Log inMarket Update – Time to be on the right side of history by Jilly Mann
As the war in Ukraine continues, global leaders are increasingly urging their counterparts to be on the right side of history. As China’s Foreign Minister quoted at the weekend, “Time will tell that the Chinese stance is on the right side of history”, the world remains unclear what exactly that stance is, but the last week has seen the shoots of some catalysts for change, with China at the heart of them.
In this update we shall cover the following:
- China’s timely market boost
- The invasion of Ukraine
- Inflation & interest rate concerns
- Resources and the warning of nickel
China’s timely market boost
For some time now, China has been adopting domestic policies aimed at reducing the divide between the wealthy and the masses, general social improvement one could say. This has led to some punitive tax charges on big business and some public spats between big corporations and the Chinese Government. The net result has been largely positive for the Chinese people, where living and working conditions are improving, but has been negative for the Chinese economy and stock market. It became only a matter of time before the next target came into focus, be that Alibaba (the Chinese Amazon/Ebay) or Evergrande (the failing property company). This made investing into China a tentative business, because the market didn’t move marginally, it would move significantly when the next industry or business was targeted.
Allied to the domestic issues within China, Chinese and US relations have been relatively acrimonious in recent years. Started by the Trump regime policy of America first and then continuing thus far under President Biden. Chinese businesses listed on the US stock market were increasingly hit with increased taxes and barriers with China then retaliating in a tit for tat manner.
So, what has changed? Last week saw an announcement from Chinese Vice Premier Liu He that encouraged the Chinese Government to roll out market-friendly policies and be cautious when introducing measures that risk hurting markets. This pronouncement coincided with the Government confirming that they are not continuing with their property tax trial for the coming year. It was this tax trial and the focus on property company balance sheets that led to the Evergrande issues last year. The fact that the Government are now pausing further imposition of those measures is a nod towards needing to reinstate confidence in the sector and the broader Chinese market.
Last week also saw Chinese stocks which are listed publicly on the US stock exchange leap upwards. As a result of continued cooperation talks between the US and China, Regulators from both countries feel like they are making progress and news brought immediate relief to those stocks, with Alibaba jumping over 36% in one trading session. The overall performance of these type of stocks has been around minus 69% over the past 12 months.
The reason I have started with China over Ukraine, is because for markets, this could be the catalyst we have been waiting for. In 2008 when the Global Financial Crisis hit, China’s willingness and ability to step in and shore up the global economy created a period of sustained recovery.
Whilst neither the Ukraine war, nor Covid, have replicated the drama which hit markets in the wake of the Global Financial Crisis, markets are uncertain for many reasons at the moment, China making more positive noises domestically and with the US could provide an underpin to where markets go from here. Irrespective of your view on China itself, this would likely prove beneficial for global markets more broadly and so is worthy of consideration.
The invasion of Ukraine
Clearly the dominant factor for markets over the last month has been the continued invasion of Ukraine by Russia. Whilst the human suffering remains immeasurable, investment markets adapt and find their new normal.
We continually repeat that investment markets like certainty or to put it more strongly, markets despise uncertainty. The Ukraine conflict provides little in the way of certainty, but as it unfolds, clarity does emerge. The Russian economy and stock market is crippled. Sanctions have stifled liquidity; the Russian stock market is effectively suspended from trading and global trading partners are few and far between. In Putin’s desperation, he is increasingly isolated with only those fellow sanctioned countries around the world for support, Syria being at the top of the list. The reason why so much focus is on China is because they haven’t publicly condemned Putin’s attack on Ukraine. We mentioned last time China’s potential vested interest in the consequences of invasion with Taiwan in mind, but China have subsequently made murmurings towards the need for peace. In terms of global diplomacy and appeasing nations with whom the West has not historically enjoyed strong relations, it perhaps isn’t a coincidence that we have seen renewed UK urgency in resolving the release of some, but not all, of the detained citizens in Iran or President Biden’s one to one talks with President Xi of China last week. If China falls in line with Russia publicly, then the ramifications of that would be hard to quantify, but thus far China have played the neutrality card and publicly at least, Putin hasn’t achieved the carte blanche support from China that he perhaps anticipated. The West need to make other nations think twice about supporting Russia in this conflict and direct lines of communication have seemingly been forged to achieve this.
