Please find below our Investment Market Update as at 1st April 2022. Today’s communication is written by Andrew Dunn as Gary is on holiday.
In this current climate, it is often difficult to guess how apparently good news is going to be received. Higher economic growth is surely just such good news, unless it then raises the prospect of higher interest rates to counter the inflationary growth.
Often the determining factor is the sentiment that the news creates or reinforces. This is very much where the majority of the world’s central bankers now exist with ‘Goldilocks’ policy decisions ahead of them; raise interest rates too much, too soon and the economy could go stone cold, or risk doing too little and it could run far too hot. They need to find the right temperature between reducing inflation without hurting future growth which will require Blondin like poise. This debate will shape asset prices over the remainder of this year.
So far this week, markets have broadly been positive and below is a snapshot of this effect on a range of our funds. This has been due to a combination of the much hoped for peace process progressing and also a variety of economic news; high energy prices supporting the price of companies operating here and particularly in the US where we have seen a selloff in bonds that has left investors looking for an alternative, with some funds moving into equity stocks.
Corporate profits, at least for now, remain buoyant and this is of course supportive of share prices. We are also seeing a recovery in the oversold large technology sector – companies with large and growing markets, strong balance sheets and reliable income. Microsoft is a prime example of a company with very strong pricing power, with the depth and breadth of its product suite and integration in many businesses making it an excellent company to invest in. From the start of 2022, the share price was down 10% though this week it has recovered by 3.6%. Microsoft is a core holding in all our portfolios and is the type of high-quality company that should prosper in the future.
- Sapphire balanced +1.86%
- LGTV Balanced + 1.39%
- LGTV Sustainable Balanced +1.45%
- Infrastructure +2.45%
- Global Themes +1.68%
- Momentum +1.11%
Prospects for European Markets
The following is an assessment of the current European market situation by LGT Vestra (released Wednesday morning).
The European equity market has been particularly vulnerable to factors related to the war in Ukraine and has seen large moves in both directions driven by the news flow. On the grounds of valuation, the European market looks relatively attractive, but the risk of higher energy costs to the economy are significant. Ukraine, as Europe’s primary supplier of wheat, is the breadbasket of Europe and many European countries such as Germany are highly reliant on energy from Russia. Now, commodity prices, especially for energy, are set to stay higher for longer as Europe struggles to diversify its sources of supply away from Russia. However, in the face of a military campaign on its doorstep, Europe has been united with its countermeasures and we are seeing collaborative fiscal responses, which may mitigate these headwinds. Below we assess the main risks to the region from commodities and impacts on supply chains, plus other factors affecting the macro-outlook.
Grain prices have risen as fears grow over this year’s harvest in Ukraine, for example, the price of wheat rose nearly 15% from 25th February to its peak on 7th March, but have since settled and retracted somewhat. Ukraine and Russia are major exporters of fertiliser used by agricultural businesses globally; if supplies are cut, it may reduce crop production elsewhere. Ukraine also provides a number of obscure but nevertheless essential components to Western Europe’s factories, for example, cable harnesses for Germany’s auto manufacturers. After 18 months of supply chain issues and shortages of semiconductors, another shortage of a critical element in the car manufacturing supply chain is bad news for European autos. European countries are also large importers of energy broadly, this is the same for other commodities and food agriculture, meaning they are much more exposed to Russia, whereas the US is relatively insulated from these issues.
Doing without Russian commodities and Ukrainian inputs will entail heavy costs for European corporate profitability. German Chancellor, Olaf Scholz, recently said that Europe will end its energy dependence on Russia, but to do so from one day to the next would plunge it into a recession, risking hundreds of thousands of jobs and entire industrial sectors.
One simple way to get a handle on the magnitude of these costs is to look at the relative changes in producer prices versus consumer prices. If producer prices rise at a considerably faster rate than consumer prices, it is a sign that companies are limited in their ability to pass their higher input costs on to consumers. As a result, corporate profitability will suffer. Producer price information typically leads earnings, so company earnings and profit margins over the next few quarters will be revealing.
The IFO Business Climate survey, which provides a reliable indicator of the health of the German economy six months on, recorded its biggest ever monthly drop last week – even larger than two years ago in the early days of the pandemic. However, a recession could be avoided because of the post COVID-19 recovery in the service sector – hospitality and travel sectors will have been helped by the easing of restrictions in Germany. Capital Economics forecast aggregate real household incomes to fall by around 1.5% this year, primarily squeezed by higher energy prices. This would be the biggest fall since 2013. Even in 2020, when the pandemic caused output to slump, it only declined by 0.3% thanks to generous fiscal support. Although, the saving rate remains high and this may be used to offset some of the fall in household income.
