Financial analysis of the first quarter, 2022
Here is a look at sustainability news and the global situation at the close of the first quarter, by the Investment Team.
A quick summary:
- In sustainability news, the findings of the latest IPCC report, the impact of Russia’s actions on ESG issues, and the energy crisis.
- In the UK, another positive quarter for the FTSE 100, but GDP growth is revised downwards.
- A tumultuous quarter for US bonds, and we examine what ‘inversion in the yield curve’ can mean.
- Rebound for Europe’s Stoxx Europe 600 Index, while Russia’s rouble loses value and sanctions continue. Fuel dependency on Russia remains a key issue for Europe.
- In Japan, the prime minister plans a package of economy-stimulating measures, aimed at easing the impact of rising living costs.
- In China, Shanghai has announced a two-stage lockdown to tackle growing Covid rates and real estate is struggling.
- For commodities, energy costs remain a key issue and Chinese lockdowns impact supply chains. The war is causing major disruption to farming and distribution.
- Portfolio performance faces challenges from the global situation. We are monitoring carefully and making necessary changes including reducing the growth stock bias.
The in-depth read:
A spotlight on sustainability
The IPCC Sixth Assessment Report on Climate Change released in February assessed the world’s impacts, adaptation and vulnerability to climate change.1 To avoid a ‘snowball-effect’ of increasing damage to humans and natural systems, the IPCC outlines the need to move from minor adaptation measures to a large program of anticipatory, resilient planning. The report highlights that injustice and inequality must be considered within planning, given the lack of funding and infrastructure and greater vulnerability to climate disasters that poorer countries face.
The Russian attack has sparked a debate within the environmental, social and governance (ESG) space. How can investment picks be guided by ESG and invest in a country engaged in war? ESG funds had at least $8.3 billion invested in Russia before the invasion, a small amount compared to the $2.7 trillion invested in sustainable funds, but still significant.2 Despite Larry Fink, speaking out about responsible capital, Blackrock took a large position in the Russian goldminer Polymetal a day after the invasion began (it has since suspended the purchase of Russian securities).3 These decisions highlight the importance of making sound ESG decisions ahead of time. Potentially easier said than done.
The war has caused many countries to look for alternative sources of energy after a long dependence on Russian oil and gas. It is too early to tell how this will play out for the environment. In the short-term, the UK, EU and US are looking to increase domestic production and increase their energy independence, which could negatively impact the environment if extraction begins in the North Sea for example. However, taking a longer-term view, Adair Turner, chair of the Energy Transitions Commission, states that insultation, heat pumps and wind farms will see more investment over the next five years because of today’s crisis.4
Financial analysis from round the globe
UK
Prior to this quarter, the UK equity market has struggled to keep pace with major developed international peers over the past five years, as a medley of political factors have kept foreign investors at bay. Furthermore, the mature, high dividend paying energy, mining and financial stocks have not kept up with growthier stocks dominating foreign indices such as the S&P 500. This quarter the FTSE 100 has achieved a remarkable positive return (recording its sixth consecutive quarter of gains5), despite the war in Europe and rampant inflation, while all other major indices posted negative returns in a quarter that has seen war, inflation and multiple interest rate rises. When growth forecasts deflate, and the cost of borrowing rises, it dampens the expectations attached to lofty growth stocks, and re-ignites the demand for value stocks – those that trade at lower price multiples, often mature dividend paying companies. Thus, UK equity indices have provided a port in the storm, as financial companies benefit from rising interest rates and energy and mining giants enjoy higher commodity prices.
The outlook for GDP growth in the UK has repeatedly been revised downward, whilst the not-so-transitory inflation has consistently exceeded consensus estimates. The Bank of England have raised rates twice in the first three months of the year, with the February rise being the first since the Central Bank slashed rates at the beginning of the pandemic. Expectations of future interest rates have significantly increased, and fears will always reside that in the effort to combat inflation, the Central Bank will overstep, raising rates too steeply and driving GDP growth into negative territory.
