Markets Weekly podcast – 21 March 2022

Henk Potts (HP): Hello. It’s Monday, 21^st 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, 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 will then consider the impact that higher oil prices could have on the economy, and which sectors are specifically vulnerable. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investors stepped back from panic mode last week to refocus on the diplomacy progress in Ukraine, and digest the latest policy deliberations from central bankers. Global risk sentiment eased on reports that Russia and Ukraine are making very tentative progress on a peace accord that could be established around the concept of Ukraine accepting a permanent state of neutrality, committing to not joining Nato, and agreeing not to host foreign military basses or weaponry. Ukraine would also have to accept Russian control of Crimea and the independence of the two separatist regions. Any agreement would probably need to be accompanied by a security guarantee that’s underwritten by Western governments.

Hopes of a resolution provided a boost to risk sentiment. Equity markets surged, oil eased back, although it’s still around $111 a barrel for Brent this morning, and bond yields rose. We spent a great deal of time discussing the importance of being and staying invested, how timing the markets is a difficult game to play, and recoveries can be swift, a noble example of that in the remarkable rebound we saw in equity markets last week.

In Europe, the STOXX 600 was up 5.4%, registering its best weekly gain since November 2020. The index has now erased the 9% losses racked up since the start of the invasion. A very similar picture over on Wall Street. The S&P 500 was up 6.2%. In bond markets, 10-year Treasury yields rose to 2.14%. Yields have registered their largest two-week gain since November 2016 and are up ten out of the past 13 weeks, reflecting, of course, the expectation that the US central bank, the Federal Reserve, will continue to normalise interest rates.

Chinese stocks were sent on a wild rise. Investors experienced double-digit gyrations as a range of factors appeared to unnerve investors, including concerns that China would face sanctions if it provided military assistance to Russia, something that Chinese officials have consistently denied. China continues with its near zero-COVID strategy, but also fears over the country’s regulatory crackdown which may seek to further reduce the power of the biggest tech operators as part of the government’s common prosperity doctrine. There are also worries that some Chinese tech firms could be forced to delist from US markets for failing to meet SEC transparency requirements.

However, in sentiment terms, the State Council vowed to keep capital markets stable, support overseas stock listings, said it was having a good dialogue with the US regarding AVRs, and promised to implement measures to handle risk for property developers. They also stated that the regulatory review, which has been overhanging the tech sector, will end soon, although failed to offer a timeframe in which that would happen.

We think the outlook for Chinese equities remains supportive. Valuations are attractive and earnings growth remains robust. Policymakers, you will remember, moved to this easing bias in the second half of last year, and are expected to further cut policy rates and boost credit expansion.

Its long-term growth profile, we think, remains robust as it makes that transition to becoming a sustainable, high-tech, domestic-consumption-led economy. So we think that Chinese equities could be a solid performer in the second half of the year, but that does assume that the promised support is indeed forthcoming.

Central banks took centre stage last week. The Federal Reserve, as expected, began its rate hiking cycle with a 25 basis point increase. That’s the first increase we’ve seen since 2018, taking the Fed funds range to between a quarter and half of 1%, as they seek to normalise policy further as officials react to inflation which is approaching 8%. Remember, it’s been running at its highest level in nearly 40 years and unemployment has fallen to a post-pandemic low of 3.8%.

St Louis President James Bullard was the only dissenter. It’s noted, of course, that he voted in favour of a half point hike. In a hawkish outlook statement, Fed Chair Jerome Powell stated the American economy is still very strong and well positioned to handle tighter monetary policy. That was despite downgrading its growth forecast from 4% to 2.8%.

The Committee expressed its determination to use its tools to return the economy to price stability after participants ratcheted up their PCE price inflation projections, citing that geopolitical developments are likely to extend the duration of supply bottlenecks, and some evidence that price pressures have spread more broadly across services.

This determination was expressed in the dot plot, where the medium projection was for the benchmark rate to end this year at 1.9%, and then rise to 2.8% in 2023/2024. So, in terms of the path of policy normalisation, we’ve reflected the hawkish statement in our revised forecast. We now see back-to-back hikes at the remaining six meetings, that’s marking seven hikes in total for 2022, then two more 25 basis point increases in 2023, putting the terminal rate for Fed funds at 2.25% to 2.50%.

