Monthly Investment Letter: TINA or bust?

We face significant geopolitical and economic uncertainty.

The war in Ukraine has escalated and triggered a growing humanitarian crisis. Sanctions have been imposed, disrupting commodity flows and creating extreme volatility in some markets. Cease-fire talks have yet to yield results.

Elsewhere, the Federal Reserve increased interest rates for the first time since 2018, responding in part to the effect of higher commodity prices on inflation. China, facing its biggest COVID-19 outbreak since the beginning of the pandemic, has signaled a potentially major shift in economic policy.

How has the market been responding to this uncertainty cocktail?

Recently, stocks have been going up, in part because rising bond yields and inflation have left many market participants believing that “there is no alternative” to equities. Yet further sanctions on Russian oil could lead to an “unavoidable” recession, according to the Fed.

In the near term, we believe that outcomes for markets will focus primarily on the question of when we will reach—or if we have already reached—peak sanctions and oil prices. The answer to this is uncertain, too. Some European diplomats have sounded upbeat about prospects of a resolution to the war, yet their American counterparts have offered more caution, and in a recent German survey, 55% of those surveyed are in favor of no longer importing gas and oil from Russia, even if it leads to supply problems.

Given the uncertainty, rather than make a strong overall directional call, we prefer to take positions in areas where we have greater visibility about the future.

1. First, we believe sanctions are likely to remain in place regardless of whether a cease-fire is agreed in the coming weeks. This means that we think commodities and energy-related equities remain effective as portfolio hedges, amply supported in our central scenario but also likely to do well in our downside scenario.
2. Second, energy costs are likely to lift inflation and contribute to higher rates. The Fed has already hiked interest rates and signaled a greater willingness to do more, sooner. In an environment of rising rates, we currently prefer global value and financial stocks and US senior loans, but are also starting to see some value in parts of the investment grade bond universe, which we upgrade to neutral this month.
3. Third, we expect that Russia’s invasion of Ukraine will usher in a new era of security around the world, spanning the areas of energy, food, data, national defense, and climate. We expect heightened international mistrust to spur governments and corporations to put greater emphasis on security and stability over price and efficiency.

In the rest of this letter, I look in more detail at our scenarios, the paths and catalysts that could lead us there, and the potential longer-term consequences of the war for investors.

Key market drivers

Part of the reason markets feel so uncertain today is the diversity and interrelatedness of key market drivers. The war, movements in key commodities, Fed intentions, inflation, and China’s economic and pandemic policies have all contributed to the ebb and flow of markets in recent weeks.

The many macro drivers can lead us to many different market scenarios, but we believe the most critical question is, “When will we reach—or have we already reached—peak sanctions and oil prices?” While it may seem overly simplistic to deemphasize the Fed as a core driver, we note that the Fed would adjust policy based on the war and sanctions, but the war and sanctions will not change course based on what the Fed does.

• In our central scenario, the war continues, but developments allow sanctions and the oil price to peak by the summer. Falling inflation in the second half of the year allows monetary policy concerns to ebb and markets to move higher. Commodities and energy stocks remain well supported, financials perform well amid rising rates, and quality stocks that have been indiscriminately sold alongside the broader market stage a recovery.
• In our downside scenario, sanctions continue to escalate and drive the oil price significantly higher. Fears and realities of stagflation drive much tighter monetary policy, and financial markets move lower. Energy and defensive equity sectors are relative outperformers, alongside inflation hedges like gold and Treasury Inflation-Protected Securities (TIPS).
• In our upside scenario, a relatively quick end to the war means we see little further increase in sanctions or oil prices from today’s levels. The limited impact on growth, inflation, and monetary policy, and the relief from reduced geopolitical uncertainties, drive markets higher. The winners are similar to those in our central scenario, but the extent and breadth of equity gains are greater.

Our central scenario

In our central scenario, prices of commodities, particularly energy, stay elevated in the coming months before retreating through the second half of the year. This would be consistent with a cease-fire in the war and rhetoric between NATO and Russia cooling by the summer, alongside an only gradual removal of Russia from European and US energy supply chains.

