Active Thinking

At GAM Investments’ latest Active Thinking forum, Mark Hawtin, Wendy Chen and Adrian Owens discussed the impact of the Russia-Ukraine conflict on their respective asset classes, the implications for the global economy, the inflation outlook, as well as how this informs their positioning.

14 March 2022

Mark Hawtin – disruptive growth

We do not see an easy way out of the Russia-Ukraine conflict. The West is fighting the war with sanctions, with Western companies embracing this and adopting an aggressive approach. We have seen Visa, Paypal and Mastercard ban use in Russia and Apple has refused to do business in the country. We expect this to expand further, with the effect of balkanising Russia and making it almost impossible for trade to take place there. This has obvious implications for the energy sector and we are already seeing oil prices reach multi-year highs. Our concern is that this drives inflation further for longer, threatens economic growth more generally and precipitates a recession. We see this as a real possibility that we are factoring into our analysis.

Geopolitical risk necessitates that we take a more cautious stance on Chinese companies in the near term. We believe a higher risk premium will be attached to China as a result of the Russia-Ukraine conflict, based on fears China will act in a similar way in relation to Taiwan. We nevertheless remain positive on sectors with clear support from the Chinese government, such as electric vehicles, renewables and infrastructure.

Historically, we have seen that growth equities have tended to be hit first in a market downturn – but they have also recovered first. In 2008/9, the big tech names hit their low in November 2008 while the market bottomed in March 2009, meaning they were five months ahead of the market; we think it is conceivable that we will see a repetition of this trajectory.

We do not believe the structural growth areas we are focused on will change. In fact, current trends could be accelerated by the crisis. Cybersecurity, for example, is likely to attract continuous and higher levels of investment going forward. If globalisation has peaked and the Russia-Ukraine conflict signifies a move towards deglobalisation, this will feed into our longstanding theme of Digital 4.0, including manufacture on a much smaller scale and greater automation. Market timing and investment discipline, however, remain key.

Wendy Chen – disruptive growth

Current elevated energy prices are stoking fears of a recession across the globe. We see historically that a surge in energy prices tends to increase the probability of a recession. In our current environment, however, the predominant fear is a stagflationary environment, which could potentially impact a lot of economies, not least the US and Europe. Since the outbreak of Russia-Ukraine conflict, we have seen notable fund flows out of emerging markets (EM) and into the US. This flight to safe havens represents a move away from the more energy dependent countries, or energy importing countries, towards the US which is relatively stable and benefits from energy self-sufficiency. At the same time, there are fears that Russia may not be the only target for sanctions as the US could add countries that are not supporting Russian sanctions to the list. All in all, the fear surrounding emerging economies has brought more money to the US market. As a result, the S&P 500 Index is down only 125 bps over the first week of March, making it among the best performing indices. In fact historically, in comparison to an economic recession, the impact of geopolitical tensions on stock markets is generally shorter in duration, often limited to a quarter or two.

Other than the Russia-Ukraine conflict, the bigger concern is inflation, or stagflation, as well as whether we have reached the peak of globalisation. We see that sanctions, trade wars and trade restrictions have been picking up since last year, not only between China and the US but on a global scale. For the past few decades, high growth sectors such as consumer or tech have been key beneficiaries of globalisation, allowing them to reduce their costs, improve margins and boost top line growth. For instance, Facebook’s highest user growth has been coming from the Asia Pacific region and EM for multiple quarters. If such anti-globalisation trends persist, we believe this could hurt the profitability of some growth names with global exposure.

Looking at China, the topic that has been top of mind over the last few weeks is the National People’s Congress, where the growth roadmap and development priorities for 2022 were set. The GDP growth target, set at 5.5%, might seem unimpressive, but we need to bear in mind that last year China set a growth target of 6% and achieved 8% at the end of the year. So there is still upside to growth and the biggest upside could be in the Chinese government’s fiscal measures which have not been fully utilised. We see China as one of the only larger economies which still has some scope to reduce effective rates and utilise expansionary fiscal tools to inject more money into the market.

We have also seen earnings for China ADRs over the last week, which tell us a lot about fundamental trends. For example, the cloud sector in general still has relatively good earnings growth showing that cloud infrastructure and software as a service (SaaS) companies are still benefiting from structural growth and are relatively less impacted. We believe software and security is still a key theme for self-resiliency amid global security turbulence. Furthermore, we believe green energy and renewables can expect even greater policy tailwinds as steeply rising energy prices urge countries improve their energy self-efficiency, further accelerating the green energy replacement roadmap in China.

Adrian Owens – global rates

The Russia-Ukraine conflict has added to uncertainty in a number of areas. One aspect we can be more certain about is inflation, which will almost certainly be exacerbated by the war in Ukraine. Central bankers face significant challenges because although growth is holding up generally for now, the risks around it have clearly increased. We believe the war in Ukraine will accelerate a process we have been seeing for some time, namely a deterioration in the trade off between growth and inflation.

What does this mean for markets? The last two weeks have shown that investors continue to worry about inflation, hence inflation breakevens have continued to perform well. Typically, in a situation like the current one, bonds rally, but that has not been the case. Bonds tried to rally when Russia-Ukraine hostilities first broke but since then investors have come round to the view that even though the growth outlook is deteriorating, central bankers will need to act. As a result, we have seen front end rates sell off.

Looking ahead, we still think front end pricing in markets looks out of line because, unless central bankers are prepared to look through inflation, there is still not a great deal being priced in. What is being priced, however, is the view that inflation will be over in the next 18 months and by then central banks will have had to start cutting rates.

In the US, for example, over the next year investors are pricing in 175 bps of rate hikes. Over two years that increases to 195, but by year three they expect rates to start to be cut. That is even more noticeable in the UK where fewer hikes are priced in and the cuts coming in year three are even more aggressive. We believe this view is wrong because even at the peak in rates in year two, they are not going to be anywhere close to a neutral level. That is not going to be enough to slow inflation in our view.

One may disagree with this view if one holds the belief that central bankers accept inflation will be much higher for much longer – and to some degree we think that is the case. We have heard comments from the European Central Bank (ECB) and from the Federal Reserve (Fed) saying they are likely to raise rates by 25 bps, whereas there was previously some expectation that US rates may increase by 50 bps in March. We think that clearly illustrates the more cautious approach central banks will be taking going forward and as a result, the rate hiking cycle is likely to be more drawn out, at least initially. That said, if six to eight months in the future the inflation situation is not showing any signs of improvement, we should not rule out the possibility that central banks may start to panic a little more.

In our view, the investment implications are that one needs to remain short rates, but primarily at the front end, because there is a very good chance that curves of two- to 10-years will invert. Inflation breakevens have moved some way. We still see some potential there, but not to the same extent as short positions on rates.

The other big call is whether one tries to fade some of the other risk-off moves we are seeing. We have been reticent about doing this just yet and we are seeing that driving a lot of moves, even in currency markets. For example, anything euro related has been much weaker than elsewhere. There are three currencies that we think stand out as particularly cheap - Korea, Sweden and Poland. We recognise that the Polish zloty is currently being buffeted in the short term by the geopolitical situation. We think that selective Latin American markets (Brazilian and Mexican rates) look attractive, but there is a need to be mindful from a risk-reward perspective that moves are currently being determined by the tragic events in Ukraine.