We’d like to start by saying we condemn the invasion of Ukraine and our thoughts are with those affected. We are extremely grateful for your continued trust, and appreciate that the past quarter may have been challenging in terms of upsetting news headlines and heightened market volatility.
In 1937, an animator at Walt Disney (Bill Tytla) stated, “there is no particular mystery in animation… it’s really very simple, and like anything that is simple, it is about the hardest thing in the world to do.”. And this is also true of navigating the financial markets.
When there are shocks such as the coronavirus outbreak two years ago, or more recently, Russia’s invasion of Ukraine, markets act irrationally with a “sell first, think later” mindset, and all of the best laid plans of using detailed and complex macro and micro economic analysis and company research go out of the window.
This knee-jerk type reaction was reflected in the undiscerning falls we saw in financial markets during the valuation period, following Russia’s invasion of Ukraine.
As with the coronavirus sell-off two years ago, we believed it was important not to lose one’s composure: in uncertain times financial markets often tend to overshoot on the downside, before the fundamental picture ultimately decides the level at which financial markets should trade.
As such we decided it was best not to get caught up in the day-to-day noise of the market and instead maintain a long-term perspective, rather than simply following the crowd.
And thankfully, this strategy was correct, as these same portfolios had recovered much of their initial falls by the end of the valuation period, despite the fact that many of the global markets and regions remain well down over the same period.
However, we are well aware that we will likely still face economic uncertainty on the back of this horrible humanitarian crisis in Ukraine, in fact, Russia’s attack on Ukraine is likely to turbocharge inflation.
Why is this the case? Food prices are likely to see significant increases – Ukraine is one of the world’s most important exporters of wheat, corn, barley and sunflower oil – and unsurprisingly port activity in Ukraine has come to a standstill. Likewise, Russia is also a large producer of these grains – and sanctions have put an end to their supply.
Additionally, we have also seen a jump in energy prices, impacting not only fuel at petrol stations, but any number of items that have oil as part of their production cost.
Therefore, things have clearly changed since our last valuation commentary, within which we argued that inflation would peak during 2022 and start to fall back towards central bank targets of 2%. We now believe that inflation will be higher and last for longer than previously expected. However, as this inflation is not a result of excess demand we still believe that central banks will be cautious with interest rate increases. Why? Well, they won’t want to put the economic recovery at risk, and policymakers can’t control this type of inflation with higher interest rates – higher interest rates won’t make oil come out of the ground any faster, or harvests more crops.
Furthermore, the drivers of this inflation (supply chain disruptions and war) can still be called ‘transitory’. In order for inflation to remain elevated we would require the current supply chain issues to worsen and the oil price to continue to climb sharply – both of which, we believe, are unlikely.
And lastly, these drivers will still shortly become next year’s ‘base effect’ – meaning we should see inflation numbers peak later this year and then fall (and fall sharply) during 2023 on its own volition without the need for central banks to aggressively increase interest rates.
Consequently, we believe the pendulum has swung too far: by underestimating how quickly inflation will self-moderate, financial markets are expecting (and therefore have priced-in) an aggressive increase in interest rates. This means we think market expectations for inflation and interest rates will need to be corrected lower over the course of the year – which should be supportive for financial markets.
Investment Management Team