MARKET UPDATE
Market sentiment: Capital markets remain skittish. Rising inflation and tighter monetary policy from central banks, together with warnings from the U.S that Russia is about to invade Ukraine, dominate sentiment. Gold is on a rally, as a traditional safe haven asset. The focus on value stocks over growth stocks continues, with a large outperformance by the UK main market so far this year compared to the U.S market.
How might investors respond? A combination of strong global growth supports corporate earnings, and unless central banks do engage in policy error and tighten too monetary policy fast (see below) stocks continue to look attractive relative to cash and bonds. But remain diversified, if inflation is tamed this year bonds will rally. Do not try to ‘time the market’ with short-term tactical bets (anyone who sold European stocks on Monday of this week, as the Ukraine story turned bleaker, would have been wrong-footed on Tuesday, when Russia announced a troop pull-back and European stock markets rallied in short-lived relief). A bias to value sectors, such as energy, mining, financials etc might be appropriate until the inflation fear subsides.
Ukraine. Having effectively annexed Belarus, Russia appears to have set its sights on Ukraine. President Putin’s aim is probably to instal a pro-Kremlin leader, who will then re-orientate Ukraine towards Moscow. So ensuring the return of a large buffer of controlled territory between Russia and the West. The risk for Putin is that the West closes ranks (as it appears to be doing), and raises the military and the economic stakes of an invasion. Confronting Russia is also risky for the West, but the risk and the cost may be less if done now, rather than if delayed.
The risk for global investors from a conflict is primarily through higher energy prices driving inflation higher. Russian oil and gas may be boycotted by the west, or supplies halted on orders of the Kremlin. Fertiliser exports from Russia might suffer a similar fate, driving up global fertiliser prices and food prices. An invasion would therefore delay the rolling over of inflation.
Russia. The Russian economy is more self-sufficient than it was in 2014, when the West first introduced sanctions following the Crimea annexation. But the relatively small economy (it has a similar GDP to Spain) remains dependent on raw material exports in order to buy imported manufactured goods. The domestic environment has too many rent-seekers to support the complex supply and distribution chains needed for a manufacturing economy. Indeed, the improvement in Russia’s self-sufficiency is mostly in food and other basic goods.
The current high prices of raw materials is clearly advantageous to the economy and to the government’s ability to finance a war. Russia is taking out insurance by building ties with China, and a second gas pipeline from Siberia into China is now being discussed. But this raises a new longer term risk for Russia: of finding it has swapped one semi-malleable trading partner (the West), for one that expects obedience from its smaller trading partners, particularly if that partner is facing trade boycotts from other countries. In trying to bring Ukraine to heal, Russia risks finding itself at the beck and call of China.
Inflation outlook. Investors are unsure how the inflation story will develop. Rising inflation is bad for bonds. But if inflation is going to roll over in the spring, as central banks tell us, does that mean bonds might be worth buying now, during a time of maximum inflation fear? Or are central banks merely trying to talk down inflationary pay awards? Perhaps a nasty second-leg to the inflation story is developing, fuelled by tight labour markets and accelerating wage growth that might soon exceed inflation.
So far, wage rises remain, in aggregate, below the current inflation levels of 7.5% in the U.S and 5.5% in the U.K (both are January’s CPI numbers, year-on-year). The gap between wage growth and inflation is effectively a tax on consumption, it represents a fall in the standard of living. This should lead to self-correction in inflation, as prices fall in discretionary goods. This is the key argument made by central banks as to why inflation will roll over, so long as wage growth remains below inflation. In addition, the year-on-year inflation numbers will fall, as the price increases that affected energy, food and other goods in early 2021 move out of the calculation.
Central banks keen to assure us inflation will roll over. Central banks, keen to manage inflation expectations downwards in order to dissuade high pay settlements, point to April as the peak in the current inflation cycle. The Bank of England predicts U.K CPI to come in over 7% that month. Thereafter, inflation will steadily fall thanks to the disinflationary impact of lower real incomes, the base effect of the inflation calculations, and the impact of the interest rate hikes and adjustments to asset purchase programs, already enacted.
However, central banks do not have a track record of accuracy, and neither are they disinterested in their inflation forecasts. They see managing expectations of inflation as itself a tool of monetary policy. To use a cricket metaphor, central banks do not go into the crease with a straight bat.
More reassuringly, bond investors appear to concur. The flat long-end of the U.S Treasury yield curve is indicating inflation is not seen as a long-term problem; indeed -as we have pointed out before- there is a risk of policy error, that central banks over-tighten monetary policy, and induce recession.
It seems reasonable to assume inflation will roll over in the spring/ early summer, and that interest rates may peak at much lower levels than those seen in previous cycles. So long as wage growth remains below inflation.
The Metaverse. The Financial Times reports that Meta, parent of Facebook, is filing many patents virtual reality-related inventions. School, work and home life might one day be done from our bedroom, wearing a headset. We will control key boards with eye movements, or with electronic impulses from the brain. We will go virtual shopping with our virtual partner (who may, or may not, be our real partner), and we will both look completely real because we have been perfectly cloned. What’s not to like about it?
Meta has promised $10bn a year in investment in the Metaverse. Microsoft recently stumped up $75bn to buy the online games company Activision, suddenly placing itself in the vanguard of gaming tech, which itself is the gateway to the Metaverse in terms of software engineering skills. China Mobile, a state-controlled company, has set up a Metaverse Industry Committee to co-ordinate China’s IT efforts in the field, and to develop common standards and regulations. Chinese local governments and state-backed entities are funding some Metaverse ventures directly.
And yet…is this where we want to go? A more sedentary life is not good for our health. Neither, surely, is an addiction to the dopamine rushes, that electronic games and social media generate in order to put our eyeballs in front of advertising. Indeed, the Chinese government has set limits on the number of hours that children can game.
But the Metaverse promises more of what is, effectively, gaming. If successful, it will mean less ‘real ‘activity, with less use of the heart and our muscles, and more addiction to dopamine rushes. Meanwhile, what of our responsibilities as towards each other? A world of love and hate is more appealing to Metaverse developers than one in which nuanced ideas are discussed, one in which we might get bored and switch off. The Metaverse hints at an exhausting world of over-stimulation of the brain, while our bodies atrophy.