The Bank of England maintained its back-to-back hiking cycle by raising UK base rates for the third consecutive meeting. The increase to three-quarters of 1% marks the fastest pace of tightening since 1997, driven by strong growth, tightening labour markets, and rising inflation. The UK economy, of course, grew at a better-than-expected eight-tenths of 1% in January. Unemployment has fallen to 3.8% and vacancies now stand at a record 1.3 million in the UK.

The Bank of England are forecasting that inflation will hit 8% in the second quarter. They’ve also warned that peak inflation may only come in Q4. This is as Ofgem increases energy price caps and the war in Ukraine exacerbates those global supply-disruption issues. However, uncertainty from the war in Ukraine, fears that the rapidly rising squeeze on disposable income, and forecasts that inflation will fall back materially as you look through 2023 did encourage the MPC to soften the outlook language to “future tightening might be appropriate”, which is a downgrade from “likely”.

In terms of the interest rate outlook, we expect one 25 basis point hike at the main meeting, then UK rates on hold at 1% as the MPC assesses the incoming data.

So that was the global economy and financial markets during the course of last week. In order to discuss the impact of elevated energy prices on markets, I’m pleased to be joined by Dorothée Deck. She’s Cross-Asset Class Strategist with Barclays Private Bank.

Dorothée, great to have you with us today. So, let’s get started. The oil price has been extremely volatile, as we know, in recent weeks and despite its retrenchment in the past ten days, it is still up substantially from its December levels. How much of a risk does this represent for markets?

Dorothée Deck (DD):  Hi, Henk, good to be here. Yes, absolutely, the oil price has been extremely volatile lately on fears of supply disruptions. It’s moved from $97 a barrel, just before the Russian invasion of Ukraine, to a peak of $128 in early March, then back below $100 mid-March, and up again in the past couple of trading sessions.

The situation in Russia and Ukraine remains highly unpredictable, and until we have more clarity on the geopolitical front, energy prices and commodities in general are likely to remain highly volatile. Between late December and early March, the oil price surged by 73%, and that was mostly driven by supply factors, according to data from the New York Fed.

Now, when trying to assess the impact of higher energy prices on markets, one has to consider the speed and magnitude of the increase, but also its drivers. So, since the global financial crisis there has generally been a positive correlation between equity returns and the oil price because gently rising oil prices have tended to coincide with periods of stronger economic activity.

However, sharp and sustained increases in the oil price have often led to recessions, especially when they were driven by supply shocks. And, as I mentioned earlier, the most recent shock, which started in late December, was supply-driven. So, while it is impossible to predict how the situation in Russia and Ukraine will evolve, or how long it will last, it is certainly a risk that we cannot ignore.

HP: Dorothée, are there any reasons to believe that the global economy might be more resilient to an oil shock today than we’ve seen in the past?

DD: Yes, we believe so. Of course, the geopolitical situation complicates the environment and adds another layer of uncertainty, but generally speaking we see a few reasons why the global economy would probably be more resilient today than it was back in the 1970s and ‘80s.

First, and foremost, the global economy has become significantly less energy intensive in the past few decades, especially in advanced economies. Today, for example, the US generates almost three times as much output for every unit of energy consumed than it did in 1970, and for Europe that figure is more than two times. The world economies have also come into this crisis with strong economic momentum and above-trend growth. In addition, consumers in the US and Europe have accumulated large excess savings following the pandemic aids, which means that they should be able to absorb higher energy costs more easily.

And finally, we see the potential for governments to implement fiscal measures to mitigate the impact of high commodity prices on the consumer.

HP: So what lessons can we learn from history? How have markets generally behaved following supply-driven oil shocks?

DD: So, we identified 10 supply-driven shocks in the past 50 years, which lasted five months on average, and saw the oil price increase by at least 20%. We used data from the New York Fed, which basically decomposed weekly changes in the oil price into demand- and supply-related factors. Their dataset only goes back to 1986, but we classify the shocks of 1973 and ‘79 as supply-driven as they were well known to have been caused by supply restrictions following conflicts.

