Markets Weekly podcast – 7 March 2022

Henk Potts (HP): Hello. It’s Monday, 7^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, 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 the importance of maintaining composure during times of economic and political uncertainty. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

As we know, it was a truly tumultuous week in global financial markets as traders rushed to price in the full political, economic, and financial market ramifications of the conflict in Ukraine, as Russia intensified its military campaign, and the West implemented a programme of sweeping sanctions.

Equity markets drowned in a sea of red, developed government bond yields slumped, and commodities extended their relentless rally. European markets were at the heart of the turmoil. Investors sold out of European equities and fled to cash. Data from EPFR Global showed, in the week to 2^nd March, European equity funds and financial stocks had their largest ever outflows.

European shares registered their biggest weekly decline since the start of the pandemic. The STOXX 600 was down 7%, taking into account the near 4% drop that was seen on the European bourses this morning. It’s now down around about 20% from its record high in January. Banks and automakers have been amongst the biggest decliners.

The euro dropped below the $1.10 mark for the first time since May 2020, and is down from $1.23 in early 2021. This is as traders price in widening growth and rate differentials.

Over on Wall Street, the S&P 500 was also down last week, but only down 1.3%, but is still down 9.2% year to date. Some of the most dramatic moves were across the commodity complex, where supply routes are becoming dislocated as Russia becomes increasingly isolated from the global economy, exacerbating already historically low stockpiles.

The Bloomberg Commodity Index had its strongest week in 60 years, surging more than 9%. Aluminium jumped to fresh record highs. Wheat surged above the €400 a tonne mark, which is the highest since 2008. The real action, of course, has been in the energy market, where we’ve seen Brent crude this morning surpassing $130 a barrel. That’s its highest level since 2008.

Investors certainly appreciate the main challenge of the impact for the European economy comes from the energy market, with Europe importing about 40% of its gas from Russia and about 25% of its petroleum oil products.

Ukrainian pipelines are the second most important route, accounting for around one-third of the Russian flows into Europe. So, as we know, there are valid concerns over how much gas will Russia send through that Ukrainian pipeline, and any potential damage to the infrastructure. Alongside that, Russia, as we know, is a major oil exporter, at around five million barrels per day, almost half of which goes into Europe.

In an effort to try and reduce the upward pressure on crude prices, the International Energy Agency said the US and supporting nations, including the likes of Japan and Germany, agreed a coordinated release of oil reserves. Sixty million barrels of crude will be released from those strategic reserves, 30 million of which is coming from the United States. It’s the second time, actually, in only a few months the US has tried to improve supplies.

The impact on crude prices so far, you have to say, has been derisory. This is after traders realised the release equated to just six days’ of Russian production. Markets, I think, also appreciate the level of strategic reserves are limited. Remember, the SPR was set up by the US back in 1975, following the Arab oil embargo. At the end of last year the US had around 600 million barrels. Data showed at the end of September OECD governments held around 1.5 billion barrels, but to put that in some sort of context for you, the global economy uses around about 100 million barrels of oil per day.

The impact of higher prices and even potential rationing, of course, could weigh on industrial production, corporate profitability, and households’ real income, which in turn would have a negative impact on real GDP, and that’s started to be reflected, I think, in economists’ forecasts. We’ve lowered our 2022 global growth forecast from 4.3% to 3.4%, so the biggest impact likely to be felt in Europe, where we’ve reduced our growth this year by 1.7 percentage points to 2.4%, and raised our inflation expectation by 1.9 percentage points now to 5.6% for this year.

That said, the size of the impact, as we know, will differ across countries, and will also depend on the fiscal measures governments might take to try and limit the path through this additional energy shock on consumers and firms. Such measures would include special mitigating payments, and potentially the reduction in levies and taxes.

So, in order to discuss the importance of understanding our emotional response to dramatic events, and how they can influence our investment decisions, I’m pleased to be joined by Alex Joshi, who’s our behavioural finance expert.

Alex, great to have you with us today. Why is it particularly important to be aware of the behavioural and emotional aspects of investing during periods of market stress?

Alex Joshi (AJ): Hi, Henk, great to be here. So, at times like these there’s a risk of investors becoming more short term in our thinking and our actions, because during periods of stress our time horizons shorten, and this gets exacerbated by the continuously updated news cycle, which is going to be far shorter than investors’ typical investment horizon.

