Q1-2022 Update: Navigating Uncertainty

Just as investors have come to terms with the impacts of covid, 2022 has unleashed a barrage of new challenges. By the end of 2021 the prevailing narrative had become “transitory inflation”, a term we opposed from the outset. Since then, the onset of the war in Ukraine has washed away that narrative entirely. Inflation in most major economies is now in the high single-digits and it seems unlikely to normalize anytime soon. Despite that backdrop markets have been rallying throughout March and are now at a higher level than they were at the start of the war. In today’s piece we attempt to explain this and go into detail about why markets are more riddled with pitfalls than ever. We also touch on a few ideas to help navigate the current uncertainty. 

Why have markets rallied since the start of the war in Ukraine?

As we close in on the end of Q1 most major markets are trading higher than they were at the start of the war on the 20^th of February. This seems counterintuitive given the resultant additional strain on commodity prices and supply chains ensures that any hope of controlling inflation has been lost. Whilst labelled as an economic war on Russia, in reality what we are witnessing is more like mutually assured economic destruction. Sanctions of this nature are almost as punitive to the imposer as they are to the recipient. There are no real winners. The situation is made worse by the fact that we have just been through a multi-year pandemic characterized by extremely loose monetary policy. There couldn’t be a worse time for central banks to be forced to tighten the reins.  But if the macro-economic backdrop is so poor, then why have markets been rallying? There are a number of possible explanations which we will go into before revealing what we believe the real reason is.

1. Markets had already sold off significantly before the start of the war, in fact some markets had even entered bear market territory. By that rationale, however, one would not expect all and more of those losses to be erased as a result of a war breaking out.
2. The war may have created an expectation for renewed stimulus, or at least delaying of the phasing out of the pandemic stimulus. This is likely misguided given the uphill task central banks face in curbing inflation. This point is discussed in more detail below.
3. Markets generally tend to sell off sharply at the start of a war before rallying to higher levels. This is usually predicated on having a somewhat sound fundamental backdrop before the outset of that war (i.e. the war is merely a temporary setback). In this case, however, the war itself amplifies the exact underlying problematic markets were dealing with to begin with – i.e. inflation. This war is also objectively far more economically disruptive than previous localized flare-ups which were accompanied by far milder sanctions (if any). So on this occasion an ensuing long-term rally is almost certainly unlikely.
4. Some believe that the impact of the world finally putting Covid behind it has a greater impact than the war. This argument probably needs to be given the least amount of consideration, mainly because it is debatable to what extent Covid is no longer having a wide-spread impact (in China for example lockdowns are now as wide-spread as they were at the height of the pandemic in Europe and the US).

We don’t believe that any of the above offer convincing explanations. Instead, a far more plausible explanation is that we are in the midst of a classic, text-book bear market rally. Investors like to believe that markets are efficient. The stark reality is that markets tend to be extremely inefficient in extraordinary times. The most recent examples are 2008 (the credit crisis showed real signs of stress a full year before the GFC ensued) and 2020 (it took markets 5 months to enter panic mode after it was already widely accepted that Covid was a real problem). The period we are in today is no different – markets are struggling to fully embrace the carnage that is guaranteed to ensue as we move into the first real global hiking cycle we have seen in decades. There is no doubt that equity markets will eventually react negatively. 

As a result, we are still positioned incredibly defensively even in our most aggressive mandates, and this approach has allowed us to stay well ahead of most equity indices this year. Even so, 2022 has been one of the trickiest starts to a year that we can remember, and it is worth going into some detail on the nature of the challenge presented.

What makes markets so tricky right now?