What usually accompanies excessive inflation is higher than expected growth, but in the current instance of deflating growth economic fears arise of ‘stagflation’. Stagflation is the economic scenario of low growth and high inflation, and it is meddlesome as the two economic actions to resolve either issue could, theoretically, make the situation worse: raising rates to combat inflation could further dampen growth, or to stimulate growth by cutting rates you potentially fuel higher inflation. The Spring budget offered little to sway financial markets, consumers were offered small reprieves through fuel duty cuts as the overall tax burden increases.
Bond markets experienced heightened volatility, grappling with rising interest rates, war in Europe and increasing expectations of a recession in the near future. Almost all credit suffered by the end of the quarter, but once again our decision to move into shorter dated securities last year has proven beneficial.
US
In the US, unemployment reached 3.7%, with a strong labour market that has buoyed consumer confidence despite inflation hitting a 40-year high.6 The Federal Reserve ended two years of near-zero interest rates in March by raising the funds rate to 0.5%, as policy makers pivoted towards plans of aggressive interest-rate hikes in an attempt to cool inflation scares. US equity markets largely suffered throughout the quarter but posted an impressive 10% rebound in the last two weeks of March.7 US equities recouped much of the losses since the Russian invasion, with impressive first quarter earnings releases overpowering the political risks, as Biden championed Russian sanctions and harsher judgement from developed peers. Large US technology names remain down year to date but have shown resilience as investors eagerly anticipate a buying opportunity, as earnings forecasts climb once again. But with such economic uncertainty, questions remain over the sustainability of what is already being termed March’s bear market rally.8
Much like the UK, US bonds experienced a tumultuous quarter and ended in the red as aggressive interest rate rises were priced into financial markets. When GDP growth is deflating, all eyes look to the yield curve, where an inversion is a famous precursor to an impending recession. Some inversions hold more weight than others, but a key indicator has been the two- and 10-year yields. Simply put, you should be rewarded more for holding longer-term securities, and this is demonstrated by a normal upward sloping yield curve. An inversion means that investors will receive lower returns for holding a 10-year US treasury over a two-year treasury. The most common explanation for this is that an interest rate cut is predicted, an action associated with recessions to support the economy, an environment that benefits longer term bond holders. This indicator flashed in late March, but the indicator’s strength is associated with longer periods of inversion, and arguments exist that the inversion could imply an interest rate cut to avoid a recession.
Europe
In Europe, Russia’s invasion is having a devastating impact on Ukraine. As the war remains contained for now, we believe it is unlikely that a systemic shock to the markets – such as that seen during the Covid pandemic – will arise. For example, the Stoxx Europe 600 Index has rebounded more than 9% from a low on March 8. However, compared to its January record high, the index still reflects lingering concerns around slowing economic growth.9
Russia’s economy has suffered because of the invasion. The rouble lost half its value in the first few days of conflict, credit rating agencies downgraded Russian debt to ‘junk’ status, and Moscow’s stock exchange was closed for nearly a month. Sanctions continue to be in place by major economies. Estimates of the long-term impact on the Russian economy this year vary from of contractions ranging between 15% and 7%.10 Weakened and separated, there is a risk that Russia could increase its reliance on China in the future.
Europe’s over-dependence on Russian energy has been the elephant in the room for some time now, with the country accounting for the following levels of imports into the EU: 27% – crude oil, 41% – natural gas, and 47% – solid fuel.11 The European Commission has proposed a plan to end dependency on fossil fuel imports from Russia ‘well before 2030’, with a focus on diversifying gas supplies, increase in energy efficiency and the roll out of renewables.12
Japan
The Bank of Japan continues to be an outlier amongst the global shift towards tighter monetary policy. Having adopted negative interest rates in 2016, the bank continues to support their loose approach by favouring low rates and stimulus.13 Despite rising commodity costs, inflation remains relatively low, partly due to reduced consumption (particularly on services) stemming from a resurgence of Covid. At the time of writing, the TOPIX and Nikkei 225 indices are down 0.9% and 2.89% respectively year to date.14
Prime Minister Fumio Kishida is preparing to implement a package of stimulating measures in April, aimed at softening the blow of rising living costs – growing at their fastest rate in Tokyo for two years – and aiding their recovering from the pandemic. While the full details remain to be seen, a state budget of 107 trillion yen ($874 billion) was approved by Parliament for the fiscal year.15
Along with this, Kishida announced plans to lift Covid restrictions as the country looks to implement its exit strategy from the previous wave. Emergency measures ended following a decreasing trend in the numbers of new infections.16 Border controls were also relaxed in March; however, tourists are still not able to enter the country.
