Monday digest

Posted 14 February 2022

Overview: investment climate change in the air
Stock markets around the world continued their volatile trading pattern last week, albeit trending slightly up rather than down, while bond markets continued to retreat. This type of market action has become characteristic for capital markets this year, which are undergoing their very own transition, now that the coronavirus appears to have lost its lethal impact on most of the population. That said, several new data points are offering more clues to the direction of travel. In the UK, GDP growth of 7.5% was reported for 2021, which put the economy roughly back to where we were before the pandemic started two years ago.

January’s inflation data for the US also came in at 7.5%, which resulted in US stocks selling off as markets priced in the US Federal Reserve (Fed) choosing to tighten policy and raise interest rates even faster than previously expected. Looking at the granular inflation data though, the strong market reaction felt counterintuitive, given all the major inflation-driving components of last year had continued to decline in their contribution, especially durable goods. What may have caused the negative response is that inflation appears to have started ‘leaking into’ areas broadly unaffected by supply chain issues, and which are seen as more ‘sticky’, especially the services sector. On the other hand, US wage growth – while hitting an uncomfortable 5% – was very much concentrated among the very lowest earners.

Given bond yields are now broadly back to where they stood before the pandemic, equities have not in fact performed too badly so far this month. It appears markets are getting their collective heads around change in the investment climate. Of course, not all is well and there are plenty of dark clouds still on the horizon, be they the cost-of-living challenge from energy prices reducing aggregate consumer demand, or Russia’s President Putin still threatening to extend the fossil fuel shortage that is now the main driver of inflation. However, the overall mix of data last week provided positive evidence that the current economic slowdown may not be as deep-seated as feared, and that diminishing inflationary pressures should also lower the temptation of central banks tightening too fast and too soon.

Metal prices signal optimism – and a warning to speculators
Commodities stole the show in 2021. Copper, aluminium, lithium and nickel – crucial elements in technology and infrastructure – all soared last year. Lithium was an incredible standout, with prices jumping around 500% between January 2021 and January 2022. Those good times have rolled into this year: aluminium shot up to $3,200 a tonne this week, its highest level since late 2008, while nickel jumped to a ten-year high last month. Contrasting these with non-industrial metals is revealing. Gold exchange-traded funds (ETFs) suffered $9 billion of outflows last year, resulting in a downward trend. Silver saw a similar trajectory – while industrials spiked. As well as a general risk-on sentiment from investors, this shows a great deal of optimism about economic activity.

Growth spurts always increase demand for raw materials, but current trends point to a more fundamental shift. The global green transition requires a huge amount of industrial metals, in everything from building wind turbines to batteries and microchip materials. According to analysts at Bernstein, electric vehicles (EVs) use 45% more aluminium than internal combustion engines cars (ICE) – with EVs expected to make up half of all cars by 2035. Recognition of this fact is perhaps why the commodity boom continues even though growth optimism has weakened.

Industrial metals still look well supported, though. Aluminium’s price action last week was spurred by reports of supply troubles, which have driven down inventories to multi-year lows. And, while global activity may have come off the boil, the Chinese government’s attempt to bolster its economy should underpin strong demand. Citi research predicts China’s stimulus could add another 20% to copper prices. This looks like a very positive story of demand which, in turn, would suggest a vibrant global economy. But as noted, recent signals point to a noticeable (albeit not huge) slowdown. To us, these factors point to a mismatch between investor demand for industrial metals and demand from their end users. That is, traders are stockpiling materials in the fear of continued supply pressure. Indeed, inventory management is said to be at all-time extremes.

Most commodity trading houses are bullish for the nearer term, due to the undersupply problems, as well as structural support for demand. Overall, we agree that industrial metals are well supported, but we think there may be a bumpier road ahead. The speculative hoarding practices are likely to cease, either by force from the authorities or by a general easing of transportation and movement – which would allow raw materials to get to end users quicker. This could result in an adjustment of expectations, even if the underlying conditions remain the same.

Meanwhile, COVID complications and a host of production issues severely dampened supply. For most of us, recent fuel and energy price rises have been the clearest signs of soaring input costs, but the metals were the ones to get the lockdown party going.

Small-cap dynamics
Last week we wrote about the change of fortunes for US mega-caps. Indeed, there were spectacular selloffs for Meta and Netflix after disappointing results and outlook statements on profits and user growth. With that in mind, it might seem strange that US large cap companies in the S&P 500 have comfortably outperformed their small and mid-cap Russell 2000 counterparts, both over the last 12 months and so far this year. But looking at the overall economic picture, this makes sense: growth is slowing from strong levels, while liquidity is less abundant in the market (thanks to central bank tightening). Should investors be negative on small cap stocks then? The answer depends on what region you look at.

The UK, for example, had a very different experience to the US last year. Its large cap companies underperformed small and mid-cap peers at the beginning of 2021. This was mainly down to Britain’s sectoral composition, as the UK’s largest index skews in favour of energy and financial companies. These have done well recently but struggled a year ago. The US, on the other hand, is dominated by its large technology or platform companies.

Small-cap performance is heavily tied to liquidity conditions and general risk friendliness in markets. This was a boon for the market when growth was rebounding strongly, and investors were pushing for the cyclical rotation. But that trend peaked in the first quarter of 2021 (the same time that business sentiment surveys reached their highest levels) and has come down since. This helps to explain the underperformance of small caps over the last year, and suggests indiscriminate upside will be difficult to come by. Despite slowing growth, ample stock-specific opportunities still exist. Investors will likely become more selective in their stock-picking and prefer small cap companies with more sound fundamentals.

Tighter financing conditions also make things more difficult for smaller firms. From the investment side, it also means that broad ‘risk-on’ periods – as we saw earlier in the pandemic – are less likely. There is still plenty of upside to be found for lots of companies, but markets are likely to make a more granular assessment. This does not mean large cap companies are bound to outperform their smaller counterparts, but investors will need to pay more attention to their specifics. Judging from the significant relative moves between different sectors and investment styles like growth and value, the message of change in the investment climate appears to be getting through. Positive returns may no longer be as readily available across all asset classes, sectors and styles, but for those who analyse, search and skilfully anticipate the progress of this uncharted post-pandemic economic cycle, there should be ample opportunities.

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