Monday digest

Posted 21 March 2022

Overview: Is optimism returning to global investment markets?
Last week we reminded investors of the importance of ensuring long-term investment decision-making is not overly influenced by short-term market fluctuations. The strong rebound in stock markets around the world has reinforced our point. With oil prices having rapidly fallen from over $130 per barrel back to around $100, the severity of the anticipated energy price shock has dissipated, returning more optimistic sentiment to markets. Was the reversal due to the faltering of Russian progress in Ukraine, and therefore the rising probabilities of a near term peace settlement? Well, it was certainly a major influence, but the sheer magnitude of recent volatility could have left the speculative commodity market participants without the liquidity to match their appetite. In other words, the opportunity for commodity bets simply dried up. The past decade tells us that commodity price movements are often boosted by momentum-detecting trading algorithms. Once the ‘price-tide’ turns, the dynamics go the other way, as occurred in 2020, when oil prices turned negative. 

This left investors grappling with whether more realistic expectations were finding their way into capital market valuations, while not losing sight of the other risk, namely that central banks in the US and UK would upset the apple cart with extreme rate hikes. In the end, rate-setting committees on both sides of the Atlantic raised interest rates by just 0.25% as had been expected, while the US announcement hinted at expectations of a strong economy which were taken positively by markets. However, the longer the price shock carries on, the greater the risk of embedding inflationary expectations, turning inflation from transitory to structural. Therefore, while central banks are tightening monetary policy gently enough to not cause serious upset at the moment, they have also signalled they are prepared to step up their actions should labour markets become too buoyant – even when price rise pressures dissipate later in the year.

Perhaps the biggest unanswered question of the week was how Russia’s war on Ukraine will affect the relationship between the US and China. Presidents Biden and Xi held a two-hour call on Friday, ostensibly to discuss Russia’s aggression, but beneath the surface both sides would have been considering Taiwan, and China’s own territorial ambitions. Behind the diplomacy is a very uneasy supposition. If peace in Ukraine is to be achieved soon, it may only happen with some form of international acknowledgement that allows Russia to gain control of Donetsk, Luhansk and ultimately Crimea. China’s claim on Taiwan is stronger than any that Russia has over these areas. Peace in Ukraine would therefore make Taiwan very nervous.

We welcome last week’s market dynamics, while acknowledging an almost equal probability for improvement or deterioration of the economic outlook from here. Much will depend on whether supply bottlenecks ease, consumers feel confident enough to increase their demand for services, and whether central banks resist the urge to overreach in their attempts to force the inflation genie back into the bottle.

China benefits from the ‘Beijing Put’
Chinese stock markets went on a wild ride last week. A torrid few trading days for corporate China saw the CSI 300 index slump 5% on Tuesday, while Hong Kong’s benchmark Hang Seng index dropped almost 6% to its lowest level since 2016. Then came the almighty rebound on Wednesday; the CSI climbed 4.3%, while the Hang Seng jumped a whopping 9.1%. It was the latter’s best trading day since 2008. The decline began after the announcement from the US Securities and Exchange Commission (SEC) that five Chinese companies risked being delisted from US stock markets for failing to hand over proper audit documents. However, although the SEC ultimatum exacerbated investor fears, it did not start them. Chinese equities had been in a downward trend since the beginning of last year – a sell-off that gained pace in recent few weeks. The backdrop of slowing growth in the world’s second largest economy – as its property sector started crumbling – a trigger-happy interventionist government and the looming threat of lockdowns from Beijing’s zero-COVID policy have all fractured confidence.

Hong Kong has recently seen some of the worst COVID death statistics of anywhere throughout the entire pandemic, and the Chinese mainland is now suffering similar problems. China’s containment policies appear to have been much less effective against the Omicron variant. Confused messaging on vaccines has left large sections of the population unprotected – particularly the most vulnerable. The government’s original zero-COVID policy has reached its limit and, in the short-term, authorities can only stem the tide through tighter restrictions, harming growth.

For now, though, growth seems top of the agenda. Vice Premier Liu He announced that Beijing would take measures to “boost the economy in the first quarter” and pursue “policies that are favourable to the market”. While light on detail, this kind of reassurance has been rare in recent times. Indeed, it was the main driver of last Wednesday’s dramatic stock market rebound. If authorities are prepared to reinforce the rhetoric with action, Chinese equities have much to gain. Global markets have suffered a bad start to the year and China’s stock markets have underperformed global markets. This has left Chinese equity valuations much lower than elsewhere, at the same time as the economy hopes to recover from its slump. If this is backed up by firm policy support, China’s lowly valuations could look like a bargain.

Why ESG needs to be more than just ‘feel-good’ investing
If you want your money to do good as well as achieve decent returns – as an increasing number of investors do – this also means avoiding morally dubious assets or rewarding righteous ones. This is where ESG investing – where assets are screened for their environmental, social and governance credentials – is supposed to help. You might reasonably think that polluting energy companies or military defence stocks would be excluded, but this could be changing. Last week, Swedish bank SEB reversed its decision to exclude defence stocks from six of its funds. The U-turn has come from Russia’s invasion of Ukraine – and the subsequent conversation around boosting western military spending. Germany has announced a €100 billion investment in its army, while the European Union (EU) seems to have dropped proposals to deem defence companies unsustainable. Examples like SEB are still rare, but the debate has certainly begun. This also extends to conversations around energy security, with both the US and UK being forced to reconsider current fossil fuel output. In the US, President Biden is now encouraging more oil and gas exploration, while in the UK, Boris Johnson is considering giving the green light to fracking. And while lawmakers claim this will not come at the expense of building green technology, the attractiveness of fossil fuel investments – when oil and gas prices are so high – will likely drag capital away from the green sector.

This is all the more pressing because of the popularity of ESG funds, meaning that financial institutions have an incentive to use the label where they can. Climate-friendly indices have performed better in recent years than conventional ones, regardless of whether they give low or high weighting to the US. This only increases the appeal of ESG for investors. However, the reason for this outperformance is more to do with the underlying business models of ESG-labelled companies than anything else. ESG companies are usually not ‘value’ stocks with high near-term earnings. Most are investing in newer technologies for the future, and as such, have low or negative current profits with high expected returns in the future. This makes them growth stocks, which have performed well in the era of easy monetary policy. The end of this ‘easy money’ era is therefore a negative for such companies, whereas value stocks like financials and energy utility companies are precisely the ones that benefit the most from a rising yield environment, meaning that such stocks are likely to outperform.

All of which is to say, weaker returns this year from ESG stocks might have very little to do with a general reorientation toward energy security or defence, but instead just be an artefact of the overall growth to value rotation. The fact European renewable energy stocks stand to gain from energy independence is a case in point. These matters are complicated by the debate around what gets included under ESG. Since this style of investing is driven by moral or political concerns, it is sensitive to political trends. Policymakers would do well to give firmer guidelines that investors can stick to – otherwise what makes a ‘good’ investment will remain too loosely defined.