In this scenario, we see a path for equity markets ending the year higher, with the S&P 500 at 4,700, or 5% above today’s levels.

The fact that the S&P 500 has already regained its pre-invasion levels shows how, absent additional escalation and disruption to energy flows, the impact of the Ukraine conflict on global equities can diminish over time.

Apart from the possibility of peaking sanctions and oil prices, the catalysts that could unlock this scenario include:

• Signs that economic growth is resilient to higher rates and inflation. Our base case is that we won’t enter a global, US, or European recession. The Fed continues to argue it can raise interest rates and manage a soft landing, with Chair Jerome Powell taking pains to point out that the Fed pulled off rate hiking cycles without causing recessions in 1965, 1984, and 1994. Evidence that it is achieving this “soft landing” would likely be taken well by equities. The risk of recession is greater in Europe, in our view, given its reliance on Russian oil and gas, and this is part of the reason we have moved our view on Eurozone equities to neutral.
• Greater confidence about a turning point in China’s economic policy. China’s State Council’s promise of market support looks to have addressed most of the key pressure points that have undermined sentiment in the past year: tech regulation, the threat of delisting US-traded Chinese instruments, and the economic slowdown. Our conviction would be reinforced if the promise of support is followed by policy action, for example if US and Chinese regulators reach agreement around listing rules, and if renewed COVID-19 lockdowns do not greatly disrupt production and supply chains.

Our downside scenario

In our downside scenario, commodity prices increase significantly and stay high for an extended period. Such an outcome would be consistent with a prolonged war and escalating sanctions leading to a sudden disruption to Russian energy exports.

In this scenario, we would expect significantly lower economic and corporate earnings growth in Europe, stretching into 2023, and a negative, though lesser, impact on the US. This scenario would also heighten the risk of stagflation, in which wage-price spirals lead central banks to continue increasing interest rates sharply to contain inflation.

A backdrop of low growth, high inflation, high interest rates, and high uncertainty would be detrimental to markets. Our S&P 500 target for this scenario is 3,600.

Fears of stagflation are often associated with the 1970s and energy crises. But prevalent wage and price controls, unionization, and politicized central banks no longer apply today, which makes a stagflationary regime like we experienced in the 1970s unlikely. We think a move toward stagflation and this downside scenario would require:

• A further and persistent rise in commodity prices, if, for example, oil prices were to reach USD 150/bbl or Russian gas supplies to Europe were interrupted;
• A wage-price spiral, if higher energy prices and perceptions of inflation lead to increased pay demands, particularly in sectors of the economy that are experiencing skills shortages; and
• Households economizing on discretionary spending, if higher energy prices and inflation in essential goods and services make less money available for discretionary items and reduce demand in areas such as leisure and the hospitality sector.

At this stage, we do not see this as likely. Energy price base effects will diminish over time. Brent crude is currently around double the levels of a year ago but would need to continue to rise to have the same contribution to inflation in the coming months. In our central scenario, we expect oil prices to recede as the year progresses.

Nominal wages have been rising, particularly in the US. But the impact of higher wages is being mitigated by rising productivity: In the US in 4Q21, 2.1% fewer workers produced 4.5% more output compared to 1Q20. Low-paid jobs are also those more susceptible to be replaced by automation, such as the use of phone apps in the restaurant sector.

While higher prices will lead to some demand destruction, we think there is room for savings ratios to fall, which will help sustain discretionary spending. Unemployment is also low, which should also support discretionary spending.

Should we move toward a stagflationary scenario, we think consumer staples, healthcare, and real estate would likely outperform, while TIPS, floating-rate notes, and gold would also likely be sought after as hedges against inflation and higher rates.

Our upside scenario

In our upside scenario, disruption to commodity markets proves short-lived, which could occur if a cease-fire is agreed and tensions between NATO and Russia ease within weeks.

