Markets Weekly podcast – 14 March 2022

Henk Potts (HP): Hello. It’s Monday, 14^th March and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts. I’m Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider how investors should be positioned, given the vast amount of uncertainty that we see in the financial markets at the moment. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

There are few signs that Russia is willing to reduce its military action in Ukraine, and confirmation that sanctions will be extended to include Russian energy exports led to an intensification of the turmoil that’s been permeating the global economy and financial markets during the course of last week, although some cautious dip buyers did emerge as the week progressed. This is on a tentative hope that a diplomatic resolution to the conflict could eventually be achieved as peace talks continue and negotiators voted the concept of Ukraine committing to a permanent state of neutrality.

While European equity markets registered gains over the course of the week, they were not enough to recover the dramatic losses racked up in the first week of the conflict.

The STOXX 600 rose 2.2%. That was the biggest weekly advance since 10^th December but is still off 12% year to date. Over on Wall Street, the fallout from the war in Ukraine and the multidecade high inflation print led to a drop in consumer sentiment and pushed stocks lower. The S&P 500 fell 2.9% over the course of the week and is now down also 12% year to date.

Yields on US government debt soared ahead of the US Federal Reserve meeting this week. The two year note was higher by more than 20 basis points, touched 1.76%, that’s the highest since September 2019. The 10 year yield was up 26 basis points to 2%.

Commodity markets continued to be at the epicentre of the disruption in global financial markets. Crude prices gyrated as traders reacted to the decision by the US, Europe and the UK to ratchet up sanctions. Brent hit $139 a barrel on Tuesday, which is the highest level in 14 years. However, energy prices eased back from the recent peak on speculation that key Gulf producers would increase production to mitigate some of the shortfall. It’s estimated that Saudi, Kuwait and the UAE have a combined excess capacity in the order of 2 to 2.5 million barrels per day.

Relief for stretched oil markets could also come in the form of a revival of the Iranian nuclear deal. To remind you, Iran holds the world’s second largest gas reserves, number four in terms of crude reserves. A reactivation of the seven year old deal could result in 60 to 80 million barrels immediately being released to the market and pave the way for 1 million barrels per day of crude to be added to the global market over the course of the next six to 12 months. The US are also apparently reviewing oil trading sanctions on Venezuela.

Soft commodities are also reacting to the supply disruption. Remember, Russia and Ukraine produce massive quantities of wheat, of corn and sunflower oil. Their combined production is estimated to account for 10% of globally traded calories. Russia is also the world’s largest producer of fertilisers. Wheat prices have surged more than 50% over the course of the past two weeks, corn is at its highest level in a decade, all of which has significant ramifications for both inflation and food security, particularly in developed nations.

Surging inflation and falling growth is adding further complexity to the balancing act being performed by central bankers. However, the European Central Bank provided a hawkish surprise after forecasting that the war will only have a mild macro impact and projected inflation will stabilise at its 2% target over the medium term.

The European Central Bank unexpectedly said it would slow down its bond buying from the start of May. We now expect the ECB to end its quantitative easing in June and July. On rates, officials now say any hikes will be gradual and take place ‘some time’ after bond purchases end rather than ‘shortly’ after. We expect rate hikes in Europe to be postponed out until 2023.

So that was the global economy and financial markets last week. In order to discuss the key stress points and possible areas of opportunity for investors I’m pleased to be joined by Dorothee Deck. She’s the Cross Asset Class Strategist with Barclays Private Bank.

Dorothee, great to have you with us today. Given the significant pullback that we’ve seen in terms of equity markets since the start of the year, is now a good entry point?

Dorothee Deck (DD):  So thanks a lot, Henk, good to be here. The short answer to your question is that it’s too early to tell. The near term outlook for risk assets has significantly deteriorated following the invasion of Ukraine, so in the near term and until we have more clarity on the geopolitical front we remain cautious on risk assets.

However, on the 12 month horizon we maintain our constructive view on equities.

So put the situation in context, global equities are now down 12% year to date. The correction started after the hawkish stand from the Fed and other central banks as the market became increasingly concerned about the risk of excessive policy tightening.

Those risks were further exacerbated by the Russian invasion of Ukraine as the conflict led to a substantial increase in the price of energy and commodities in general which add to the growth and inflation scare. So basically, the magnitude of this impact will depend on the duration of the conflict but if the energy crisis deepens or becomes more entrenched it has the potential to push growth momentum below trend and precipitate a recession, and that’s the scenario that the market has started to price. So the narrative has changed very quickly from inflation to stagflation or even recession.

So the difficulty for investors today is that there are a wide range of possible outcomes which depend on the duration of and the evolution of the conflict as well as the policy response. So for now our base case is that the geopolitical situation will improve over the next few months and that global growth will remain above trend and on that basis we remain constructive on equities on a one year view.

However, we also recognise that the uncertainty around our central case has increased and that adverse events could have an outsized impact on portfolios and that’s why we believe investors should position for an extended period of high volatility as price action will be driven by headlines for some time and with that in mind we encourage investors to stay invested but keep hedges in place and increase diversification in portfolios.

We also favour a more balanced positioning in portfolios and an increased exposure to the more defensive areas of the markets.

HP: So as you mentioned the near term outlook has certainly deteriorated. What makes you feel more positive about the longer term outlook?

