Themes For February

4 April 2022

The Russian invasion of Ukraine threw financial markets into turmoil during the month which saw equity markets continue their slide from January. Higher energy prices due to uncertainty over supply from Russian saw European markets particularly hard hit, falling 4.3%. The US market declined 3% as rising fuel prices added to the already concerning inflation outlook. The Australian market was a standout, improving by 2.1% due to strong commodity prices especially crude oil +8.6%, coal +23%, iron ore +8% and gold +5.8%. The inflationary impact of higher energy prices pushed bond yields up, with US 10-year treasuries up 9 basis points to 1.86% while the Australian 10-year bond was 27 basis points higher finishing at 2.17%. As a commodity-based currency, the $A firmed by 2% to finish the month at US 73 cents.

Energy prices, economic sanctions to challenge the global economy

First and foremost, the Russian invasion of Ukraine is a humanitarian disaster. The unprovoked attack by Russia of a neighbouring sovereign nation of kindred spirit has produced tragic loss of life, destruction of property and unleashed a wave of refugee migration not seen since World War Two. The financial market ramifications stem from the fact that the European Union has become very dependent on Russian oil and natural gas, constituting around 40% of their energy needs. Somewhat naively, countries such as Germany have transitioned away from energy self-sufficiency based on nuclear and coal fired power, preferring natural gas imported from a geopolitical adversary in Russia. Early sanctions imposed on Russia from the western world were somewhat tepid and centred around constraining non-energy related financial transactions and seizing assets from Russian Oligarchs, but skirted around direct sanctions on energy exports, the lifeblood of the Russian economy. Paradoxically, the sanctions that would hurt Russia the most are those that Europe can least afford, given limited short-term alternate energy sources. In this environment, a spike in oil prices was inevitable which stoked inflation fears in addition to concerns the economic sanctions imposed on Russia would have a knock-on effect to Europe and the global economy. More recently, the US government has responded to internal political pressure to ban imports of Russian oil, which constituted around 8% of US oil consumption. It was not that long ago that the US was energy self-sufficient however this is no longer the case due to cutbacks in local oil production and exploration activity over the past year. Recent events have highlighted the fact that energy policy is inexorably linked to national security.

Inflation outlook becomes more problematic

As mentioned in last month’s report, the need to subdue inflation has become the primary target of central bank policy. Recent events have made this task more difficult. Policy now must walk the very fine line between suppressing inflation without driving the global economy into recession. The US Fed was poised to tighten policy in March by 50 basis points, however we are now likely to see a less aggressive move. While US inflation printed at 7.9% per annum in February (another 40 year high), it is likely the Fed will err on the side of caution and tighten by only 25 basis points so as not to engineer the adverse economic scenario where high inflation is accompanied with slow growth. This is commonly referred to as “stagflation” and was the scourge of the global economy in the 1970’s, instigated by two separate OPEC induced oil price shocks.

While the global economy was recovering quite well post-pandemic, growth expectations are now likely to be revised lower. The outlook is clouded by uncertainty about how Russia’s military intervention in Ukraine plays out. The stern resistance of the Ukrainian army and the resilience of its leadership and people has come as a surprise to Russia who expected a swift victory and to install a compliant puppet government. The likelihood now is that this will be a drawn-out conflict followed by a hostile occupation should Russia prevail. Any future sanctions that extend to Russian energy exports to Europe will no doubt push energy prices well beyond what we’ve seen to date. Of course, geopolitical events such as this can be quite volatile, so it is impossible to predict outcomes with any great certainty.

Investment Outlook

We took the opportunity in both December last year and January to reduce our exposure to both International and Australian equities based on a declining risk premium. This was a consequence of both negative profit revisions due the impact of the omicron variant on global production, rising US inflation together with the brewing uncertainty of geopolitical events such as Russia/Ukraine and China/Taiwan. While we still expect the global economy to expand this year, there’s no question that recent events have dampened the outlook. Consequently, we are taking a relatively cautious approach to equities given the uncertain nature of the immediate investment environment. While the $A usually falls in a “risk-off” scenario, the reverse is likely to occur in the current environment. Being a commodity-based currency, we could well see an appreciation of the $A so we have taken the opportunity to reduce the exposure to the $US by switching the weighting to US Treasury inflation protected securities in favour of their Australian equivalent, which offer similar characteristics without the risk of currency loss.