does anyone care? Because the US yield curve between the 2-year and 10-year points has inverted ahead of every recession since 1955 (typically, about 6-24 months in advance). The last recession was no different: the US yield curve inverted in 2019, and the country entered recession in 2020 (albeit driven by events that were unforeseen by the bond market a year in advance!). Against the current backdrop of surging inflation (now at the highest rate in 40 years), made worse by the war in Ukraine, the US yield curve inversion is a very real worry. Much inflation is clearly being driven by rising energy prices, and the US government’s decision this week to release 1m barrels of oil per day from its strategic reserves will go some way to ease the pressure here. But it is difficult to gauge exactly how much impact the move will have on end consumers and many factors are pushing in the opposite direction. US consumer confidence may have recovered somewhat in the past month, but it has fallen year-to-date as household bills rise; and higher borrowing costs by year-end would certainly take some of the wind out of America’s sails.
 


Europe has also found itself in a tricky position with regards to inflation, even if the European Central Bank (‘ECB’) and markets anticipate far fewer policy rate hikes in the Eurozone this year in response. According to data released earlier this week, inflation in Germany reached +7.6% in March (vs. +5.5% in February) while inflation in Spain hit a whopping +9.8% (vs. +7.6% in February). The release of this data weighed on European government bonds mid-week; and today’s release of the Euro Area’s headline inflation reading for March (+7.5% YoY) is set to drive yields even higher. To make matters worse for Europe, Putin has threatened to halt gas exports to European countries that fail to open Russian bank accounts and pay for the gas in rubles. Germany, Austria, and Hungary, among other countries, are highly dependent on imported Russian gas. Should they not do as Russia commands, rationing is likely to be necessary to mitigate a severe power crunch. This will exacerbate the pain being felt by European consumers already, may force rate expectations higher, and will almost certainly weigh on European growth. Stagflation is a real risk going forward.

China, meanwhile, is experiencing its most substantial covid-19 outbreak since the Wuhan lockdown in early 2020 and the impact on the country’s economy is likely to be significant. Indeed, a recession may be underway already if the most recent data is accurate: the manufacturing PMI reading for March came in at 48.1, which suggests the steepest contraction in factory output since February 2020, while the PMI for services was also below 50. While much of the rest of the world has learnt to live with the coronavirus (whether they are masked or mask-free), the Middle Kingdom has yet to give up on its aggressive zero Covid strategy. The result is that Shanghai is in lockdown, Shenzhen’s port is in chaos, and the growth trend is decidedly unfavourable. Lockdowns are likely to spread in the coming weeks given how hard it is to contain the more contagious and more frequently asymptomatic Omicron variant, causing further supply chain problems for the world economy. That being said, the government has promised to deploy its considerable fiscal and monetary firepower to help keep the economy on a relatively even keel and to introduce ‘market-friendly policies’ to coax investors back to China following last year’s technology sector crackdown and related equity sell-off. We believe that following that downwards move, many of China’s leading onshore and offshore companies are now attractively valued. If you can grit your teeth and hold your nerve, there are some rich pickings for specialist managers in China today.