1. At the beginning of the pandemic one could make an argument for riding out volatility and sitting in cash; inflation was virtually nil. Today, with inflation running at ~7%, sitting in cash translates into a fairly significant erosion of wealth.
2. As we are at the start of a new interest rate hiking cycle the prospect of bonds couldn’t be more unappealing. Inflation will eventually stabilize, but most central banks have a lot of catching up to do. As a result, credit markets have already taken far more strain than equity markets.
3. If not cash or bonds, then what about equities? Well, part of the explanation for why equities have held up “reasonably well” is because many investors have continued to flock towards equities due to lack of better options. It is not uncommon for equities to initially rally at the start of a new inflation cycle. Equities are theoretically a good inflation hedge as companies can raise the prices of their products. The problem is that these equity rallies are usually short-lived.
4. What about crypto currency as an alternative? Our views on crypto have been clear for a long time, and while the technology clearly has merit and potential, it is simply too volatile to form the cornerstone of any sound investment portfolio. Bitcoin is quite simply, and contrary to what the experts will have you believe, a speculative asset. It is not an inflation hedge or a value store. That’s not to say it can never become one, but so far Bitcoin has been extremely highly correlated with high beta risk assets such as tech stocks.
5. Tech stocks themselves, which we have now steered clear of since July 2021, present a new booby trap to markets, and this is completely down to the catalyzing effect that trillions of dollars of liquidity have had: It is now possible, and in fact not uncommon, for large tech companies to lose 20-30% of their market cap in a couple of hours. This is something we have warned about on numerous occasions, yet there are still those out there who believe certain stocks are immune. This is despite us having seen the valuations of companies like Facebook, Netflix and Shopify obliterated recently. Netflix has gone from a 300bn dollar company to a sub-100bn dollar company in the space of 5 months.

Stuck between a rock and a hard place

Clearly the investment environment is far more toxic than it has been for many years, and it is not surprising given we are now paying the price for our actions during the pandemic. Unfortunately, the war in Ukraine has thrown an additional spanner into the works, and at the worst possible time. If inflation wasn’t a problem before (we believe it was), it certainly is now. We are essentially seeing the complete opposite central bank stance to 18 months ago, i.e. a pivot from unconditionally loose and supportive, to uncompromisingly tight.

Investors are now sitting on the wrong side of the old “don’t fight the Fed” adage. The Fed, and other central banks alike, are stuck between a rock and a hard place. Ultimately their mandate is to control inflation and maximize employment. The latter certainly doesn’t appear to hinder them from raising rates given employment data in the US and Europe has been strong. They therefore have only 2 options: 1) raising rates in order to combat spiraling inflation, thereby increasing the probability of a recession, or 2) continuing to be supportive and losing the battle with inflation entirely. It is quite clear to us that the former is the lesser of two evils. Ultimately equity market valuations should not be the priority of any central bank, so one can argue that there is probably quite a lot of scope for markets to decline further before this influences their decision-making processes.  

How does one trade this market?

It is tempting to increase one’s allocation towards obvious beneficiaries at a time like this. If oil is scarce, why not just buy oil? If the next inflation crisis is quite obviously going to be food, then why not pile into wheat? If there is a metal shortage, why not jump into various commodities? If geopolitical tensions continue to flare up, why not invest in defence? And if inflation is a foregone conclusion, then isn’t gold the obvious trade? While we have already had exposure to some of the obvious beneficiaries coming into the war, one does need to exercise caution. War is inherently unpredictable and as a result of the extreme leverage in the system we have already seen some unprecedented moves. One does not want to be caught out making a big call days before a resolution that could cause these asset classes to reverse sharply. When investing in commodities in particular, we need to bear in mind that we are already very deep into the current commodity-boom; prices tend to drop off quite violently when these cycles end, in particular in the case of recession.

Now more than ever it is vital to be diversified, disciplined and patient. It makes no sense buying into a short-term rally when the macroeconomic backdrop is as dire as it currently is. It also makes little sense to sell volatility in the teens or low 20s at a time when we still have no real idea as to how the war will finally play out and what consequences it will have on inflation and supply chains. There are a few safe assumptions to make: Inflation will not be short-lived, short-term interest rates will continue to rise, over-valued rate-sensitive stocks will continue to be vulnerable, and commodity prices will continue to be volatile for the foreseeable future. It certainly makes sense to continue to have some exposure to energy, gold and defensive inflation-proof stocks. Ideally these exposures should be taken in a defensive format. Having downside protection on investments is more valuable than ever.