The impact of of war continues

As we move into Q2, tragically we are now more than a month into the war in Ukraine, with the conflict sadly showing no signs abating. The war has exacerbated inflationary pressures, which continue to dominate the narrative for investors with things likely to get worse before they get better as Europe attempts to wean itself off Russian oil & gas and supply chain issues push prices higher still. Markets have had a rollercoaster ride through March, sinking initially after the outbreak of war then roaring back from their post-invasion lows before slowing once more.

Bond yield volatility causes a stir

A lot of headlines were generated by the inversion of the yield curve (the yield on a two-year bond rising above the yield on a 10-year bond). This is a useful indicator because it has tended to invert ahead of recessions and, by implication, ahead of large equity market drawdowns. Bond yields lurched higher in response to the release of employment data for the US. The data was broadly in line with expectations in terms of the number of jobs created, with figures remaining strong. The aspect to note for the Federal Reserve will be unemployment, which fell to 3.6%. Prior to the onset of COVID-19, unemployment had reached 3.5% but, nevertheless, this is a level of joblessness which suggests a tight labour market.

The inversion of the yield curve is not a precise tool of timing. It tells you we are in the last throes of an economic expansion. However, those last throes can last many months, perhaps even a year or more. During that time, equity returns have generally been pretty respectable and earnings growth was also red hot. The annual pace of growth is the fastest in over a decade (excluding the period immediately following the pandemic, which was distorted by the types of jobs that were lost).

Inflationary pressure as Europe looks for alternatives to Russian oil supply

The estimates of inflation for the month of March (the first full month since Russia’s invasion of Ukraine) are in and shed some light on the impact the war has had on the wider supply chain crisis. Covering Spain, Italy, Germany and France, these estimates continue to surprise analysts by the strength of their inflation. The principal driver of this is energy prices which soared after the invasion but have been very volatile since. Prices had reached over $130 per barrel but after some toing and froing they are now back down around $100. There hasn’t been too much good news to drive that and OPEC+ appears reluctant to provide much assistance. Members took just 12 minutes to decide to increase oil production by 432,000 barrels per month in a move designed to show how strong the unity is between members. It left little time to discuss the impact on supply from the loss of what is estimated to be around 1.5 million barrels a day of Russian supply. However, by some estimates the current COVID-fighting lockdowns in China may be denting demand by around 1 million barrels a day. The Biden administration has announced plans to release 180 million barrels of oil from the US strategic petroleum reserve (SPR). Historically, many commentators have observed that these kinds of releases are short lived in their impact before attention shifts to the increased demand needed to restore the SPR back to its previous inventory.

The surging oil price has certainly been good news for the energy majors with BP and Shell up 10% and 25% respectively over the first quarter. Investors eyed stocks with an immediacy in terms of earnings whilst more growth-oriented investments, with returns projected out into the future, have languished.

Is there a recession looming?

The main controversy for investors relates to how soon a recession could fall upon us. Currently, the employment market is too strong, which tends to align with a strong environment for stocks and a weak one for bonds. That can change quite fast, but at the moment, every indication is that companies want more staff. The likely driver to change that dynamic would be the rising level of consumer spending that has to be channelled into non-discretionary areas such as heating, motor fuel and food - all of which are rising for everyone. Utilities bills are a particular problem for those of us in Europe. Rents and house prices are rising fast in the US. Spending on discretionary consumer goods and services will reduce as a consequence. At some stage, the risk is that demand for consumer goods declines to a level below supply, at which point companies need to cut back on supply capacity and the labour market goes into reverse, followed by interest rates. These are the conditions that cause a recession, something which investors concede is required as a firebreak to end the cycle of inflating prices and wages. There will, of course, be volatility along the way, but it need not be the scarring events that we saw in 2002 or 2008.

COVID-19 continues to impact Chinese economy

To varying degrees this is the challenge in many markets, but the one exception is China. Looking at the Chinese economy seems almost like going back in time to the middle of 2020. China has just completed the first of two lockdowns in Shanghai, during which residents are not permitted to leave their homes except to go to mandatory testing sites. The two lockdowns are lasting four days each, with the first covering the east of the city and the second covering the west. It is indicative of a heavy-handed COVID1-19 suppression policy that the Chinese Communist Party is having to impose in order to minimise the rise in infections. The lockdowns are already evident in the disappointing result in the Purchasing Managers Index, but the situation is sure to deteriorate further.

Looking forward

So, as we enter the second quarter of an already hectic year, challenges remain, particularly in the east of Europe and the path is littered with pitfalls. Volatility is likely to remain at elevated levels but there are reasons to believe that markets have a way to go yet with corporate earnings continuing to grow and balance sheets in relatively robust shape.

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin)