Monday digest

Posted 14 March 2022

Overview: After the shock of war, the energy price shockwaves
Global capital markets continued their wild ride last week, as market participants struggled to gauge the extent to which Putin’s barbaric war on Ukraine would dismantle their outlook for the global economy. At Tatton, we started the year with a cautiously optimistic outlook – against the backdrop of another post-lockdown surge in economic activity, but with central bank and government support on the wane, and persistent inflation eroding household spending power. Despite the shock of Russia’s war on Ukraine, and the energy price shockwave it has brought us, much of this continues to hold true, although some positive elements will now suffer delays and may also be less pronounced, while there is also a risk of another brief recessionary period should the war drag on and/or central bank policy setters opt to fight energy price inflation with sharp interest rate rises.

Equity market swings are usually the focal point for investors when major upheaval occurs, but this time the oil price was front and centre. Higher petrol prices are hitting consumers across the world. Having started the year at around $80, last week the cost of a barrel of Brent crude rose as high as $130, the highest oil price in a decade, before settling down amid hopes that OPEC countries would increase production. Last week one of the UK’s most senior energy experts even recommended British drivers should limit their speed to 55mph in a bid to lessen dependence on Russia’s oil. This comes on the back of import bans from both the US and UK.

We have seen various investment indicators signalling that we may have reached ‘buy’ territory. However, we also know that when near-term uncertainty is determined by dictators, one should not count on the markets having completed their correction journey. We are closely monitoring how much the energy price cost shock will drive down projected corporate earnings as well as the likelihood that central banks might make the policy error of hiking rates rather than supporting the economy through a temporary rough patch. These headwinds have to be weighed against the likely tailwinds of beefed-up defence spending and fiscal investment initiatives designed to accelerate energy transition projects that not only reduce Europe’s energy dependency on Russia, but also the global dependency on fossil fuels that ultimately endanger the planet.

In our view, a ‘let’s wait and see’ attitude is wholly appropriate given the circumstances. Our longer-term investors have learned over the years that markets are quite prone to overshooting and also that, once the dust settles, market positives always emerge. Given globally diversified multi-asset portfolios give investors access to the long-term growth potential of the entire global economy, then as long as we continue to believe this global economy will continue to exist and grow – just as we did two years ago when markets fell precipitously due to the COVID pandemic –  then we should believe portfolio returns will recover and continue on their gradual upward grind.

As such, for the time being, we are happy our current portfolio positioning will achieve our goal of protecting investors’ portfolio values from the negative impact of inflation, while harnessing the most promising sources of return potential available in the current market environment. For those who need to make the decision to invest cash (or not), experience has taught us that a drip-feeding of cash into markets, when assets are available at considerable discounts, has been one of the most effective ways for investors to turn negative short-term volatility into long-term growth for their portfolios. Conversely, choosing to wait on the sidelines until all uncertainties have vanished usually equates to considerable loss of opportunity.  

Oil dynamics could prompt a paradigm shift
Last week’s actions in the oil and gas markets drew parallels in some quarters to the Yom Kippur war, when in 1973, a coalition of Arab states led by Egypt and Syria initiated a surprise invasion of Israel. Saudi Arabia and its allies imposed an embargo on Western countries that supported Israel, causing the price of crude to triple by the time the embargo ended in 1974. Crucially, current sanctions are self-imposed rather than coming from suppliers and there is a much lower global energy dependency on oil today, meaning they could have less force. US President Biden is resolute now, but this could be a different story should surging prices at the pump threaten his party’s popularity. The same could be true if sanctions do their intended job and Putin’s invasion ends. Assuming the invasion keeps going and Western governments stand by their sanctions, structural changes to the global energy mix similar to the 1970s are very possible. The Biden administration has called for US shale producers to increase their output. Meanwhile, UK Prime Minister Boris Johnson is reportedly considering lifting the UK’s ban on fracking. This is a huge shift in both countries’ energy policies. Biden was keen to emphasise his green ambitions in the run-up to the 2020 election, while Johnson’s Conservative government had previously resisted calls from backbench MPs to end the fracking ban.

There is significant debate around how effective these measures will be at securing enough oil supply. What it does mean, though, is that these changes are likely to result in higher total production of oil around the globe than before the invasion began – even if some Russian production is shut down to account for reduced demand. In the context of decade highs for crude prices, that is significant. When we also bear in mind that the European Union (EU), India and China – some of the largest buyers of Russian oil – have yet to ban Russian energy imports (and may never do so), it brings into question whether oil can keep its recent price gains for long. The crucial point will be how OPEC and its Saudi leaders react. They clearly have a strong interest in a higher oil price, but that is only if they can still sell it. With fuel and overall inflation now so high, we are quickly approaching the point where price destroys demand and ultimately dampens global economic activity. That is not in OPEC’s interest, and further oil increases will therefore raise the incentive to loosen controls.

All eyes on policy setters
The Federal Open Markets Committee of the US Federal Reserve (Fed) meets this week, and will almost certainly raise rates by at least 0.25%. Although the war in Ukraine has ensured markets expect a more cautious approach at this meeting, US inflation as measured by the consumer prices index (CPI) has been rising at an unchecked 6% annualised rate for the past three months. The Fed will therefore want to be perceived as fighting inflation, if last week’s European Central Bank (ECB) council meeting is any guide. Given the much greater proximity and impact of the war, most economists expected a rather dovish outcome, but the ECB turned more hawkish. Its bond purchases are now set to finish before October and a rate rise could happen at the same time.

Judging by ECB President Christine Lagarde’s demeanour in the press conference, the meeting might have been rather fractious. She tried to “sell” the idea that the ECB retains more flexibility and is more data-dependent now. However, the bond markets didn’t think that was the outcome, and two-year bond yields rose 0.125% during the announcement. In the US, and possibly also in the UK, fiscal policy latitude also seems to be limited. However, there is much hope for Europe that the fiscal policies are not exhausted but positively enlivened by the current events. France’s President Macron (now extremely likely to win a second presidency) advocated another round of mutual bond issuance to cover more European defence and green investment. It was not immediately welcomed by all, so it will take more effort, but it seems likely Europe’s fiscal policies will remain accommodative for some time.