Quarterly Insights – Q1 2022
“How did you go bust? Two ways: gradually, then suddenly.” Ernest Hemingway
Writing a quarterly centred around financial markets and investment returns seems rather inappropriate in the context of the very real human suffering currently being endured by the people of Ukraine. These tragic events do however serve as a timely reminder that we cannot ever become complacent as to the risks we face when trying to ensure that our peace, prosperity and hard-earned freedoms are secure for future generations. As President Zelensky keeps reminding us, the Ukrainians are not just fighting for their freedom but for ours as well. Whilst what we do at Shard Capital very much focuses on trying to secure the financial future and wellbeing of our clients we understand that right now the bigger picture matters just as much, if not more.
With this reality firmly in our minds we can all agree that the first quarter of 2022 was understandably a very challenging time for the global economy and global financial markets. The conflict in Ukraine has revealed Putin to be openly hostile to the west and effectively means that the “new global order” which came into being in November 1989 with the fall of the Berlin Wall, and which heralded the rise of globalisation, with all the benefits that has brought millions of people around the world, has now gone sharply into reverse. For sure the Covid pandemic had already put in play a greater focus on “re-shoring” of jobs and of ensuring global supply chains were more secure, but the political and economic fallout from the invasion of Ukraine has most certainly expedited this trend. With the global economy gradually re-opening during the second half of 2021 the sudden increased demand for good and services, added to constrained supply chains as mentioned previously, caused an upsurge in inflationary pressures around the world. As the graph below shows consumer price inflation in the US has now reached almost 8%, more than three times the average over the last 30 years! Events in Ukraine over the last month further added to these inflationary pressures, particularly in the crucial sectors of food and energy. Central banks around the world are therefore now faced with the prospect of having to raise interest rates in order to try and get inflationary pressures back under control.
Worries that interest rates were going to rise sharply was the primary reason that most global bond markets have had the worst start to the year for over three decades. Since hitting an all-time high on the 31st December 2020, the Bloomberg Global Aggregate Bond index has since fallen 11%, with more than half of that loss coming over the last 3 months alone. Losses from the December 2020 high equate to a monetary loss of close to $2.6 trillion in nominal value. Equity Indices have also fared badly this Quarter with the S&P500 falling 4.6% and the tech heavy Nasdaq down 8.8%. Given the proximity to the conflict in Ukraine and the generally higher reliance on Russia for energy supplies European markets were particularly badly hit during Q1. Having been down as much as 18% at one stage during the quarter the Stoxx 50 Index closed the first quarter down “only” 9% as investors became reassured that the conflict was unlikely to spread further into Europe.
Chinese stocks had a particularly bad quarter given continued economic pressures resulting from their Zero Covid policy which has obviously had a negative impact on GDP. Added to that, investors have also been concerned at increased government intervention and the use of regulation as a policy tool. This has in particular affected large consumer facing technology companies and the property market. In this context it is therefore unsurprising that the CSI 300 fell 13% over the first quarter.
Clearly commodity prices have fared a lot better during Q1 2022. Wheat has risen by 30%, Oil by 38% and Natural Gas by 51%. To give a broader perspective on commodity prices the S&P Goldman Sachs Commodity Index rose by 33% over Q1, clear evidence of the inflationary pressures referred to earlier which is now concerning governments and central banks around the world.
“A geopolitical supply shock of epic proportions created the perfect storm”
In view of the foregoing how do we see things unfolding for the rest of 2022?
If we were to briefly summarise the outlook for 2022 we would say that, given the two major events that have unfolded over the last 3 years – the Covid Pandemic and the Russian invasion of Ukraine – this is likely to be the year that many of the mistakes made by policy makers over the last 20 years finally come home to roost. Some (ourselves included) would argue that central banks now face a perfect storm of their own making. Why is that? Here are our thoughts:
After the GFC, and in order to rescue technically insolvent banks, most major central banks introduced “temporary” emergency measures in March 2009 and, as they say, there’s nothing more permanent than a temporary government program! Rates were cut aggressively, and central banks embarked on Quantitative Easing (aka QE, where you create money out of thin air and use it to buy government bonds in an attempt to drive interest rates down across the entire risk-free curve). Of course, what started as a “temporary” measure has ended up becoming part of official central bank policy. I mean, if you can create money out of thin air to keep interest rates artificially low what could possibly go wrong?
The chart below shows US CPI compared to the Fed Funds rate, i.e. the rate of interest set by the Federal Reserve. You will note that for pretty much the entire period from March 2009 to today the orange line (inflation) has been above the white line (interest rates), in other words inflation has been consistently higher than the rate of interest earned safely with a bank. We call this negative real rates of return. It will not have escaped anyone’s attention that whilst negative rates of return averaged around -2% for most of that period, today the negative rate of return stands at a staggering -7.3%! You don’t have to be an economist to conclude that the Fed is not just “behind the curve” here……it is positively asleep at the wheel.
So, why is the Fed so far behind in raising rates in order to fight inflation? Well, this is the bit where “actions have consequences” comes in.
In a world where rates of interest are below the rate of inflation investors can effectively borrow money “for free”, and if you can borrow money for free why would you not do it. At a personal level millions of people around the world have benefited from the lowest rates of interest on record as home prices have soared. In the same vein, financial assets such as equities and bonds have also risen sharply over the last decade supported by record low interest rates and plenty of bank liquidity.
