“Inflation is always and everywhere a monetary phenomenon” — Milton Friedman, Nobel Laureate,

LAST QUARTER REVIEW

The first quarter of 2022 has borne witness to a humanitarian crisis and an escalation in geopolitical uncertainty not seen in Europe for, at least, two generations. We can only hope, and pray, that for the sake of peace, resolution can be found through diplomatic means and quickly.

Rightly or wrongly, markets, are primarily concerned with the changing economic circumstances of the day, and as highlighted in our previous Market View, have been digesting continuing inflationary pressures in the US, UK and elsewhere. These concerns have now been heightened as a consequence of sanctions recently imposed upon Russia, putting additional upward pressure on the price of basic commodities such as oil, gas and staple foods.

We had anticipated that following the stellar performances of equity markets on Wall Street and elsewhere in 2021 resulting in relatively rich historic valuations, positive progress this year was likely to be less spectacular and more volatile. Accordingly, last quarter the S&P 500 declined almost 5%, the Dow Jones Industrial Average fell just over 4% and the Nasdaq 100 more than 5% while the domestically focused smaller company index Russell 2000 dropped almost 8%, but perhaps most alarmingly the yield on the benchmark 10-year US Treasury Note rose from 1.63% to 2.32% over the three months, hitting a three year high of 2.56% at one point.

One of the few global equity markets to show a positive return during the first quarter was the FTSE 100 which rose almost 2%, reflecting the fact that many of its constituents are commodity and resource-based companies with global operations and investors have been keen to invest in this area as a potential recession resistant sector should the situation worsen in the Ukraine. Unfortunately, UK mid and smaller company sectors did not fare as well with the FTSE 250 falling more than 10% and the FTSE SmallCap down 7% during the quarter.

In the UK bond market, the same trend as in the US Treasury market prevailed as the yield on the benchmark 10-year gilt rose from 0.97% to 1.60% (touching a three and half year high of 1.75% on the 28^th March) despite the Bank of England raising interest rates twice during the quarter. The Bank of England (BOE) appeared to be trying to get ahead of the inflationary curve here in the UK as it first raised interest rates by 0.25 at its January meeting and then by a further quarter percent to 0.75% at its March meeting taking the base rate in the UK back to pre-Covid levels.

With UK inflation currently running at just over 6%, the BOE advised at its last meeting that it expects inflation to increase to around 8% before the end of the second quarter and exceptionally even higher later this year. Accordingly based on these assessments, the BOE’s Financial Policy Committee expects that some further modest tightening in monetary policy may be appropriate in the coming months, but there are risks on both sides of that judgement depending on how medium-term prospects for inflation evolve.

The Federal Reserve (Fed) at its March meeting of the Federal Open Market Committee (FOMC) raised its target for the fed funds rate by 0.25% to 0.25-0.50%, its first interest rate hike in three years, and indicated it was likely to increase rates further at each of its remaining six FOMC meetings in 2022. The Fed expects inflation to be sharply higher at 4.3% in 2022 (2.6% in the December projection) and while the economic implications from the Ukrainian war are uncertain, the likelihood is that it will add to inflationary pressures, and meanwhile the central bank’s median projection for GDP growth this year is at 2.8%, 2.2% for 2023 and 2% for 2024.

At its March meeting, the European Central Bank (ECB), as expected, kept its base interest rate at 0% but surprised markets when announcing that it would be speeding up the asset purchase programme (APP) schedule in coming months and said it could now be completed in the third quarter if medium term inflation does not weaken. Anticipating the Ukrainian conflict to impact economic activity and increased inflation through higher energy and commodity prices as well as disrupted trade, the ECB expects inflation this year to be 5.1% (previously 3.2%) and GDP to slow to 3.7% from the previously anticipated 4.2%

In China, the People’s Bank of China (PBOC) at its March meeting maintained the interest rate on its benchmark corporate and household loans with the 1-year loan prime rate (LPR) at 3.7% and the 1-year medium term lending facility (MLR) which affects some CNY 200 billion of loans at 2.85%.  The PBOC reaffirmed its commitment to remain accommodative and increase its support for key weak spots in the economy, and if necessary introduce further counter cyclical policy adjustments.

In currency markets, the dollar DXY index (a basket of foreign currencies) closed the quarter at 98.37 up from 96.67 at the beginning of the year reflecting the anticipated flight to safety that occurs during times of uncertainty and conflict. The Fed’s decision to begin increasing interest rates for the first time since 2018 also contributed to the currency’s appreciation.

In energy markets, the oil price was especially volatile and after reaching a high of over £114 during the quarter (up from $76 at the beginning) following uncertainty surrounding Russia’s Gazprom gas supplies to Europe, it eased to $102 at the end of March as the Biden administration announced plans to release 1 million barrels of oil a day for the next six months from the US’s strategic petroleum reserves. Meanwhile, gold bullion enjoyed a brief resurgence as the price rose from £1823 at the start of the year to more than $2050 in early March before falling back to $1936 at the end of quarter.

GDP Data shown are to the 31st December 2021; Interest Rate, Equity & Bond Index Data are to the 31st March 2022; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzhen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

Last quarter as we looked ahead for the year, we cited the key consideration for this year would be inflationary expectations and central bank decision making regarding interest rates, which has so far proved correct. However, as we have regularly cautioned in the past, it is impossible to anticipate black swan events, and it’s unfortunate that barely two years after the Wuhan pandemic caught the world and markets unaware, so it has been with the Russian invasion of Ukraine.

While the human suffering in the Ukrainian conflict may have already rivalled the total who suffered with Covid, the market reaction has been relatively calm. We can only hope that peace negotiations will soon succeed which will enable investors to move on and focus purely on the economic factors that have been plaguing markets all year

For now it is impossible not be concerned about the impact this conflict is having upon the price of one of the world’s most important commodities, oil. More than a month on from Russia’s invasion of Ukraine, volatility in the oil markets shows little signs of abating as the price of WTI has whipsawed between a low of $98 and a high of $128.

Not only is the price of the black gold being swayed by sentiment concerning both the Ukrainian conflict and the economic impact of increasing inflationary pressures, but in late March the world was told that Shanghai had launched a phased lockdown and suspended public transport, to curb surging Omicron cases. The news sent oil’s value crashing almost 5% in a day.

With the exception of the energy complex and nickel (Russia is a major global producer and Western sanctions helped create price swings of between $20,000 and $50,000 a tonne during March with a brief surge exceeding $100,000-per-tonne), the prices of other commodities have remained relatively stable, suggesting that longer term demand does not appear likely to exceed supply. This of course should result in the longer-term inflationary pressures abating, much as was being suggested by most central banks up until fairly recently.

However, the yield on the benchmark US Treasury 10 Year Note that we cited as a key bellwether for inflation in our last commentary has increased dramatically from 1.63% at the start of the year to 2.32% at quarter end. The 30 Year US Treasury Bond has also seen its interest rate rise from 2.01% to 2.60% over the same period.

Accordingly, some economists now suggest the bond market is finally falling into line and signalling secular as opposed to transitory inflation ahead. However if we look more closely at how the middle part of the US Treasury curve has now inverted, history suggests the bond market is not signalling secular inflation but instead short-term stagflation followed by a likely return to the deflationary longer-term trend.

The US Treasury yield curve began inverting on the 11^th March when the 7-year note at close of business yielded 2.01% while the benchmark 10-year note was at 2.00%. Then on 21^st March the 5-year note inverted also with the close of business yields being 2.33% (5s), 2.36% (7s) and 2.32% (10s).

On the 24^th March, the yield on the 3-year Note inverted also with close of business interest rates being, 2.35% (3s), 2.37% (5s), 2.39% (7s) and 2.34% (10s). At the end of the quarter the inversion had continued to grow and extend with the interest rates at 2.45% (3s), 2.42% (5s), 2.40% (7s) and 2.32% (10s), while briefly on the 29^th March the 2-year note inverted relative to the 10-year before closing slightly higher.

Once the 2s close above the 10s, the Fed is likely to begin facing some serious questions as to whether its proposed monetary strategy of raising interest rates another six times potentially taking the base rate to 2%, is the correct one when the bond market is suggesting recession is around the corner. As we have noted previously the US Treasury bond market historically has proved the most reliable indicator when it comes to forecasting likely longer term interest rates and inflation expectations.

The American bond market has also proved incredibly reliable when it comes to forecasting recessions as evidenced by a Federal Reserve research paper in 2019 that showed of the ten times that the Treasury yield curve had inverted since 1953, recessions occurred following all but one of them. Of course it is always possible that the yield curve will correct out of its inversion or that just maybe this time if it remains inverted that no recession will occur, but with the eurodollar futures yield curve having also inverted recently, history suggests it is more likely policymakers that have not for the first time in history made an error.

As economics guru and Nobel Laureate Milton Friedman never tired of reminding policymakers, “inflation is always and everywhere a monetary phenomenon” which sadly no longer seems to resonate with many central bank economists and investors. Those ignoring the US Treasury Bond market’s warning may do well to ponder Mark Twain’s timeless words, “History does not repeat itself, but it does rhyme.”

FORWARD OUTLOOK

Prior to the invasion of the Ukraine, markets were already volatile and lacking positive momentum due to the uncertainty surrounding inflation. Now we have the added concerns that the longer the Ukraine war goes on, the more economic uncertainty investors will have to face and particularly with regards to the price of key resources like oil and energy, nickel and some of the key food commodities.

The decision of United States and some other Western countries to boycott Russian oil has put short term pressure on some the key Opec members like Saudi Arabia and UAE to step up to the plate and produce more oil, something that they have been reluctant to do until now. The other option appears to be for American shale producers to try and increase output dramatically but many market commentators believe that won’t be doable short term as the conditions in this industry today are nowhere near as positive as they were during the fracking boom of a decade ago.

The silver lining to the energy mix, albeit not one that will reassure investors concerning price volatility but could at least help keep a lid on prices is Chinese demand uncertainty. The China economy is already reeling from the fall-out in the property market which threatens to impact the national and international economy, and more recently has once more begun to implement zero tolerance with total lockdowns where the Omicron virus strain has been located.

Accordingly, we shall keep a close eye on developments and in particular any change in the bond market’s perception of inflationary trends, and the likelihood of an American recession if the Fed continues to raise interest rates as intended. In reality the Fed’s interest rate increases are likely to prove short-lived if the inversion of the yield curve foreshadows recession and an eventual return to the longer-term deflationary trend in late 2022

Meanwhile, we continue to believe that equities offer the most attractive opportunities on a relative valuation basis (risk reward, yield and liquidity) when compared to investment grade government and corporate bonds, property and alternatives (including infrastructure, private equity, commodities, precious metals). Nevertheless, we shall where appropriate look to reduce exposure to aggressive growth funds and reallocate to more defensive oriented sectors.

In uncertain markets like these, maintaining a well-diversified and appropriately balanced portfolio is fundamental and we will seek to provide a mix of both growth and value stocks, both from the US and other equity markets, including the UK large cap sector which remains significantly undervalued on a relative basis at this time. Additionally, we remain comfortable in continuing to include some exposure to balanced Fixed Interest funds investing in a combination of blue-chip government debt markets (primarily US Treasuries and UK gilts) and investment grade corporate debt exposure.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs.

Copyright © Ash-Ridge Asset Management 1^st April 2022.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.