Asia Pacific & Emerging Markets
Asia and the Emerging Market have seen very much the same headwinds as the rest of the globe although whilst the rest of the world seems to have taken a more liberal approach of how to deal with Covid, China has put large parts of its country into lockdown as the virus picks up pace. In the last few days Shanghai has announced it will be entering a two-stage lockdown over nine days.17 This is off the back of multiple other lockdowns across the country with millions being told to stay at home.
The Chinese real estate woes have worsened with many real estate companies recently announcing that they are no longer able to release their financial statements.18 This is worrying situation for a sector that has already be beaten up significantly. At Holden & Partners we have very low exposure to China so we are not concerned by direct exposure but by the ripple effects that may be seen.
Having spoken at length about the Russian invasion of Ukraine we will not discuss here other than to highlight that the invasion continues to cause devastation.
Commodities
The issues surrounding rising energy costs have been heavily exacerbated by the ongoing war in Ukraine. Sanctions imposed by the West targeting Russian exports of oil, gas and solid fuel have led to extreme levels of volatility in the month of March, with the price of oil reaching new highs.19
While such sanctions have great long-term implications particularly for those reliant on Russian energy, further shocks from around the world are also being felt. China’s zero tolerance to Covid continues to throw up regional restrictions, raising concerns over supply chains and output as tens of millions of people are subject to testing.20 While unlikely to fully counteract the inflationary pressures, persistent lockdowns will certainly dampen demand from the world’s largest crude oil importer. A recent missile attack on an Aramco oil storage facility in Saudi Arabia was also a cause for concern.21 Despite spooking markets, we believe this is unlikely to cause any long-term supply issues.
The war is also having a profound impact on food. The conflict between the two countries, who account for about 30% of the world’s traded wheat,22 is causing major disruption to farming and distribution, leading to wheat futures reaching levels unseen since 2008.
How have our portfolios fared?
Rising inflation and impending rate rises have now come to fruition. Combined with the already troubled supply chain, growing input costs and Russia’s invasion of Ukraine. The first quarter of the year has provided headwinds to portfolio performance.
With our portfolios having a growth bias, the raising of interest rates has created a less favourable environment for growth stocks in favour of more value stocks. This has not taken us by surprise, and we made changes within the portfolios at the beginning of the year to counteract some of this. By introducing a more value focussed global fund we have reduce the growth stock bias.
We continue to believe in the benefits of long-term investing, the importance of diversification and investing in a broad asset base. The road ahead looks volatile; however we will continue to monitor and make any necessary changes.
Do get in touch with your adviser if you’d like to discuss this update or your investments.
The value of investments can fall as well as rise. You may not get back what you invest.
Past performance is not a reliable indicator of future results.
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3 The Week, 2022. “ESG and the war: what the pundits say”, 12th March 2022 [1374].
5 UK’s FTSE 100 marks sixth consecutive quarterly gain | Reuters
7 Morningstar Data – S&P 500 TR local currency return from 14/03/2022 – 29/03/2022.
8 Rebound was bear market rally, says Morgan Stanley | Business | The Times
11 https://ec.europa.eu/eurostat/cache/infographs/energy/bloc-2c.html
12 https://ec.europa.eu/commission/presscorner/detail/en/ip_22_1511
13 https://www.boj.or.jp/en/announcements/release_2022/k220318a.pdf
14 Data collected from Morningstar, from 01/01/2022 – 29/03/2022