War and Peace
At the end of February, Russia led a ground invasion into Ukraine. This remains front and centre for the next quarter as hostilities play out. Firstly, our thoughts and prayers go to Ukrainians, and we wish for a swift and effective cessation of combat and an effective truce.
We see this episode as a step change in the influence of geopolitics in financial markets.
The extent and breadth of the sanctions are breathtaking: as the world’s 11th largest economy prior to invasion, they dwarf previous implementations post the Crimea invasion in 2014 and those implemented on Iran. The court of public opinion is firmly on Ukraine’s side, leaving Russia few trading partners. This will put Putin’s leadership under threat as the conflict continues.
However there appears little common ground for Ukraine and Russia at the moment. A negotiated peace seems but a distant dream, with Ukraine’s leaders unlikely to agree to regime change, and Russia unlikely to settle for anything other than the creation of a puppet regime.
Unfortunately this means the war could drag on with no resolution in sight. The threat of Nuclear weapons means in practical terms NATO is unlikely to get involved unless a member country is attacked.
In the long term the West will need to find ways to build relationships with autocracies, as we can see a future in which a divided world has two parallel financial and trade systems, making sanctions largely redundant.
Market Implications
As investors, this conflict has significant ramifications for portfolios, in a year in which interest rates remain likely to rise to combat stubbornly high inflation, particularly in the US.
We have already seen the Oil price shoot up to $130 – with energy prices continuing to climb, this situation is starting to echo two previous inflationary periods in the aftermath of global conflicts – the Yum Kippur war and the Iranian Revolution, both of which sustained high inflation in the US in particular through the mid 1970s and early 1980s. Then, as now, conflicts damaging the Oil supply occurred at times of existing inflationary pressures, and rising interest rates.
In addition, a broad re-opening of economies as COVID goes from pandemic to endemic in 2022 will likely only exacerbate the upward trend in Oil.
This will impact the European economies probably hardest given their reliance on Russian gas, but also fertilisers, agricultural products, and other downstream items dependent on oil and gas for manufacture. In addition, supply chain issues are unlikely to be resolved quickly under this backdrop.
All of these factors will add to already existing inflationary pressures, which look likely to go higher for longer.
Figure 1: A History of Oil Prices
Equity Markets
While conflict rages, we still remain quietly optimistic for equities, given:
• Global GDP growth as pandemic becomes endemic, driven by services. Australia is expected to grow GDP at 4% over 2022, the US around 3.7%, Japan by 2.8% and France and Germany between 3 and 4% according to leading economists polled by Reuters.
• Rates will remain accommodative, outside of the US.
• Valuations are attractive in certain regions and sectors.
• Alternatives are thin on the ground, given near zero cash rate, and negative sentiment in the bond market.
We do note however the fluidity of the situation at the moment, with stagflationary pressures of slowing GDP growth and rising inflation, as higher energy prices take a toll. The changing macro-economic situation is something we are watching very closely.
We continue to favour domestic equity markets over global counterparts:
• Greater commodities exposure, whether gold, iron ore, or energy. Resources make up nearly 30% of the S&P ASX 200 index.
• Attractive valuations. Trading on just a touch over 15x, around long term averages, with the benefit of franking credits.
• A decent reporting season broadly ahead of expectations, and earnings are on an upgrade cycle.
• Distance from conflict.
• Wage pressures under control and a less hawkish central bank.
In global equities, we continue to favour Europe & Japan over the US: with the US market P/E has moved up beyond 20x in recent years, leaving it especially vulnerable to rising rates. The Fed looks certain to raise rates aggressively in 2022, regardless of the global geo-political situation: they are behind the inflation cycle.
Figure 3: US Implied Rates 2022-2032 (source Refinitiv Eikon, Resonant)
The US bond markets are in fact picking an inverted yield curve in a years-time, suggesting future recessionary conditions, and rate cuts in 2024 as soon as inflation is brought under control in a years’ time.
Our preferred interest rate and bond exposure remains domestic, given the pace of tightening, and the comparative dovishness of the RBA versus the Fed.
Disclaimer: This is general advice and does not consider your particular circumstances. You should not act on this advice without speaking to Truwealth Advice who can consider if it is right for you.