Monthly Investment Update — March 2022
In this newsletter, we look at the Ukraine/Russia conflict and potential market implications.
The main points are as follows:
The low probability of Ukraine's invasion by Russia is now a reality.
The human tragedy cannot be ignored, lives lost, homes destroyed and millions displaced.
The economic impacts will also be broad as Russia is a global commodity superpower.
The biggest factor for markets over the next 6-12 months is the impact this will have on inflation and growth.
Central Banks and Governments lack the traditional flexibility to respond (ie. they cannot “print” oil or gas) so this time may be different.
These developments have increased downside risk to markets which is best managed from a defensive position.
Investors spent most of February weighing up the possibility of a Ukraine invasion by Russia. What was initially considered to be a low probability event increased in probability as the Russian armed forces at the Ukrainian border continued to grow.
The unexpected occurred on 24 February when Russian president Vladimir Putin announced a special military operation in Ukraine. Initially, the expectation for military activity was confined to the eastern provinces of Donetsk and Luhansk. Soon Russian forces moved further west with reports of conflict in the capital Kyiv.
The reality of the human tragedy to follow cannot be ignored. With sanctions already being drafted and implemented, the continued financial penalties on Russia will only increase the uncertainty on how Putin will respond.
What does this mean for markets? Hardest hit will be countries and companies with direct links to Russia. The economic effects are however much broader as Russia is a commodity superpower. Reducing or eliminating Russian supply from the global economy will come with significant costs (inflation risk).
Risk of war initially weighed on markets, then an invasion saw heightened volatility and the repricing of markets. What do we expect now? The biggest factor for markets to contend with in the next 6-12 months is the risk of stagflation. The combination of high inflation and slow growth which is negative for share markets.
With this new crisis short on the heels of the COVID-19 crisis, Central Banks and Governments lack the traditional flexibility to respond. Interest rates still at or close to 0% and war-like stimulus programmes are already utilized. This is uniquely different to prior wars.
Baron Rothschild famously said, "the time to buy is when there's blood in the streets". Will this work once again or is this time different? We think it is still too early to know as the situation remains highly uncertain.
Given this added layer of uncertainty, investors are best placed to hold on to/seek portfolio resilience. Still invested, but with some flexibility to take advantage of attractive opportunities once the situation becomes more predictable.
What has happened?
Russia has invaded Ukraine and appears intent on toppling the Government.
This is an escalation of Putin’s initial move of sending in ‘peacekeeping’ troops to reclaim the Donetsk and Luhansk provinces (see map).
Current conflict is centred on Ukraine’s capital Kyiv where Russian forces are reportedly facing strong resistance.
A diplomatic path is also being pursued with Russian and Ukrainian representatives commencing talks.
Source: University of California (UCLA)
What is at stake for markets?
For markets already grappling with inflation and interest rate worries, the current situation complicates matters.
Russia accounts for just 1.75% of global GDP. But this statistic belies the fact that Russia is a commodities superpower.
In global terms, Russia accounts for:
Energy: 10% of oil production, 18% of coal exports (Russia accounts for about 1/3rd of European gas and 60% of European thermal coal imports).
SoG Commodities: 17% of wheat exports and 13% of fertiliser output.
Industrial Metals: 7% of nickel, 6% of aluminium, 4% of copper, 4% of cobalt and 4% of steel production.
Precious Metals: 40% of palladium, 10% of gold and 10% of platinum production.
Disrupted Russian production would therefore represent a significant global supply shock, in an already tight commodities market.
The flow-ons are more supply shortages, higher inflation and growth headwinds (stagflation risk).
Cutting Russia from the world also increases the risk of broader financial system instability. All financial transactions have a counterparty, and this interconnectedness could result in contagion.
The response from the West.
Currently in the form of sanctions and providing military assistance to Ukraine (without direct involvement).
The removal of some Russian banks from the Swift financial messaging system.
Permit energy-focused Russian banks to remain on the network.
Direct aim at Russia’s central bank and limiting their ability to support their economy with its $630B stockpile of foreign reserves.
Whilst the pressure from the West on Russia is important, insulating domestic economies is also critical.
At the heart of the challenge is protecting economies from commodity supply disruptions and shortages.
Central Bank and Government tools are increasingly being rendered ineffective as they are unable to “print” what’s needed (physical commodities in this case).
Expect more pressure on Governments to expand subsidies to cushion households/business from higher costs.
This adds to the debt pile and financial system risks.
Our View…Wait for a clearer picture.
There are high levels of uncertainty at this stage making it hard to be sure what happens next.
We see current events as an added layer of complexity in an already challenging environment.
We do not see this as a buying opportunity yet, instead of maintaining an already defensive portfolio position.
This view changes once we gain more clarity on the future direction of inflation and economic growth.
Australian Equities
The S&P/ASX200 Index posted a +2.14% gain for the month of February and +10.19% over the last 12-months.
For the second month running the top-performing sector is the Energy sector. Gaining another +5.81% as the oil price reached a new 7-year high. Sector heavyweight Woodside gained +13.8%.
The consumer staples sector gained +5.57% for the month albeit from oversold levels. The market welcomed good half year profit results from both Woolworths and Coles.
The weaker part of the Australian market continued to be in the expensive/ higher growth technology sector which declined -6.88%. Xero declined -17.01% and Square declined -3.84%.
The rotation continued to be away from expensive stocks into cheaper stocks. More recently defensive sectors have been favoured and should continue as Russia/Ukraine uncertainty lingers.
International equities
The MSCI All-World Index gave back -2.46% over the month. Despite the recent weakness, international equities remain a strong performing asset class over a 12-month period.
Regional relative strength over the month favoured the S&P Japan500 Index which declined -0.81%. The S&P Europe350 Index declined -2.89% and the US S&P500 Index which declined -2.99%.
The S&P Dow Jones Emerging Market Index gave back -3.22% in February. Dragging the index lower was the 3.4% allocation to Russian stocks which declined -50.32% (S&P Russia BMI Index).
Property and Infrastructure
Australian Property Index underperformed the broader domestic equity market declining -1.42% for the month.
Global Listed Property (Hedged) gave back -2.27% over the month. Global Listed Infrastructure (Hedged) gained +2.06% over a month providing great diversification benefits.
Fixed income
The Bloomberg Australian Bond Index slipped -1.21% over the month. Most of the damage was done earlier in the month as markets priced higher rate expectations. Demand for safe assets saw bonds perform well into the month-end.
The 10-year Australian government bond yield closed the month at +2.12% after reaching as high as +2.24% earlier in the month.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.