Q1 2022: Quarterly Review

Studying the markets can often seem stressful, occasionally euphoric, but rarely dull. With 2020 and the incredible market moves that year brought still looming large in the rear-view mirror, it would be easy to feel investors were due a calmer investing environment. That has not been the case though.

As the year began, inflation was already high, but forecasters hoped it was close to its peak rate. Interest rates were still incredibly low, while many central banks were still actively pursuing quantitative easing programmes (buying bonds to lower long-term interest rates). But the tone from policymakers had changed. They were getting ready to slow the economy down and to start addressing inflation, rather than supporting economies that had been buffeted by Covid and lockdowns. Investors knew this threat was looming and were preparing for it.

Tension

During those early weeks of the year, however, another threat was emerging in the form of Russian troops massing on the border with Ukraine. Russia had been bristling at successive waves of NATO membership expansion that brought the organisation closer to her Western flank. That some new members were former members of the Soviet Union was concerning, and would become more so if Ukraine were to join them. For Kiev to go from being capital of the Kievan Rus empire that Russia claims as its cultural ancestry, to seeking membership of an organisation that was forged to resist Russia’s military threat was troubling. Parts of eastern Ukraine and the Crimean Peninsula had large Russian communities who had claimed loyalty to Viktor Yanukovych, the pro-Russian Ukraine president who was ousted in 2014. Since then, the regions have remained in states of occupation.

Conflict

In retrospect, there seems a certain inevitability that conflict would follow and, increasingly, warnings came from global leaders whose intelligence briefings cited the troop build-up as a source of concern. To many analysts, though, an invasion seemed unthinkable for the simple reason that the logistical challenges of conquering those regions of Ukraine that were determined to resist would prove incredibly challenging. And so it has proven to be.

Human losses on both sides have been tragic while Russia has also suffered a staggering loss of sympathy, prestige and respect for this bungled attempt at a show of force. The event has served as a galvanising force amongst liberal democratic governments, resulting in military support for Ukraine that is designed to show support whilst avoiding direct confrontation with Russia.

Sanctions

When Covid struck the markets slumped, not because of the threat to life but because of fear of the economic consequences of lockdown. A sell off following the invasion of Ukraine reflected concerns about sanctions rather than casualties. This kind of dispassion from markets can be disconcerting. It is perhaps most evident in the investors’ aphorism that you should “buy on the sounds of gunfire and sell on the sounds of trumpets”, by which they mean that these horrific events often offer better opportunities to the courageous investor than the cautious one who waits until the outlook has brightened. In the weeks after the invasion, the stock market followed this time-honoured pattern once more.

As well as underestimating the military resistance from the Ukrainians, Russian president Vladimir Putin may also have underestimated the sanctions response that Russia would suffer. Official sanctions covered individuals, state-influenced entities, oligarchs, foreign exchange reserves, financial entities and goods with potential military uses, but the impact of sanctions went far further. Many companies took the step of self-sanctioning – voluntarily withdrawing from Russian markets due to the incompatibility of Russian business with their corporate values. No doubt that decision was made easier by the way in which Putin’s autocratic rule has largely squandered the enormous potential benefits of financial liberalisation for such a mineral rich country as the one that could have emerged from the collapse of the Soviet Union.

We should make no mistake that, like the war itself, these actions are what economists term a negative sum gain. That means that, however the situation is resolved, overall society will be poorer.

Inflation

Away from the front line of the conflict, what does it mean in the relatively comfortable homes of Western developed democracies? The war manifests itself by further inflating an already bulging cost of living. Globally, consumers have had to digest sharp increases in oil prices (Russia is the world’s third-largest oil producer), in food prices (also the third-largest wheat producer) and, of particular concern to Europeans, gas prices (the second-largest gas producer with nearly 40% of European gas coming from Russia, largely through fixed pipelines, including those crossing Ukraine).

The cost of these sanctions to Western consumers cannot be isolated with precision, as inflation from other sources was already elevated and disappointingly persistent. Needless to say, it has not helped. It will now be very hard for most consumers to maintain their incomes in real terms (after accounting for the effects of inflation) but they will, of course, try.

In the UK and the US, companies are competing to attract new employees of whom there is a shortage. While that helps wages to rise and try to keep pace with last year’s increases in prices, it also means higher costs for companies which they will try and recoup through rising prices in future periods. This creates the risk of a vicious cycle in which prices drive wages and wages drive prices.

Interest rates

These were some of the circumstances that drove inflation back in the 1970s. They are another example of a negative sum game. The market for labour relies upon people seeking fair wages for the work they do. However, in driving wages higher, individuals are sometimes unwittingly driving prices even higher still, raising the cost of living and eventually causing unemployment. Faced by such circumstances policymakers know what to do. In the short run, these challenges are most likely to be solved by action that slows demand and therefore reduces the upward pressure on prices. It is with that in mind that central banks like the Bank of England and US Federal Reserve are increasing interest rates.

It was likely also a factor encouraging the UK chancellor in delivering an underwhelming spring statement. Offering tax cuts or spending increases in the current economic environment risks adding fuel to the current inflationary fire. The economy moves in cycles and towards the end of those cycles inflation often picks up. Often, inflationary pressures are brought to heel by the onset of recession. Economically, it is probably better for that to happen sooner rather than later. Politically, too, with an election required by May 2024, a modest contraction might be the least-worst option.

Outlook

These are not the best conditions for making money in stock markets. However, nor are they the worst. The threat of inflation is being partly driven by the reopening of economies as countries learn to live with the presence of Covid. It is quite common for stocks to continue to rise alongside interest rates, as both reflect strong economic activity. Investors hold stocks knowing that at some stage the economic cycle may need to take a turn for the worst. That might seem unintuitive, but inflation eats away at the real value of cash savings while bonds (which pay a fixed rate of interest) are less valuable as interest rates are expected to rise.

Over most reasonable time periods investing in stocks offers the greatest scope to protect wealth against the ravages of inflation, or even to grow it in real terms (after the deduction of inflation). While the short-term response to inflation can only be demand-sapping policies from central banks and finance ministers, the driver of improved living standards comes from innovation by the private sector finding new and improved ways of doing things with less cost and greater efficiency.

At some stage, cash and bonds will seem attractive relative to stocks, but it is devilishly difficult to judge what can be gained or lost from selling out of a bull market in the hope of trying to buy into a bear market. And while recessions have seen the value of shares fluctuate, the US has suffered eight distinct recessions since 1970 and the UK has suffered six. After each one, the stock market has recovered and moved onwards to make greater gains. As the legendary investor Peter Lynch said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.