Given the current negative sentiment by investors towards the region, there is significant upside risk if Russia and Ukraine reach a settlement or ceasefire. Any resolution would likely cause the oil price to fall significantly, inflationary pressures to begin to abate, or supply chain issues to fall away. All factors which could cause a fair tail wind towards European equities. With four out of six parts of the settlement allegedly already agreed, this is something to look out for.
We have written quite a bit about inflation, but it is right now the most important economic issue as it cuts across so many areas of life and business. Inflation has often been associated with wage rises but not this time as it is wages that are responding to higher inflation, not driving it. Nor is it consumer demand that has, in the past, pushed up prices. At the start of the year in the UK over 40% of inflation came from just three areas – home heating, petrol and the cost of used cars (which would have been a great investment this last year!). There will be no surprises here as we are all feeling these effects, but it seems likely the cost of energy will abate a little with a hoped-for peace in Ukraine, supply chains fully opening and reliable extra oil and gas supplies becoming available.
Joe Biden’s administration, in their latest Budget proposal, estimate that the US rate of inflation in 2023 will be down to 2.3%, though many see this as over optimistic. The Governor of the Bank of England is also optimistic that inflation will be back to his 2% long-term target by 2024. Interestingly though, a recent YouGov survey showed that UK consumers expect our rate to be twice as high as the government forecast.
Options for Energy Production and Renewables
We know that energy is a big part of current and future inflation. The geo-political changes in Europe will alter many things and one of the most significant will be the need for independent energy supply and storage. Russia currently supplies nearly half of EU gas imports, a quarter of oil and nearly half of coal imports too. The UK is much less dependent, with under 5% of gas imports and 10% of oil coming from Russia. Moving away from reliance on other countries is highly likely to boost renewable energy and the infrastructure to support and store energy. The EU believes that it can replace two thirds of Russian gas by the end of this year and be wholly independent before 2030. There are many hurdles technically, financially and politically but this remains great news for European and other renewable energy companies.
There has been talk of boosting North Sea oil once again, to solve our own problems. The Business Secretary, Kwasi Kwarteng, said ‘that gas is our gas’ and ‘it means we can be energy independent’. He also restated the government’s net zero pledge and suggested that gas was only a short-term solution.
Shell is now reviewing some previous decisions it had made not to pursue oil and gas in the North Sea Cambo field. However, even setting aside the difficulty of persuading its shareholders/public opinion, the cost of this would be massive and the lead in time for the necessary infrastructure and hence payback would be years away. Fracking is also likely to re-enter the conversation, though it was very unpopular last time. At least for some time it appears we are likely to have a hybrid model with various sources of energy, but renewables will make up an increasing part.
The US has promised to support Europe with supplies of LNG (liquified natural gas) and the executive of one American gas producer said he would like to supply the gas but that the infrastructure was not there to achieve this. Right now, LNG is the cleanest fossil fuel and investors will play their part by helping to fund the necessary infrastructure. The interest generated by the changes to energy supply have and will be a big boost to our infrastructure and renewable energy funds.
Selling England by the pound?
Please forgive the heading, it’s my favourite Genesis album and they are now on their farewell tour. But, it also nicely describes what is going on with so much foreign interest in buying up undervalued UK companies.
Hardly a week goes by without bids being made – Ted Baker, Morrisons, Macquarie (an Australian company) buying 60% of National Grid’s gas transmission business, Royal Bank of Canada buying adviser Brewin Dolphin and Rolls Royce that may or may not happen. When a hedge fund sees value in a UK company, they have usually done a lot of research and feel they are getting a great deal. To add to this, so far in 2022, FTSE 100 companies have spent £22 billion of their own cash on buying back shares in their own company. These purchases are again good news for investors in that it creates a demand and also demonstrates that company profitability remains vibrant. We have previously expressed our strategy to focus on companies that have strong profitability and this reinforces that approach. Investing in the UK stock market for the last few years has been a testing experience, with the FTSE 100 lagging the other main growth orientated world markets.
We have seen a slight reversal in 2022, with so called ‘old economy’ stocks such as oil/gas, banks and miners outperforming their peers. In fairness, the UK has for some time appeared to be good value in comparison with other markets though Blue Sky remains very focussed on investing our clients’ money in quality forward looking companies that will solve, and benefit by doing so, the problems of tomorrow. That said, diversification is your friend when investing and so the addition of a FTSE 100 tracker a couple of months ago to most of our Sapphire funds means we have benefitted from this recent outperformance.
Let’s all enjoy a sunny, if rather chilly, weekend.
Andrew Dunn and the Blue Sky Investment Team
Please Note: This communication should not be read as giving specific advice regarding your personal circumstances. This would only be given following detailed assessment of your individual needs. The value of investments may fall as well as rise; you may get back less than invested. Past performance is not necessarily a guide to future returns.