RUSSIA’S invasion of Ukraine is creating second-order effects which the market is struggling to read, leading to dislocations.
We can see two ends of the spectrum in commodities which are “melting up” and European equities (banks in particular) which are plunging.
The markets are facing a four-way collision: the pandemic, a geopolitical crisis, an interest rate tightening cycle and an inflation shock. This is a unique combination.
Historically a geopolitical crisis such as Ukraine and the resulting supply side shock would be partly managed through a reduction in interest rates — as was the 1998 Russian default.
But last week we saw Fed Chair Powell deliver as hawkish a testimony as we have seen in decades.
The market’s saving grace has been the strength of the economy and corporate earnings. But this degree of uncertainty and risk is likely to drive markets lower in the near term.
European markets are bearing the brunt at the moment, but the consequences could spread.
Australia is proving to be the most defensive of markets, with the S&P/ASX 300 up 1.8% last week. It is down 3.5% so far in 2022 compared to -8.2% for the S&P 500 and -13.4% for the NASDAQ. It has also done much better than European or Japanese equities.
We expect this to continue given our combination of commodity exposure, geographic distance, less need to tighten policy and strong economic growth.
Sanctions are becoming more severe, though many are subject to a grace period and so may not yet be fully biting.
There is a notable degree of self-sanctioning, where companies are refusing to buy Russian products. Trade and shipping companies are finding it difficult to insure Russian cargos, or unload them.
In the oil market it is estimated that 2-3 million barrels a day of the 5 million that Russia produce have been effectively removed from the market as a result, creating a squeeze.
Shell has been criticised for purchasing a cargo of Russian oil at a US$28.50 discount to spot. This highlights the public opinion that underpins self-sanctioning.
Shell’s statement — that they could not secure an alternative and had no option other than to stop producing refined products — highlights the growing complexity of supply chains in this environment and the risk of economic disruption.
Debate around potential solutions emphasises the uncertainty and unintended consequences that could eventuate from various courses of action.
For example, there is a view that there needs to be some face-saving scenario for Putin, such as the permanent deployment of troops and nuclear weapons to Belarus. This would result in a higher state of risk for European security than we have seen for some time.
At this point a clean resolution looks unlikely. While current market risk premiums will fall away, there will be a significant strategic shift in the West.
This is likely to see a significant rise in defence spending, an acceleration of the move to renewables, substantial investment in gas storage and the need for reinvestment in strategic commodities.
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In combination, this means substantially more investment spending and less optimised supply chains.
This underpins a higher level of inflation.
Russia’s 5 million barrels a day account for about 12 per cent of global supply. This is already disrupted and hardening public opinion may see the US ban imports of Russian oil, with other countries likely to follow.
The political problem for the West is that at current prices Europe is paying an estimated 1 billion euros a day to Russia.
The question is whether this can be sustained in the face of growing public opposition. We may even see Russia ban exports as a reaction to sanctions. The situation is highly unpredictable.
Russia is believed to have enough storage to house surplus production for 2-3 months. Beyond this they would need to rein in production. Once done, this is hard to unwind. This would present a medium-term constraint on oil supply.
The potential for a deal between the US and Iran adds further complexity.
There is clearly motivation to get a deal done, which could see Iran’s roughly 1 million barrels a day return to global markets. (Although how much is already being sold via other channels is unclear).
This could provide some relief, but this would be short-lived if Russian volumes continue to disappear.
Russia produces about 8% of global LNG supply (roughly 30 million tonnes per year). Again, this may become hard to replace.
In addition Russia relies on Western technology and companies for infrastructure servicing and repairs. This could lead to further decreases in supply if withheld for an extended period of time.
Another 20 million tonnes of capacity are under construction in partnership with western firms. The latter’s withdrawal could see these projects delayed substantially.
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In the medium term, Australian gas projects potentially become more attractive given the security of supply and Europe’s desire to reduce reliance on Russian volumes.
Like oil and natural gas, coal prices are surging on tighter markets.
Russia provides 17% of the world’s thermal coal and 9% of metallurgical coal. This may drive more interest in Australian coal as a reliable alternative, though in the near term it means coal prices are likely to rise to the point where it chokes off demand.
Russia and Ukraine together supply 25% of the world’s wheat, 24% of its barley, 14% of corn and 58% of sunflower oils.
History suggests agricultural supplies are not disrupted during wars. But clearly there is risk given reliance on the region.
Planting season is from late March into April. The question is whether there will be access to seeds and fertiliser to allow a proper planting. The wheat price rising 50% in 10 days reflects the risk here.