Putin could resort to nuclear weapons, he could continue this assault on Ukraine by launching missiles from Russia to counter the underperformance of his army on the ground and if he does start to use the nuclear card, then global markets would not react well, although obviously that may not be the biggest of anyone’s concerns at that time. This may sound worrying, but the clarity emerging is that Putin does not have the undivided backing of the Russian people, his options are now limited, and his financial reserves will dwindle from here. Increasingly he is a man isolated and without a plan. Last week, the news flow hinted at an improved appetite for peace talks from both sides. From a self-preservation perspective, Putin will need to be seen as the victor of this mess that he has created. Many of his demands could be met relatively easily, but perhaps one or two would be less palatable. Ukraine wants to continue talks and for their part seem willing to cooperate to end the bloodshed. That movement towards a potential deal again encouraged markets and we saw a positive reaction across stocks quite widely.
There is no deal yet and whilst one is agreed, Putin may well take more desperate measures, but the net does feel like it is closing in on him and at the moment markets are viewing the increased sense of clarity with greater optimism. A deal could take a while to finalise, but if the bombing can stop and people can stop living in fear in the near term, that would likely be sufficient for markets to rally from here.
I am not saying we have seen the bottom of the market or that further falls aren’t possible before things sustainably improve, however, unless something fundamental changes, such as Putin clinging onto power and launching nuclear weapons asunder, markets feel like they have found a point at which they don’t want to go beneath for the time being.
As a result of this, we have broadened our investment allocation to include increased exposure to European equities, emerging market equities and smaller company funds both in the UK and globally.
The graph above models the valuation of the FTSE Europe ex UK index since September 2008. As can be seen, the impact of the Ukraine crisis has been worse than the impact of Covid. Assuming that a resolution can be found, this signals that there should be some recovery due within European equities to bring the market back in line with the overall trend for the last 14 years.
We have been fairly constrained in our investment allocation during the Ukraine conflict, preferring to mainly hold cash and commodities, but the sentiment towards peace talks and the latest Chinese economic policy gives us the catalysts we needed to be positioned for the next chapter of the story.
Inflation & interest rate concerns
There remain the arguments that existed before Russia invaded Ukraine of global inflation and rising interest rates, notably in the US, Europe and the UK. These arguments have not gone away and so we still need to factor these into our investment decision-making, however, we think any rally from here will be twofold.
Firstly, there will be almost a relief rally. Relief that the conflict has been contained and that for the time being at least, World War III is not on the cards. Some of those stocks who have fallen as a result of widespread fear in the region will regain ground when the reality emerges that their business functions are unrelated to what is happening in Eastern Europe.
This relief rally may not last long, but it is likely to benefit all sectors, even those such as technology where we are generally more reticent about future stock valuations. The mini rebounds we have seen thus far, have seen this type of sector and company lead the charge.
Secondly, we think that as the relief rally dampens, inflation and interest rate concerns take precedence again. At this point we would expect to see the aforementioned technology type names lose ground to stocks with stronger pricing power. Essentially, the situation we have been positioned for with holdings such as Artemis Global Income, Schroder US Mid Cap and the L&G Infrastructure Index fund. We expect to then be rotating our portfolios into further more defensive names such as these, who have greater exposure to businesses with pricing power in the face of inflation, notably utilities are a good example of this.
The story with regard to interest rates hasn’t materially changed over the last couple of weeks. Rate rises in the UK and US have continued, but we maintain the view that across the year, we will see less than the predicted number of interest rate rises, stock markets are also cognisant of this.