DD: So we have already seen downward revisions in growth expectations and upward revisions in inflation forecast. For the time being our base case scenario is that growth will be negatively impacted by higher energy prices and commodity shortages but that ultimately it will remain above trend in all major economies this year, and that’s based on the assumption that the US and OPEC members will increase oil production and that the geopolitical situation will stabilise.

Now, given the recent tightening of financial conditions we also think central banks will be more prudent in the near term when they normalise monetary policy and we do not expect rates to move into restricted territory.

And finally, we think that the economy should continue to be supported by large excess savings and potential fiscal measures to cushion the impact of higher energy prices on the consumer. We are also encouraged by a few areas of support.

First, following the pullback, valuations are now back to their long term averages. So global equities are trading at 16 times forward earnings in line with their 30 year average and down from 20 times in September 2020.

Second, investor sentiment and risk appetite measures are quite depressed and are at levels that have been good contrarian signals in the past.

And finally, in the absence of a recession it seems that a lot of bad news is already priced in. So global equities are now discounting a sharp slowdown in economic activity and broadly flat earnings growth this year which we feel is very conservative. So all those factors contribute to a constructive view on equities on a 12 month horizon.

HP: We know that investors are very nervous. What can they do to protect their portfolios?

DD:  So option strategies to protect downside risk should be maintained, but for investors who didn’t have them in place before the selloff they have obviously become much more expensive. In multi asset portfolios investors can increase their allocations to commodities and US Tips (inflation-protected US Treasuries) to hedge inflation. In the past 50 years those asset classes have shown the beset returns in periods of rising inflation, above the 3% level. So, typically, industrial metals have been the best performer in the commodity complex in periods of high inflation, that is between 3% and 5%. But precious metals, and gold in particular, have been the best performer in periods of very high inflation, above 5%.

When it comes to US Tips they’re already quite expensive with tender 10 year breakeven rates close to 3% so you should buy them at current levels only if you believe that inflation will be above that level for an extended period of time.

In equity portfolios, as I mentioned earlier, diversification has become increasingly important and at the current time we favour a more balanced positioning and an increased exposure to the more defensive areas of the markets. So we maintain our preference for cyclicals on the one year view as they tend to benefit from higher yields and inflation, but given the risks and uncertainty in the near term we add exposure to defensive sectors as a barbell strategy.

So out of the more defensive sectors our favourite one at the moment is healthcare. It’s modestly outperformed the market year to date but it has lagged other defensive sectors. We view healthcare as an attractive hedge in case of the worst shock or further market selloff. As a typical defensive sector its earnings growth is significantly more stable than that of the overall market and almost never negative, even in times of stress. It enjoys superior EBIT (earnings before interest and taxes) margins and return on equity. And finally, relative valuations are supportive with the sector trading at about one standard deviation below its 20-year average based on forward price-to-earnings (PEs).

HP: So, following the recent underperformance of European versus US equities, which regions should investors be really focusing on now?

DD: So in our 2022 outlook we expressed a preference for non US equities and more specifically for Europe versus the US. This reflected our preference for cyclicals and value which are more heavily represented in Europe than in the US.  It also reflected our view that European earnings should continue to grow faster than in the US, a trend that we started to see about a year ago after a long period of underperformance.

So the call worked well from mid December to late February with Europe outperforming the US by 7% in local currency terms helped by the value rotation, but after the invasion of Ukraine Europe lost all of its outperformance and in early March it started to recover again. So we think Europe will remain challenged in the near term, given its proximity to the conflict and its reliance on Russian energy. We might need a resolution of the conflict or significant de-escalation of tensions for the region to outperform, but in the absence of a recession we think the relative downside risk is limited and we continue to favour Europe over the US over the next 12 months.

European equities are now trading at a historical low versus the US based on forward PEs. They’re now at a 31% PE discount versus an 11% discount on average in the past 34 years and that’s over two standard deviations below the long term average. So, to conclude, we think Europe is more attractive than the US but it might take some time for the value to be realised.

HP: Well, thank you, Dorothee, for your insight today. We know it’s a fast moving situation with broad based ramifications for financial markets and we appreciate your perspective on what it might mean for investors.

Moving on to the week ahead where central bankers are likely to take centre stage once again, we expect all Bank of England Monetary Policy Committee members will vote for a rate hike at Thursday’s meeting. They seek to remove the emergency accommodation implemented during the course of the pandemic and look to anchor inflation expectations.

In terms of the rate path, we look for a 25 basis point increase at this week’s meeting, and a further quarter of 1% at the May meeting. The back to back hikes would then put the UK base rate at 1% by midyear. However, as the UK consumer faces up to higher energy bills, higher taxes, higher interest rates, all of which could amount to the biggest annual reduction in spending power since the 1970s, we would expect some of the wind to be taken out of the Bank of England’s tightening sails. We suspect the MPC will embark upon an observation period with rates on hold from mid-year.

The US Federal Reserve looks set for policy lift off at Wednesday’s meeting with CPI expected to have an 8 handle on it in March. With unemployment below 4%, there appears to be few obstacles that will stop the Fed from hiking.

In terms of the path of policy normalisation we think that rate hikes will be frontloaded so we look for 25 basis points this week, expect five hikes in total for 2022. We think that the tightening cycle will end by mid 2023. The terminal target range for Fed funds we think will be 1.75% to 2% which is 25 basis points higher and six months sooner than the projection at the start of the year.

We also expect the Federal Open Market Committee to confirm it will complete its asset purchase programme this month and announce the balance sheet runoff in May and for that runoff to begin in June.

And with that, I’d like to thank you once again for joining us. We will be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.