Now, the emotional reaction that we might experience, whether that’s to the news itself, but also on the impact that it has on our portfolio, this can exacerbate behaviour biases, and by behavioural biases a couple of pertinent examples at a time like this.

So loss aversion is the first one. Losses, psychologically, have a greater impact on us than equally-sized gains, and so for investors, this can lead us to want to take decisions to avoid experiencing them. So this might be holding off on a planned top-up to an investment portfolio, or even wanting to sell out. Linked to that is this thing called “regret aversion”. So we don’t want to take decisions that we fear might be wrong in hindsight, and this can lead to some investors wanting to particularly time the market.

Now, both of these are exacerbated by something called the “availability heuristic”. A heuristic is a mental rule of thumb, and this is one where we overweight more recent market events. So we can lose historical perspective by focusing too much on things that are happening right now at this moment in time, and this can skew our perceptions of the riskiness of investing.

So, together, these things can lead to actions which, taken through a short-term lens, may provide short-term comfort, so selling out of investments into cash. They allow us to feel like we’re doing something, but these can, unfortunately, drag on returns over the long term, something that we call the “behaviour gap”.

So, in the absence of a crystal ball, there are two things that investors can do. The first is to look back at history for perspective, and secondly ensuring that our responses are proportionate and are in line with our longer-term objectives.

HP: Alex, what does history tell us about the importance of maintaining composure? What are those key lessons that we’ve learnt from previous global events?

AJ: Sure. So, whilst we can’t easily draw comparisons with historical events just given this chapter’s currently being written and we don’t know what’s going to happen, the analysis of previous geopolitical and military events is a very useful starting point. So, if we look back at the most similar sorts of events, 9/11, Cuban missile crisis, Iraq, etc, what we typically have seen for these sorts of crises is that there’s been sharp price action. So we’ve seen violent corrections in markets, but relatively quick recoveries.

So, in one table that I’ve seen of 12 of the most similar events, within a month, the S&P had recovered to its prior level in 50% of cases. And if we look out 12 months, in 75% cases we’d seen a rebound. And so the key point here is that these events don’t typically lead to a bear market.

However, this is the most significant conflict in Europe since World War Two. You know, we don’t know how it’s going to evolve in reality, and it’s happening within a different macro and market context. So in addition, there’s also going to be a second-round effect, such as central banks’ reactions, potential changes to consumer behaviour that need to be factored in.

So it’s important, I think, to now let’s take a step back and think about volatility on the whole. And let’s remember that volatility is the norm in investing, particularly in riskier asset classes like equities and high yield bonds.

And when we look at, you know, markets, on the whole, the broad multi-decade uptrend that we’ve seen in markets has been interrupted by regular drawdowns of 10% or more, and these tend to happen every 18 to 24 months. But the market moves on upwards, and this is due to the gradual improvement in wealth, health, productivity, technological advancements that gradually, but continuously, power on over time.

And these tend to be a constant feature of the progress of society. So, each correction had a different catalyst, and whilst these often seem extremely significant at that specific moment in time, these events have a strong tendency to fade into significance as companies and the wider economy learn to adapt to them, and that’s if these catalysts have any lasting impact at all.

So, after drawdowns, we see relatively robust rebound soon after, and just as Julien said on the podcast this time last week, we suggest that staying invested is likely to be the most sensible approach due to these difficulties of market timing.

HP: So we know it can be difficult to try and keep this perspective during such times. Why is that?

AJ: So, in terms of uncertainty, unexpected and dramatic news can lead to violent market moves. And, according to models of rational decision-making, individuals make judgements on the likelihood of events occurring based on a conditional probability rule, and we update this when we receive new or additional pieces of evidence. However, research in experimental psychology suggests that most people tend to overreact to unexpected and dramatic news events.

In revising their beliefs, individuals tend to overweight recent information and underweight prior data, the availability heuristic which I made reference to. And this is violating a basic principle, which is that the extremeness of news should be moderated by considerations of probability. And so just as we as individuals experience extreme emotions which affect how we see the world, so can the market. So sentiment often becomes excessively bearish, and this is what can prompt kneejerk responses from investors.