There are also potential second-order effects. A surge in food prices has historically been the catalyst for civil unrest in some countries.
China will also be mindful of their exposure, especially since issues with swine flu are affecting pork supply. Beijing has apparently moved to withhold fertiliser exports to ensure domestic supply to support their crop yields.
We are seeing unprecedented disruption in the supply of critical commodities.
The longer the invasion continues, the more pressing this issue becomes, underpinning inflation and damaging global growth.
In the US, food accounts for just over 20% of the after-tax income for the lowest quintile of income earners, with gas another 7% or so.
Sustained increases in prices will start to drag on consumption and become more politically sensitive given the disproportionate effect on lower-income workers.
In terms of headline inflation, the average oil price was about US$75 in Q4 2021. Even if it comes back to $100 we are still looking at a 60-80bps increase in headline inflation.
The threat to growth has been the catalyst for a rally in bonds as the market moves to assume less central bank tightening will be required.
For example JP Morgan have cut Q4 2022 global GDP growth by 0.8% to 3.1%, driven largely by a downgrade in the outlook for Europe.
The most protected economies in terms of growth are those with their own domestic commodity supply and self-reliance. The US is in a reasonable position, as is Australia.
So the market is pricing in less rate hikes.
This, along with safe haven flows, continues to push the US dollar higher against most currencies — the Australian dollar being a notable exception.
While this market reaction is understandable, it is worth highlighting Powell’s comment to Congress last week.
The Fed Chair’s comments looked like a clear commitment to bring down inflation regardless of the political consequences.
Powell did not shy away from comparisons to Paul Volcker – notable for draconian measures to bring inflation under control in the 1980s – and agreed he was prepared to “do what it takes without any reservation” to protect price stability.
While the Fed was likely to hike only 25bp in the March meeting, Powell inferred it may need to lift 50bp in subsequent ones.
This highlights the collision between inflation pressure — tied to strong growth, supply chain issues and commodity disruption — and hawkish monetary policy.
There are two major view on how this unfolds over this year, based on two different phases of history:
This is currently the key call for markets and positioning.
The latest US payroll data was strong, with 678,000 new jobs versus 423,000 expected. Average hourly earnings grew 5.1%, versus 5.8% expected, which did lend some respite to inflation concerns.
The US has returned to full employment and pre-Covid levels in terms of hours worked, in contrast to the long trough that followed the GFC.
There are only 2.1 million fewer jobs than pre-pandemic. These can be accounted for by lower participation, given the leisure and hospitality sector is still 1.5 million jobs below February 2020 levels — and there is still a lot of tightness in the labour market.
The jury is still out on whether the signal from average hourly earnings represents a turning point.
The numbers have been affected by mixed effects, more growth in lower paid workers and volatility in hours worked due to unwinding of the Omicron disruption.
US equities struggled to follow through on their rally at the end of last week, but have held up relatively well in the face of the poor news.
The S&P 500 fell 0.5% last week. It continues to face the triple headwind of rising oil prices, rising rates and a stronger US dollar.
The Euro STOXX 50 fell 10.4%. The European economy is much more vulnerable to the challenges highlighted above. But it is unusual for markets to disconnect to this degree in the short term and the relative moves need to be watched to see if acts as a lead indicator.
Australia’s bounce reflected a “catch-up” on the US for the prior week. It also reflects the higher weighting in mining and energy companies.
There has been huge dispersion this year on the ASX. The Energy sector is up 25.4% versus a 10.2% fall in the bond-sensitive AREIT sector. Nevertheless, this move remains small in a historical context, suggesting there could be plenty more to go.
The key conclusion from reporting season is that the underlying performance of Australian companies is in good shape, with the number of positive revisions almost double the long-term average.
One theme was that lower multiple stocks saw better revisions, reflecting an improved outlook for the domestic economy and higher rates helping financials.
Overall earnings per share (EPS) for the market is set to grow 13.8% for the financial year, versus 11.5% expected in January. This leaves the price/earnings ratio on 15.4x. At this point FY23 is expected to see flat EPS growth.
Looking at the market’s components:
The earnings shifts within the market mean the unwinding of the growth premium has not been as material as price movements would indicate.
There was not too much to report at a stock level post reporting season.
Resource and energy stocks saw strong rotation last week as commodity prices rose.
Insurance stocks were hit by the floods, although they all have a lot of protection from reinsurance contracts and the price reaction is substantially overstating the cost.
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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