From a market perspective, a shorter period of elevated commodity prices would both limit the negative effect on economic growth and reduce the pressure on the Fed and other central banks to continue raising interest rates. In a world of higher growth, lower interest rates, and lower risk premiums, we believe the S&P 500 could end the year at 5,100.

The key catalyst to unlock this scenario would be an end to the war in Ukraine, although we note that a cease-fire agreement is far from certain due to numerous complexities. The nature of any guarantees offered by Western nations to ensure Ukrainian security, for example, may prove to be obstacles to reaching an agreement.

But if we were to see a cease-fire, current measures of market positioning, investor sentiment, and valuations suggest that equities would be well placed to bounce:

• Market positioning indicators suggest that many investors have already deleveraged. Among hedge funds, the net leverage of equity long-short funds has fallen to 49%, in the 33rd percentile of readings since 2010 and close to the COVID-19 pandemic low. Net short positioning among trend followers is close to record levels. And leverage among volatility-targeting funds has dropped to 42%, a level consistent with prior deleveraging events.
• Investor sentiment is negative. Net bullish sentiment according to the American Association of Individual Investors’ survey is at the fifth percentile of historical readings.
• Valuations have fallen. In our view, global equities are discounting zero earnings growth this year and a US manufacturing ISM of 50. This compares with our estimate for global earnings growth of 8% this year and a current ISM level of 58.6, indicating still-upbeat business sentiment.

What are the long-term consequences of the Ukraine conflict?

The near-term market effects of the war between Russia and Ukraine are likely to stem from its effect on commodity prices.

But over the longer term, we think the biggest market trends will result from the end to the “peace dividend” that followed the end of the Cold War. In a new environment of international mistrust, we think that governments and corporations are increasingly likely to value security and stability over efficiency and price.

We see this playing out in the broad theme of security, covering the areas of energy, food, data, national defense, and climate.

Energy security

We have long held the view that the road to net-zero carbon will benefit areas like greentech, clean air and carbon reduction, as well as energy efficiency—and we think these areas have become even more crucial in an era of security as countries increasingly focus energy strategies on domestic production or sourcing from trusted allies.

The US has already banned importation of Russian oil. The European Commission has said that it plans to “make Europe independent from Russian fossil fuels well before 2030.” This will mean investment in renewable energy and liquefied natural gas import infrastructure in Europe.

Food security

Russia and Ukraine together account for around 28% of global wheat exports and 16% of world corn exports. Russia and Belarus also contribute significantly to global fertilizer production. Prolonged sanctions and disruptions to grain and fertilizer volumes could ignite concerns of shortages and reduced crop yields at a time when food prices are already setting new records as measured by the FAO.

We think fears of future disruptions are likely to incentivize investments in localized production and shoring up of supply chains, including improvements in agricultural yield. More broadly, we see opportunities in stocks linked to the “food revolution,” including areas like vertical farming, alternative proteins, seed science, transport and storage, as well as water use efficiency.

Cybersecurity

As more data and information are created, the importance of cybersecurity as an aspect of personal, corporate, and national security continues to grow. Strong cyber defense will be perceived as even more crucial, with the physical war in Ukraine accompanied by fears of a digital war.

As a result, we expect increased spending on cybersecurity in the years ahead. Gartner, a research and consulting firm, expects 10% compound annual growth in cybersecurity spending from 2021 to 2025. But given the recent events, actual spending could easily exceed these estimates, in our view.

Defense spending

Western military spending fell by 1–2 percentage points of GDP in the 30 years after 1990. We now expect this “peace dividend” to be reversed and defense spending to rise in the years ahead. Germany has already committed to increase military spending from 1.5% to 2% of GDP, and we think other European governments will likely follow. To be sure, 2% of GDP is still low by Cold War-era standards, so there could be upside to this. And while it may be too late for increased US defense spending in the current fiscal year, we would expect it in the years ahead.

Investment ideas

As noted above, amid elevated volatility and with several critical market factors still in flux, we do not think now is a time to be overly reliant on any one scenario playing out, or to be making big calls on the market direction. However, we think investors can position effectively for the current environment in the following ways:

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