Sentiments currently are at a decade low, and previous troughs have followed major geopolitical shocks, and obviously the reality is we don’t know what’s to come. But for those who recognise that they have the ability to see a period like this through, and by ability I mean financial liquidity, this could be an opportunity. What we find at times like this, is that investors are not necessarily running low on financial liquidity, it’s emotional liquidity which is being run down. It’s this composure to see through these periods.

HP: So what sort of practical steps investors can do to hold their composure through these periods of turmoil?

AJ: So, it all comes down to short term versus the long term. As we say often, long-term historical performance of markets shows that investors that can stay the course have been rewarded with growth, which compounds impressively over time.

So it’s important to find ways to keep focused on the long term, and so here are a few reflections for investors to keep in mind when thinking about news events that are going to happen in the coming days, weeks, months.

One thing you’ll notice is these aren’t specific to Russia. They’re not specific to the current geopolitical events that are going on. But that’s the point, you know, things happen regularly which cause volatility in markets, and these are in different forms.

So here are a few reflections. First, why are you investing? It’s important for investors to really think about their true motivations and goals, and then when looking at news events, consider whether and how these specific events will affect those goals.

Secondly, are you distinguishing between the wider market and your own individual portfolio?  If investors are holding a well-diversified portfolio that’s been produced using a robust investment philosophy, much of this is going to be noise.

Next, are you holding a well-diversified portfolio or adequate hedging to make it easier to withstand these volatile periods? Diversification makes sense not only from a financial point of view, but also from an emotional point of view. It protects an investor from some of this uncertainty and volatility which can lead to some of these kneejerk reactions.

When thinking about the news, it’s also important to ensure that you’re weighing up all scenarios, and not just focusing on the worst case, something which is particularly difficult when the news is emotive, as it is now, but it’s important to be thinking about all these scenarios and remembering that there is a, you know, a distribution of probabilities here.

Next, timing works if you can predict the markets, but can you? There is a lot of uncertainty here. Things change, markets move very quickly, which can catch investors out that attempt to time around events like this.

And finally, are you considering possible opportunities as well as risks? Due to what I mentioned before around loss aversion, when we’re in a period like this we see the world through a loss frame, but it’s also important that periods of market volatility also, you know, produce opportunities for investors.

So in conclusion, recognise this is a difficult time. It’s unsettling, but as investors the key focus of your attention in the context of investing, it should be on your long-term goals. You know, remember your horizon, think critically about whether and how events might affect your goals, and we recognise there is a cost of staying invested. This is the cost of holding your nerve, but for the long-term investor looking to protect and grow wealth, we’d argue, based on history, that the benefits are worth these costs.

HP: Well, thank you, Alex, for your insights today. We know markets will be particularly volatile over the course of the next few weeks, if not beyond that, so it’s really important for investors to learn those lessons from the past, and make decisions based on facts rather than their emotions.

Moving on to the week ahead, the focus, of course, for investors will remain on that developing picture out of Ukraine, specifically its impact on the European economy and policy. The increased uncertainty is expected to moderate the speed of policy normalisation in Europe, despite rising inflationary pressures. Remember, eurozone inflation exceeded expectations and accelerated up to a record high last month. Consumer prices surged to 5.8% year on year in February, that was up from 5.1% in January. We should remember, of course, that does not include the spike that was seen in energy prices over the course of the past week.

Energy continues to be an important driver, but inflation is elevated across many areas of core goods and services in Europe, with two-thirds of items included in the consumption basket growing at over 2% year on year. Pressures are amongst the greatest in goods and services that are sensitive to reopening, as firms seek to make up for lost price momentum during the course of the pandemic, or maintain or increase profit margins by passing in increased costs to consumers at a time of robust demand.

At the European Central Bank meeting on Thursday, we expect the central bank to materially downgrade its growth forecast, upgrade its inflation projections for both 2022 and 2023, and the communication we think is likely to stress the uncertainty around the forecast, and the need for the central bank to maintain flexibility.

The European Central Bank are expected to keep policy rates on hold, and could signal a new quantitative-easing programme could be launched if required. Pre conflict, remember, the market was contemplating the possibility of rate hikes during the course of this year. That was following Christine Lagarde’s hawkish pivot at the February meeting, although we thought, actually, at the time that was unlikely and lift off would actually wait until March 2023. But, as we know, rate-hiking expectations have been tempered even further, given the energy shock and the potential impact on domestic demand, along with moderate wage growth, and little evidence of a de-anchoring of inflation expectations.

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.