By Stuart Paterson
The first quarter of 2022 brought the return of volatility to financial markets as the Federal Reserve promised a faster pace of interest rate rises to address inflation, compounded by the economic implications of the Russian invasion of Ukraine. Risk assets broadly delivered negative returns except for certain commodities and commodity-exporting countries.
The invasion of a sovereign nation in Europe is an event that seemed consigned to history, yet we are experiencing the worst war on the continent since 1945. Markets have already gone some way to sizing the impact, pricing in higher inflation and an asynchronous global growth slowdown. Yet the effects are likely to be far-reaching across many industries for years to come as Russia is marginalised as a high-risk trading partner long after any resolution to the war.
It may seem an enduring breakdown in the economic relationship between Russia and the West is navigable. The direct trade linkage between the US and Russia is minimal, and even in Europe it is very limited.
However, Russia controls much of the requisite building blocks to power the societies of today.
It is the world’s largest exporter of natural gas, second largest exporter of oil and is a major supplier of important industrial metals and food. This conflict lays bare the European Union’s energy dependence on Russia as a key weakness.
With much of these supplies now at risk, the associated surge in broad commodity prices has exacerbated the inflationary pressures that preceded the war following pandemic-related disruption to global supply chains and a rapid recovery in demand as economies reopened.
This poses a challenge for central banks that must tighten monetary policy to stave off inflation, while at the same time economic growth is fading. While acknowledging the uncertainties related to the geopolitical situation, inflation is viewed as the more pressing problem to tackle unless the growth outlook markedly deteriorates.
Although somewhat overshadowed by the Russia-Ukraine conflict and Federal Reserve policy intentions, a new outbreak of the Omicron variant and subsequent lockdowns in China also brings further pressures. Manufacturing plant shutdowns will further constrain supply chains in many important sectors while also compressing demand. In light of an economic slowdown, the Chinese authorities have announced more convincing stimulus measures to support growth.
Where portfolios are concerned, investors should prepare for higher inflation and interest rates by strengthening portfolio diversification rather than exiting risk assets. The fact US equities have rebounded from March lows demonstrates how equities can often adjust to higher interest rates and inflation over time and such a move is not inconsistent with the early stages of a rate rising cycle. Markets have taken the Federal Reserve’s 0.25 per cent March interest rate rise in their stride, with the central bank re-establishing its inflation-fighting credentials and emphasising that the US economy is strong enough to withstand higher rates.
We retain a core focus of investing in “quality” companies that have high and durable profitability in sectors that are structurally growing, along with strong balance sheets. These firms generally have more defensive earnings streams and a degree of pricing power to pass through cost inflation to the end customer, combined with the financial strength to withstand rising borrowing costs. Valuations for such stocks now appear relatively attractive having been indiscriminately sold in the broader market rotation this year.
Active stock selection is of increasing importance as companies navigate higher inflation and rates with varying degrees of success. We have preference for US equities given that Europe is disproportionately impacted by the war owing to its energy dependence on Russia. For more selective equity exposure, we advocate increasing allocations to “value” stocks, such as financials that tend to outperform in periods of rising rates, as well as energy and materials that may provide somewhat of a hedge against risks arising from the war in Ukraine.
With the fog of war hanging over global markets, near-term price developments are
highly unpredictable. The inherent uncertainty
is exacerbated by the interrelatedness of
a multitude of variables; the war, surging commodity prices, inflation, Fed intentions and new lockdowns in China have all clouded the outlook in recent weeks.
As ever, we view strategic asset allocation, active management and disciplined diversification as key to navigating this uncertain outlook in the pursuit of long-term financial goals.
Stuart Paterson is executive director of Julius Baer.
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