Monday digest

Posted 4 April 2022

Overview: yield curve inversion is another reason for a cloudier Q2
While UK consumers braced themselves for a blast of winter weather and a surge in their cost of living, investors experienced a quieter end to the first quarter, with gains in equity markets, while bond market valuations suffered from rising yields. The two major events that drove the quarter – a sharp turn towards monetary hawkishness by the US Federal Reserve (Fed) and Russia’s unprovoked war on Ukraine – appear a little less frightening for investors, but their impact drags into the second quarter. The impacts of both have certainly dimmed the near-term outlook for the global economy, and have increased the risk of a recession, or at least an economic slowdown, because of a prolongation of increased energy prices. All this makes it more difficult for companies to improve their earnings, while further supply disruptions and spiking commodity prices have created inflationary pressures that central banks are ill-equipped to fight, without upsetting the global economy.

As noted last week, good news can also turn into headwinds for markets. With price pressures still looming, it was unsurprising that 10-year US government bond yields reached new cycle highs of over 2.5% before falling back. The fast-changing yields have brought another popular spectre out of the ‘scares cupboard’, that of a yield curve inversion. Inversions of the yield curve are feared by markets because they have in the past often been closely followed by a recession. It unfortunately also adds another reason for pessimism that equity investors can add to the already very high ‘wall of worries’.

This, together with increased equity valuation pressures from higher bond yields, makes current market levels look more extended on some metrics than at the beginning of the year, when the economic outlook was far more positive. We are clearly pleased with the recovery markets have experienced since the lows of the first quarter, but whether this leads to a renewed sustained uptrend, rather than a range-bound sideways trading of markets, will be determined by global politics and monetary policy over the coming weeks and months. Both currently remain extremely difficult to predict.

Why the India/Russia trade surge is ‘strictly business’
From here, it is easy to overestimate the global opposition to the war in Ukraine. China is staying as neutral as it can be, offering to play a part in peace talks while avoiding official sanctions. Joining China on the fence is its bitter rival India – which has huge economic ties to both the West and Russia. India has abstained on all of the major United Nations (UN) votes over Ukraine so far, first on the Security Council motion to condemn Russian aggression and then on the General Assembly vote for the same.

With the government in New Delhi showing little sign of signing up to the Western sanctions regime, the flow of Russian oil into India has skyrocketed over the last month. According to Reuters, India has bought around 13 million barrels of Russian oil since the invasion began on 24 February – compared with 16 million barrels over the whole of last year. The US has warned India that this surge in purchases exposes it to “great risk” of being caught in its sanctions, but this shows little sign of deterring the Modi administration. India’s big refineries have faced difficulties financing their purchases of Russian oil, due to the extensive sanctions on Russia’s banks. From recent reports, though, the Indian government looks set to double-down rather than back down: India’s central bank is reportedly exploring plans for a rupee-rouble trade agreement with Moscow. This comes despite efforts to ban Russian institutions from international payment system SWIFT, and would strengthen trade between both countries, even as the West imposes sanctions.

There is a temptation to see developments as an implicit endorsement from India – a friendly exchange between the countries’ respective nationalist leaders. New Delhi undoubtedly has its reservations about its Russian relations – and has not hidden that fact in its communications. But politicians see little benefit in alienating Moscow or cutting itself off from vital imports. On the geopolitical front, India’s political class firmly believe China presents the greater strategic threat – one which they see Russian support as key to managing. Over the shorter-term, the discount on Russian resources is simply too big to ignore. Big oil importers like India have been grappling with surging prices for a year with little respite. Nearly 100 million Indians live in extreme poverty, a figure which could rise with further increases to the cost of living. Modi is extremely politically secure – his party having just won big in state elections – but his brand is built on improving social mobility and conditions for the working poor. Choosing to increase costs for the sake of a war between two foreign countries would likely be deeply unpopular, especially so considering the historic discount on Russian oil.

India recorded stellar growth last year and, from an investment perspective, its equities saw significant outperformance. But this has left them at record valuations, and the commodity price shock presents serious headwinds for India’s economy. As a big importer, India is highly sensitive to commodity prices and concerns over ‘stagflation’ (high inflation and low growth). Goldman Sachs recently downgraded its assessment of India, suggesting headwinds are likely to persist, and a short-term correction could be on the way. India’s financial and economic woes would no doubt worsen if it got caught up in US sanctions. That could force New Delhi to reconsider its position, but for now, the commodity shock is pushing India closer to Russia rather than further away. If the West wants to ensure Moscow is truly isolated, it may need to pressure its allies too.

Is Japan good value, or a value trap?
Last week was another torrid one for the Japanese yen, which began with a 1% loss against the dollar on Monday, and ended with the yen some 5.5% below its dollar valuation a few weeks ago. Overall, it was the yen’s biggest monthly loss against the dollar since 2016. Investors pointed fingers at the Bank of Japan (BoJ), as it announced plans to increase asset purchases (quantitative easing) and keep a lid on medium-term borrowing costs. While the world’s central banks have been fighting rapid inflation for months by ratcheting up interest rates and shedding debt from their balance sheets, Japan’s central bankers are doing the complete opposite. Rather than containment, the BoJ is stoking activity. In fact, this was just the latest in a series of exceptional efforts aimed at easing financial conditions. The BoJ has repeatedly affirmed its commitment to the yield curve control (YCC) policy, whereby it buys long-term bonds with the explicit aim of keeping maturity differentials at the desired level. This is in stark contrast to most other major central banks, which have allowed bond yields to rise substantially as the global cost shock filters through.

Japan has a highly skilled labour force, lower wages than its developed market peers and – because of the BoJ’s easiness – cheaper financing than almost anywhere. The profit potential should therefore be substantial, making Japan an incredibly attractive place for investors. And yet, investors continue to be downbeat on Japanese assets, as shown by the currency’s immense weakness. This is almost certainly down to historical precedent. The BoJ has had incredibly loose monetary policy for years, even decades, without spurring major growth in the economy. Moreover, the nation’s corporate structure has often proved a major obstacle for foreign investors. Indeed, in the past the government has stepped in to limit foreign ownership of its companies. That was the past though. Japan has embarked on a series of substantial reforms recently. These have led to a more shareholder-friendly environment and have boosted the medium-term corporate profitability outlook. It should now be much easier to make money from Japanese companies than has been the case for decades. What’s more, these companies are now much more open to foreign ownership – not only for public shares, but for private equity firms too. This structural reform should support foreign direct investment, and thereby growth, over the long term. In the shorter term, it means there are many companies in Japan with highly competitive labour costs, highly trained workforces, easy access to financing and a solid corporate governance structure. That is a combination very hard to come by anywhere else in the world. If Japan presented an investment opportunity before, this most recent sell-off in the yen only adds to the appeal. The problem, as ever, is whether Japanese growth – domestic and export driven –  will be strong enough to fulfil this promise. That is much less certain, given Japan’s cyclical exposure and the global growth headwinds this year. But with the BoJ easing while everyone else tightens, there is a decent chance of domestic demand being stirred to action. We will have to watch closely, but after years of being a ‘value trap’, Japan is beginning to look like good value.