The unprovoked Russian invasion of Ukraine is a watershed moment. The Rubicon has been crossed and the west’s relationship with Putin’s Russia is now unambiguously and aggressively hostile. The economic sanctions imposed on Russia will not, in our view, be rescinded on a ceasefire but will remain in place until Putin is no longer Russian President. How long he remains in post is anyone’s guess. These sanctions will structurally increase the cost of energy, grain, fertilizer and other commodities in the west, thus exacerbating the already difficult cost of living crisis. Those western companies with material operations in Russia will be impaired. How Russia responds to the initial sanctions, the withdrawal from Swift and freezing of Russia’s central bank assets, let alone the overt military support for Ukraine, remains uncertain but some form of retaliation is probable. Such retaliation could make the current difficult situation worse for western economies.
Despite the COVID-19 pandemic and the volatility of asset prices associated with it, 2021 turned out to be the third year in a row of good equity returns. Since the virus escaped China, economies and asset prices have been supported by extraordinary fiscal and monetary policy. From an investment perspective, the good news of successful vaccines, new anti-viral drugs and the possibility that the Omicron variant might be a steppingstone towards a less harmful endemic disease needs to be tempered by the knowledge that policy makers had started to take the inevitable first small steps towards policy normalisation.
However, following the invasion of Ukraine, the number of expected interest rate rises for this cycle are being pared back and it remains the case that developed market central banks can flood the markets with liquidity, if they believe it necessary to do so.
The COVID-19 related supply shocks increased costs for companies, however these have been successfully pushed on to end customers via price rises and we have seen a spike in core inflation to levels not seen since the early 1990s. Core inflation is expected to subside as the year progresses, however additional inflationary factors are now coming into play.
The positive news, from an asset class perspective, is that in the normal course of events equities, in general, can cope with higher inflation as companies live in a ‘nominal’ world. A company’s sales are a function of both volume and price and in an environment where price rises can be put through to the end customer and demand isn’t impacted then companies, in aggregate, can manage inflationary pressures fairly well.
The MSCI World Net Total Return Index reached a new high at the beginning of January 2022 (in US Dollar terms) aided both by upgrades to earnings growth forecasts and the willingness of investors to pay more for companies’ future cashflows and earnings. Equity markets can (and often) do well in a rising interest rate environment as it usually signals economic and earnings growth. However, the high starting point for valuations this time round is problematic and signs of over-exuberance are not difficult to find.
Investors are anticipating rising short term interest rates (although somewhat truncated following the invasion of Ukraine) but there has been little change to longer term interest rate expectations. This suggests investors do not believe that the current high inflation rates will persist and that the marked increase in government debt is likely to deaden any medium term economic recovery. The irony is that a prolonged period of higher inflation which would help to deflate the debt burden away is anathema to the outlook for asset prices.
In summary, the outlook for asset prices in 2022 is challenged given the starting point of high valuations, waning consumer demand and the geopolitical dislocation. Ultimately, the interplay between tightening policy conditions in developed economies, easing conditions in China and western policy makers on red alert to prevent another economic downturn whilst confronting Russia may ensure a reasonable outcome.