Inflation will be the key story should the situation in Ukraine calm down. We had positioned our portfolios with a heavy weighting to resources in the wake of the invasion. We increased our exposure to oil, gas, agriculture and gold across our non-ethical strategies. The oil price reached $139 per barrel earlier in March 2022 as the conflict worsened. It has subsequently fallen to under $110 per barrel, but this is still much higher than we have seen for some time and an oil price at such highs inevitably prolongs inflation.
A high oil price leads to transportation costs increasing as well as production costs rising and that is allied to the struggle for businesses to recruit post Brexit, in the UK at least. For European firms, one also has to factor in the potential lost markets if trading partners are affected by the Ukraine conflict. In the medium to long term, inflation could be good for workers if the businesses can continue to operate and can either absorb or pass on costs, but ultimately, it won’t benefit workers if the businesses ceases to operate, as we have seen with P&O Ferries. In addition workers won’t benefit if wage increases fail to keep pace with the cost of living, in an environment where domestic energy and commuter costs have soared equally.
Domestically, the cost of food is also going to prove a challenge in the coming months. Food inflation has been steadily creeping up through Covid, but with Russia and Ukraine responsible for 14% of the world’s wheat production, import stocks will dwindle and will take some time to replace. That wheat production needs replacing from somewhere. Replacement from increasing domestic production levels inevitably takes some time and imports will be affected by commodity inflation as set out earlier.
Inflation feels very real for all of us at the moment and it will be interesting to see how Rishi Sunak tackles this in his Budget speech this week. The proposed rise in National Insurance is still on the cards, but whether he sees this through now or defers it, or perhaps takes other measures to temporarily ease the squeeze on domestic incomes will be key to the UK economy for the next twelve months. If he does offer some respite, then the FTSE would likely react positively to the news, as it will still be a challenging backdrop from which to work, but some respite would soften the blow.
Resources and the warning of nickel
We have reduced our exposure to commodities in our portfolios, retaining exposure through our UK and global equity funds, but reducing our resources specific allocation. We have already seen the oil price retrench from its highs, although the oil price and the performance of oil companies such as BP don’t always follow the same pattern. We think there are signs to suggest that we have perhaps seen the highs from the sector. We are aware that commodity prices can fall as quickly as they rise. We need to be mindful of Saudi Arabia’s ability to manipulate the oil price when it gets too high so as not to affect their own economy, as well as considering that the bulk of the sanctions on Russia over oil and gas have now been announced. Those sanctions continue to be modified and could be escalated if they don’t have the desired outcome, but the shock which initially hit the resources markets as a consequence of Putin’s actions appears to have passed. The elevated level of resources which we continue to see is more about the rush to develop alternative energy sources and specific companies which maybe mine nickel or silver for example, metals which are required to develop renewable energy.
Nickel is worthy of mention. Earlier this month, the London Metal Exchange (LME) had to suspend trading in nickel. A Chinese tycoon had placed a short deal on nickel for around 180,000 tonnes of nickel, i.e. he would make money if the price of nickel fell. He hadn’t anticipated the invasion of Ukraine which sent the price of nickel through the roof, it soared to over $100,000 per tonne. Had the market remained open, the tycoon would have made billions of dollars of losses. I’m sure he has few sympathisers, but had the trade gone through, this would have destroyed the nickel market and so the LME had to suspend trading and cancel all deals. We often talk about algorithms moving markets, i.e. computer programs which are pre-set to buy or sell at certain prices irrespective of newsflow which then distort market performance, well the nickel story is another good example of what can go wrong when investing gets a bit too clever. There are lots of instruments and methods out there to try and beat the market, but rarely do they win in the end.
Whilst we have made changes to our strategy to be positioned for cautiously improved sentiment in investment markets, we continue to be ready to adapt if need be. Newsflow comes thick and fast at the moment, but we need to separate out the human stories from the stories which will impact markets and your portfolios. Amidst the chaos, there are signs of clarity and whilst the world remains a worrying place right now, we have been through many a crisis before and have the sense that we are now seeing multiple potential catalysts for change. We can but hope that those with the power to engender permanent change are indeed on the right side of history.