11 Mar Why Putin’s folly provides a dilemma for Central Banks
Only a few weeks ago when we sent the January edition of the half-yearly profile report, we said that inflation would be the statistic to watch in 2022. Whilst it is probably too early in the year to wallow in self-congratulation, so far our prognosis has been spot-on. The announcement on Thursday that inflation in the US had reached almost 8%, a four-decade high was not surprising, nor is it likely to be the peak, but it serves to heighten the challenge facing central banks.
Before Putin rolled his military hardware into Ukraine, inflation in the west was already starting to gain traction and cause central bankers a few sleepless nights. The conflict is very likely to make the inflation conundrum worse and whilst all eyes are on energy costs, the world relies on Russia and Ukraine for a lot more than oil and gas. Base metals, chemicals and wheat prices have all risen strongly and that simply makes the inflation outlook worse.
This puts central banks in a tight spot. Putting the crisis aside for a moment, inflation spiralling as much as it has in recent months, would naturally lend itself to higher interest rates but recent talk in the media has been about whether central banks might soft-pedal on this given the uncertainty. This makes little sense to us because, in the case of the Bank of England, it has one mandate – to control inflation, and we think going soft on the decision to raise rates, effectively allows inflation to become unanchored and that would not send a good message to markets.
Whilst we think it is not wise, we would not be surprised to see the Fed and the Bank of England moderate interest rate rises, but they both need to remember that inflation aside, the world economy was strengthening before the conflict. Consumers on both sides of the Atlantic have shown themselves to be very willing to spend, buoyed by rising house prices, wage growth and strong financial markets last year. They also have high levels of savings by historic standards so jacking up interest rates does not necessarily spell peril for the economy.
This is relevant because usually, in times of uncertainty, investors move assets to areas they think provide sanctuary, and bond markets are usually the beneficiary of this. When this happens, bond yields fall (prices go up) but this time around, this simply hasn’t happened. This is because whilst government bonds in particular are generally seen as safe, yields were already low, and rising inflation simply compounds what is a poor return. Moreover if rates do have to rise as a consequence of inflation, bond yields will go up (and prices will fall). This is the reason we remain underweight in bonds.
Of course, if we are underweight in one place, we have to be overweight in another, and for some time that has been equities. Whilst this benefitted performance in 2021, it has meant 2022 has not got off to the best start. But investors should not get too despondent and the reason is two-fold. Let’s start with the following chart.
This shows the performance of the S&P500 index in the US for every calendar year since 1980. The blue bars represent the eventual return for that year and the amber the lowest point during that year. Notice that just because the market falls in any one year, does not mean it will end the year in that position. True 2008, 2015 and 2018 all proved to be down years for the US market, but in each case the market clawed back some of the downturn. A compelling reason, if one were needed why investors should try and resist the urge to panic, or feel like they should take some sort of corrective action.
The second reason for some optimism is earnings. The basic premise of buying equities at all is based around company profits and earnings. Very broadly, when the economy is doing well, so too will company profits. Over the long term, company earnings are actually pretty stable. During COVID company profits did take a dip, largely because of the unprecedented decision to turn off the economy, but during 2021 earnings rebounded extremely quickly. In fact about 80% of earnings announcements beat analyst expectations over the course of the year.
Whilst company earnings are generally stable, stock prices as we know, are not. This is largely accounted for by investor behaviour. Investors panic when things are uncertain, like they are in Ukraine, but they also have an unhappy knack of getting too carried away when things are going well. This disconnect between the long term driver of the stock market, earnings, and the shorter term gyration in prices creates opportunities for investors that can keep their cool.
The final point to make is that investing in stocks (or funds) is not just about selection, it’s about weighting. If we pick a fund where the manager is having a tough time, but we get the weighting to that fund right (i.e. we do not go gung-ho), it does not spell disaster for the entire portfolio. It is only where the fund selection and the weighting is wrong that truly compromises the overall return. This is why CDC portfolios use multiple funds, spread across a variety of managers and dedicated to a range of assets, meaning we do not ‘stake the ranch’ on any one theme.
For now, Putin’s actions will test the resolve of central banks and will likely weigh on market mood, but eventually, as we saw with COVID, stocks generally dance to a different tune. And that’s earnings.
Dr Andrew Mann
Investment Director