Our analysis shows that global equity markets typically troughed seven months after the start of the supply-driven shock, with an average drawdown of 7% and losses were fully recovered within nine months on average. The worst individual drawdown was seen in March 2009, when global equities were down 52% from the start of the previous shock in April 2008, but we have to keep in mind that this was at the low point of the global financial crisis and equity markets were driven more by the financial crisis than the preceding oil shock.

The second-worst drawdown was seen in October 1974, 16 months after the start of the shock, and so global equities declined by 39%. We also looked at the performance of metals during those periods, and we found that global typically performed very well in the month following those shocks.

The precious metals was up 25% on average after 12 months, and it peaked at 42% after 20 months. As such, gold acted as an attractive hedge in multi-asset portfolios when equities were weak. So typically, when global equities troughed at minus 7% after seven months, gold was already up 7% on average. Copper generally outperformed global equities in the year following a shock by 12% on average, but it was a less consistent diversifier and significantly underperformed gold in those periods.

HP: OK. So let’s drill down a little bit further. Which have been the best and which have been the worst performing sectors?

DD: So unsurprisingly, energy has been by far the best performing sector globally in the year following a shock, outperforming the market by 15% on average. Four other sectors have tended to outperform, by 4% to 6% on average, in the same period. They include basic materials, another commodity-driven sector, healthcare, and utilities to defensive sectors, which outperformed as global activity was deteriorating in the year following the shocks, and, financials, which were supported by the rising yields and inflation observed after the shock.

In contrast, technology has been the main laggard, underperforming the market by 11% on average in the first year. The sector tends to underperform in periods of rising yields due to the long duration of its cash flows. Consumer staples and consumer discretionary have also been notable underperformers, lagging the market by 7% and 4% respectively in the first year, and that probably reflects a combination of lower consumer spending activity and weaker corporate margins.

Now, if we look at the relative sector performance globally since the start of the last shock, late December, we find that it has been broadly consistent with the historical trends I have just highlighted. The best performer has been energy, the worst has been tech. Basic materials, utilities, and financials have all outperformed. However, healthcare hasn’t reacted much and has performed essentially in line with the market, but in previous shocks we also noted that this sector generally performed pretty much in line for the first six months and really started outperforming after nine months, as the economic environment deteriorated.

HP: Well, thank you, Dorothée, for your insight today. It’s great to get a better understanding of the wider impact of higher oil prices on markets, and specifically which sectors could be vulnerable.

Moving on to the week ahead, in the UK the Chancellor will deliver the spring statement and the OBR will present its updated fiscal and economic forecast. The OBR will be dealing with significant uncertainties in its fiscal forecast update, particularly on how much of the strength in tax receipts to carry over into future years. Our sense is that it will carry over much of it, leaving the fiscal forecast in a healthier position, notwithstanding the drag to the outlook from the war in Ukraine as well as much higher debt interest spending.

On policies, there are calls for the Chancellor to deliver further support for households to deal with the increasing cost of living, on top of the £9 billion package announced at the beginning of February. We’re sceptical that he will deliver anything substantial at this stage.

In terms of UK data, we expect February inflation to print strongly, continuing its ascent to above 8% in the second quarter. We forecast headline CPI will be up seven-tenths of 1% month on month, up 6% year on year, as firms increasingly pass through cost pressures to consumers.

In Europe, on Thursday we expect March PMIs to deteriorate sharply, reflecting the first effects of the war in Ukraine. Such a hit to confidence, elevated inflation, and new bottlenecks are likely to shine through. Higher disruption to supply chains could result in manufacturing output being hit more than services.

We expect the Swiss National Bank to keep rates unchanged, with a risk of its rate normalisation process lagging behind that of the European Central Bank, but domestic inflation is picking up, the inflation forecast is set to be revised higher at this meeting. As such, we expect the bank to use FX as a de facto policy tool to not curb the franc’s strength as strongly as before, as long as the euro/franc is above parity. This is despite the fact that the SNB is likely to continue to cite franc overvaluation and keep its rhetoric on no hesitation to intervene on the policy statement.

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