Concerns over the economic and humanitarian crisis resulting from the Russia’s invasion of Ukraine continued to dominate the markets in Q1. Besides, a combination of rising interest rates and record high inflation has negatively impact both bonds and equities alike during the quarter. The UK 10 Year Gilt yield hit their highest since January 2016 at 1.82%. The U.S. 10-year Treasury yield has also now ploughed through 2.8%, which is a rise of over 1% since the start of March 2022.
Although bonds with long duration are more sensitive to interest rate movements, these are considered the safest during times of extreme market shocks. The persistent rise in yields particularly along the higher end of the yield curve has negatively impacted our defensive portfolios. That said, given the magnitude of the uncertainty over the war in Ukraine and its potential repercussions for the wider global markets (should NATO get drawn into direct confrontation with Russia), we have continued to remain cautious and maintained our underweight defensive positions in long duration developed government bonds, albeit this has come at the cost of short term pain due to rising yields. Corporate bonds also posted negative returns due to tightening monetary conditions. High yield spreads widened more than investment grade (unsurprisingly), although these saw less negative total returns due to their attractive income streams.
Our domestic equity market has been a safe harbour in this storm due to its very large exposures to commodities (oil and gas in particular) which have emerged as one of the biggest beneficiaries of the recent spike in inflation, exacerbated by the war in Ukraine. The FTSE 100 is the only mainstream index which has generated positive returns of 2.9% during the quarter. All of the FTSE 100’s major rivals were in the negative territory during the quarter. The FTSE 100 also has high exposure to financial stocks that benefit from higher interest rates and negligible exposure to technology stocks which tend to come under pressure during times of rising rates. Amongst the major indices, the FTSE 100 continues to remains the cheapest and offers a dividend yield of 3.75% as of March 2022. That said, despite being less dependent on Russian energy, the UK is still exposed to the wider market impact.
As we touched on in our Q1 2022 Portfolio Update, markets had plenty to worry about before the invasion in the form of tightening monetary environment and record high inflation. The impact of these already strong head-winds has been exacerbated by the unprecedented sanctions on Russia, a major producer of several commodities including oil, gas and wheat. In our Q1 2022 Portfolio Update, we supported a bullish case for equities in 2022 with moderating gains. The consequence of Russia’s invasion could mean higher inflation (than previously anticipated) and lower growth with Europe taking the largest hit due to its relative over-dependence on Russian energy.
Given Europe’s heavy reliance on Russia to meet their energy needs, shares in the Eurozone declined sharply in Q1. Following the invasion, the European Commission announced a plan – RePowerEU – intended to diversify sources of European gas import as it aims to accelerate the bloc’s renewable energy ambitions . Germany also suspended the approval of the Nord Stream 2 gas pipeline from Russia. As these efforts are expected to take time in order to prove effective, there are fears in the short-term that high energy prices will continue to weigh on both business and consumer demand, hitting economic activity. The overall labour markets in Europe continued to improve during the quarter despite a slump in consumer confidence due to inflation.
Across the other side of the Atlantic, the U.S. stocks lost money during Q1, owing to the deteriorating consumer sentiment. Value stocks (energy & utilities in particular) were amongst the top performers whilst growth and cyclical stocks (technology, communication services & consumer discretionary) were amongst the weakest sectors. On a positive note, the risk of subsequent interest rate hikes at the remaining Federal Reserve (Fed) meetings is now very much priced in and seems to be maturing.
Similarly, the geopolitical tensions continued to weigh on emerging markets during the quarter. In China, Covid-19 related risks also remain elevated due to government’s zero-tolerance policy. A recent outbreak has led to lockdowns in economically important Shenzhen and parts of Shanghai, posing short-term challenges to the electronics supply chain. The property sector is still not completely out of the woods, with fragile sales volumes and depressed developers’ credit ratings. The recent stimulus announcements from the Chinese government however helped restore investor confidence leading to equities’ rebound towards the end of March. We expect to see more of such accommodative measures from People’s Bank of China aimed at improving economic stability towards the end of the year. Following Russia’s invasion of Ukraine, crippling economic and financial sanctions were imposed on Russia by developed nations. The sanctions also included removing some Russian banks from SWIFT and imposing restrictions on the Central Bank of Russia’s (CBR) international reserves. The CBR responded by increasing the policy rate to 20% and imposing capital controls intended to limit outflows. Despite these extra-ordinary measures, the Ruble collapsed and the Russian stock exchange remained shut for two weeks. The Ruble has since regained all of its decline against the Dollar. These severe sanctions will inflict significant damage to the Russian economy, which is expected to enter a deep recession, despite the fact exports of oil and natural gas remain largely unaffected. Europe is also contemplating imposing an embargo on the import of Russian oil and gas, however it seems unlikely to materialise given former’s high dependency on the latter. The U.S. however has announced a complete ban on imports of Russian oil given their small dependence on Russian energy.
The Japanese market had a ‘relatively’ better end to Q1 after showing some weakness during January and February. Value stocks (financial sector in particular) posted strong gains during the quarter whilst the opposite is true for Japanese growth stocks which saw notable correction during the quarter. Japan also introduced some gasoline subsidies that should help to support household consumption. The manufacturing sector however continued to be impacted by the shortages in semiconductor supplies across the AsiaPacific.
The Bank of England lifted the base rate to 0.75% in March, its third consecutive increase since December 2021. The Federal Reserve followed suit and implemented its first rate hike since December 2018, with further rises expected in 2022. The expectation for aggressive monetary tightening in the U.S. also led to dollar strengthening, which was up about 3% against both the pound and the Euro over the quarter. The European central bank has also recently started sounding more hawkish (less accommodative) whilst confirming a faster reduction in bond purchases (quantitative tightening). On a long-term basis, currencies such as the Euro and the Yen now appear significantly under-valued against the Dollar and there is a strong case for Dollar should hostilities between West and Russia retreat following potential ceasefire and withdrawal of the weakness in the second half of the year if Russia retreats from Ukraine and the Fed becomes less hawkish as inflation pressures lessen. Dollar weakness should support the performance of non-U.S. markets and will help offset some of the headwinds facing emerging markets.
The immediate threat stems from rising food and energy costs. The longer-term concern is the possibility of a new cold war between Russia and the West resulting in increased military spending. That said, the probability of a ceasefire over the coming few weeks cannot be completely ruled out given the magnitude of sanctions and the level of resistance shown by the Ukrainian military. The war is a defining moment for Europe, which now seeks to reduce and eventually fully unwind its multi-decade dependence on the Russian energy.
In view of the continued roller-coaster ride over the past two years, the Investment Committee has revised its Strategic Asset Allocation to improve our core investment strategy as detailed in the Portfolio Update section. As things stand, the broader economic outlook remains topsy-turvy given the continued uncertainty over the outcome of the war in Ukraine. The ongoing hostilities could exacerbate inflation and supply chain disruptions. The markets seem a little weary with reduced liquidity and high volatility, whilst news flow remains unpredictable.
As we anticipated in our Q1 2022 Portfolio Update, markets are likely to remain volatile with perhaps worsening news on inflation (at least in the short-term) and who knows what from Ukraine. The first quarter of the year has once again proven how important it is to maintain a diversified portfolio of assets with a long term view and to avoid emotional behaviour dictated by fear. Thankfully spring is here, so we can all at least go out and enjoy the bluebells. As always, from all of us here at Montage, stay safe and we will hopefully see you very soon.