Isolation & Inflation - A market wrap of February

Russia’s unprovoked aggression in invading Ukraine dominated markets in the closing days of February, further aggravating falls in equity markets that had already begun from inflation and short-term interest rate concerns.

Certainly, this is not a situation that will resolve itself rapidly. Putin’s campaign has begun poorly, underestimating the resistance of Ukraine; the unity of Europe and the US; and the strength of the sanctions taken. That Germany has committed €100bn to a new armed forces fund speaks volumes, but then the most evil acts of aggression historically have galvanised democracies into action that was previously unthinkable. Sadly, the situation on the ground seems like it is doomed to get uglier in the short term, with cluster bombing of residential areas now reported. Ultimately, it’s hard though to see how 190,000 Russian troops will be able to conquer a nation of over 40 million people, without complete depopulation and destruction. Unfortunately that may still be the fate of certain regions and cities before one hopes there can be some kind of negotiated settlement much further down the line. This would be needed both to allow Putin some kind of face-saving pyrrhic victory and to allow the West to avoid needing to call his nuclear bluff, which for a man reportedly so unstable and isolated from good counsel is a risk no one wants to take.

From a narrow market perspective, some comfort can be taken from the table below (courtesy of KKR) showing how resilient markets typically are in the face of geopolitical shocks, with an average drawdown of 4-5% and full recovery after an average of 43 days, albeit with significant dispersion around these averages.

Yet there isn’t room for too much complacency on this score, as the market’s major concern of inflation (and therefore short-term rate hikes) ahead of the invasion will most likely now be exacerbated, due to a further shock to inflation from commodity prices, most notably energy but also soft commodities such as grains. Supply chain issues could also be impacted with materials such as palladium and platinum important to manufacturing in autos. As such the geopolitical issue can’t be separated from the prior fundamental concerns.

In terms of the losses for equity markets in the month, the broad S&P 500 index in the US lost 3.1% in February after almost halving its earlier losses and is now down over 8% this year. The Nasdaq Composite only did fractionally worse losing 3.4% but due to January’s losses still sits down over 12% this year. Value stocks of course performed better than both, with the Russell 3000 Value index down 1.2% taking the year-to-date loss to 3.8%.

European stocks fared worse and with Germany’s Dax losing 6.0% this month, the Euro Stoxx 50 is now slightly behind the S&P 500 for the year. The FTSE 100 in the UK continues to outperform with its value tilt and was flat this month to retain a gain of 1% for the year. Japan fared better than most developed markets with a loss of under 2% and for the year to date the Nikkei 225 is now fractionally ahead of broad indices in Europe and the US. A gain of 3% for the Shanghai Composite trimmed China’s loss this year to 5%, whilst unsurprisingly Russia’s MOEX lost 30% in February.

Looking at sovereign bond yields, the US 10 year Treasury yield initially held close to the 2% level as the upwards pressures from the Fed were offset by the risk off sentiment; but as the worst fears on the ground in Ukraine were realised the yield fell back to 1.82% by month end. The US yield curve has seen significant flattening since late January, as the 2 year yield moved sharply up to 1.60%, before falling back to 1.43% at month end leaving the spread between 2 and 10 year yields at around 0.4%. No imminent inversion is expected though and this is more a reflection of shorter-term dynamics rather than the bond market’s view of the economy, although the latter may come more info focus now. German 10 year Bund yields followed a similar path to their US counterparts, peaking above 0.3% mid-month before beginning a slide to 0.13% at month end and still heading south.

WTI crude rallied with the tensions and gained 8.6% to $95.72 at month end as it headed in the direction of $100, whilst gold gained 6.2% on risk aversion and a violent retracement in real yields to close at $1909. Net currency movement was limited on the month as the DXY dollar index gained just 0.2% and most major pairs were muted. The Aussie dollar was the main exception, rallying 2.8% (aside from the rouble falling 27%). Probing a bit more beneath the surface, the dollar fell early in the month, on a hawkish pivot by the ECB, but then steadily rallied back as the month progressed and concerns escalated.

Back to the wider economy, we are surely now coming to the end of the mid-cycle and approaching the late cycle phase, which doesn’t bode well for equity returns by historical standards.

Economic growth will still be material, given that it was forecast to remain above trend this year and only normalise in 2023, but it will doubtless slow more than previously expected as the additional inflationary forces are unleashed - and the market always cares most about the second derivative (the rate of change of the rate of change).

One key question is whether the Fed will be swayed by a weaker economic backdrop, if that is what materialises. To some extent that will be the case and they are always emphasising their data dependency. Over the last week the (market priced) probability of a 50bps rate rise at the March meeting has gone from odds on to negligible with only 25bps now expected; and the year end implied rate has fallen from 1.63% to 1.22%. But ultimately the key data dependency is around inflation and unless this is tamed the Fed will surely for the most part plough on. Alongside commodity price pressures, the main additional risk comes from potential wage demands. As the Economist recently highlighted, whilst capital and labour in Europe may struggle with pricing power and wage bargaining power, in the US both camps are strong players which therefore has the potential to aggravate inflation if a wage price spiral takes hold.

To end on a positive note, in terms of the pandemic induced supply chain issues, data does now indicate that things are easing on certain fronts, as the substitution of services for goods reverts back to services with economies broadly open again.

Goods spending can be seen normalising from an abnormal peak (top left) and services from a corresponding trough (top right), in this chart from UBS. The demand imbalance remains, from Asia as a manufacturing hub against excess global demand, but air freight has improved as passenger flights adds space; and global manufacturing orders have slowed sharply, pushing orders to inventory ratios back to pre-pandemic levels. Overall, UBS estimate that a quarter of bottleneck pressures have now reversed, as measured by their own composite.

All data referenced from Bloomberg, as of time of writing on 1st March, other than where charts above are separately attributed