March 2022 - After the dark comes the light. Eventually.
Global equities and bonds sold off strongly in February, especially European assets, which are mostly impacted by the conflict in Ukraine, the worst military crisis in Europe since World War II.
For now, despite invasion, sanctions, threats and talks, no clear outcome is predictable. But one important thing is notable: Russia (and at a lesser extent, Ukraine as well), is a major player in the global commodities market. Therefore, this conflict could have a huge impact on global inflation and supply chains are being, even more than before, challenged. As reflected in the markets, Europe is especially impacted by this crisis. In fact, the dependance of Europe on Russian commodities (40% of gas imported, 30% of crude oil, raw materials, wheat etc.) makes unlikely the fact that sanctions imposed on Russia by the European Union will be related to these sectors.
Actually, if energy prices soared at first, with oil approaching the psychological barrier of $100, since the beginning of the conflict, and at the time of writing, it surprisingly seems to have stagnated a bit. And that’s because Europe doesn’t rush to sanction Russia in areas that it can be itself hurt, like the energy sector. Also, some OPEC members have already announced an increase in production to offset the potential sanctions on Russian oil.
For the central banks there is a real dilemma now: on the one hand, the conflict increases fears for more inflation and supply chain issues, but on the other hand, the tool expected to be used to combat inflation, rate hikes, could put further pressure on financial markets. Therefore, for their next meetings, we expect the ECB to drop the hawkish tone it adopted lately and the Fed to be a bit less aggressive than anticipated (our call would be a rate hike of 25 bps in March instead of the 50 bps expected).
On the fixed income side, we now see spreads not seen for more than a year. At these levels, we start to see the return of buyers of US high yield bonds (5.2% yield for 10 years duration for the corporate BB universe).
We must note that, even if the context is related in the news in a kind of apocalyptic way, there are some indicators that are somewhat encouraging, in regard to financial and economic matters. For example, The University of Michigan Consumer Sentiment Index shows that we are near all-time low, levels seen only in extreme cases, like in early 80’s and 90’s or in 2008. If, at first sight it seems bad news, it can also suggest that we could be bottoming out in terms of bad sentiment.
Another light at the end of the tunnel is the economic data showing that the recovery post Covid-19 is continuing on its way: we see the Purchasing Managers Indexes (PMI) both in the Eurozone and in the US being boosted by services as we expected, after the first part of the recovery was a manufacturing boom.
On a micro side, numbers are also positive. The last earnings results and companies’ forecasts indicate that balance sheets are strong, and disruptions in production have a limited impact or at least are manageable for most companies.
Finally, if we saw outflows since the beginning of the year, we don’t see many net sellers. Indeed, short interest ratios on big names are not jumping, meaning that investors are rather waiting on the sidelines with cash to be deployed (and there is plenty of cash out there) but are not bearish on the long term.
It’s not always that the real economy or the geopolitical tensions have a direct impact on capital markets. These last two years however, they not only had an impact, but they really called the shots. First the pandemic, now the war in Eastern Europe. And yet again, we don’t think that trying to time the market is the right response. We made minor changes in order to be protected from a possible huge commodities crisis, but fundamentally we stay confident on the positive turn of the markets when light returns, as eventually, it will.
As always, risk-management combined with rigorous sector and geographical diversification will remain key factors for investment performance.
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