But therein lies the rub. We all understand that low interest rates (negative real rates) were the primary cause of rising global asset prices. It follows therefore that higher interest rates will most likely act as the pin which bursts the global asset bubbles which central banks have helped to create. Higher interest rates, unsurprisingly, are like kryptonite to asset prices.
Below we show Robert Shiller’s CAPE Index. This plots the cyclical (10 year) Price-to-Earnings ratio of the S&P 500 against long-term interest rates. With rates at historic lows and markets close to historic highs we pose a simple question……what do we think would happen to asset prices if interest rates get anywhere near to long-term average levels? Say only 4%? As the graph above shows, US CPI is currently at 7.8%, so even at 4% rates would still result in deeply negative real rates! We believe that asset prices are so highly dependent on low (negative) interest rates that Fed funds are unlikely to get anywhere close to that level without asset prices collapsing. We suspect the Fed share this view, though they are unlikely to admit it publicly.
So, this is the dilemma the Fed faces this year: do they make a real effort to raise rates in order to meet their price stability mandate by fighting current inflationary pressures or do they only pretend to fight inflation and end up compromising on their mandate and let inflation “run hotter for longer” in order to fend of a likely recession which would result from pursuing the first option.
We suspect the latter for two main reasons.
Firstly, we believe that the level of indebtedness within the US economy, in particular at the Federal level, presents a systemic risk in an environment where rates are raised to anywhere close the level required to generate positive real rates of return and where inflation becomes less of a concern.
Secondly, we believe the US economy is fundamentally weaker than many analysts estimate and that much of the “strength” seen over the last decade was principally a function of an economy which is deeply “financialised” and therefore highly dependant on low interest rates in order to “prosper”.
The “Bubble of Everything” that central banks helped create over the last 12 years now hangs as the proverbial Sword of Damocles over their collective heads. The room for manoeuvre is perilously narrow and by extension therefore the room for policy errors is extremely high.
“Another reason we believe the Fed will move very cautiously is due to the importance of house prices for the average American”
Home ownership, certainly in the likes of the US, UK, Canada, Australia and NZ, has been at the heart of economic prosperity and wealth creation for over 30 years. It is a highly political asset class and one which, as the sub-prime crisis highlighted, is deeply interconnected with financial markets globally. In most cases house values are a function of affordability and one of the key determinants of that are interest rates. Given the very high valuations in the housing markets around the world low interest rates are critical in helping to support valuations. However, the chart below shows show 30 Year mortgage rates in the US have skyrocketed in a matter of a few months and are now at their highest level in 10 years.
Now it is true that higher mortgage rates “only” affect those currently looking to buy but added to higher food and energy costs resulting from the conflict in Ukraine, higher mortgage (and other loan rates) are only going to further weigh on consumer confidence in the months ahead.
It is also worth noting that, as the graph below shows, the Fed is being forced to raise rates in an environment when Manufacturing PMI’s have already begun to roll over, not something that would usually be advisable all things being equal. This in itself will likely cause them to exercise considerable discretion in the months ahead.
Neither is the US in the same comfortable position it enjoyed during the oil price shocks of the 1970’s (Yom Kippur in 1973 and the Iranian Revolution in 1979). At that time US Government Debt to GDP was only 35% whereas now it is 4 times higher at 140% of GDP. Likewise in the 70’s Household Debt to GDP was only 45% whereas it now stands at 75%, so flexibility to raise rates is severely constrained given the high level of indebtedness.
Lastly much energy is expended by market practitioners as to what is the most accurate indicator of the probability of a recession in the US. We do not want to add unnecessarily to the debate except to say whether you look at the spread between 2 Year US Treasuries and 10 Year US Treasuries (2’s/10’s) or 5-year vs 10 Year (5’s/10’s), or 10’s/30’s, they all send a similar basic message, namely: something is not quite right with the US economy just now. We prefer the 2’s/10’s where the attached graph would suggest a slowdown in economic activity is likely between 6 to 12 months down the road. Effectively, so the theory goes, every time the yield on the 10 Year Treasury is the same as or lower than the yield on the 2 Year Treasury a recession occurs within this time frame.
“In this more uncertain environment why would anyone limit their Asset Allocation to only Equities and Bonds”
One of the consequences of high and persistent inflation and extreme valuations, is that historic correlations tend to breakdown. Evidence suggest that once inflation is structurally above c. 3%, bond and equity correlations turn positive, an environment capital markets have not experienced for the last 30 years. If bond and equities are the only two asset classes you can allocate to, and these prices start to move in the same direction, investors will be in for a difficult ride.
This, in combination with our more cautious outlook for the global economy in 2022, is why we continue to have a significant bias towards alternatives. Alternatives means different things to different people but for us it encompasses commodities (including precious metals), property (including infrastructure), Hedge Funds or Relative Value investment strategies and Private Equity.
We run two core hedges within portfolios. One covers equity risk via a fund which uses Index and single stock options to protect against spikes in market volatility and the other covers equity and high yield credit risk through short exposure to a high yield bond index. Both performed very well over the quarter, with the Equity hedge rising by 4.5% by quarter end and the HY hedge returning +3.5% in USD terms over the period. In fact, given the mean reverting nature of volatility, we took profits on the Equity hedge in mid-March thereby capturing a realised return of closer to 11% over the quarter. The chart below highlights the fund’s defensive characteristics.
Given the persistent debasement of fiat currencies by most of the major central banks around the world over the last decade we have consistently retained exposure to Gold within portfolios. This allocation again proved its worth during times of market and/or political stress, rising by 6% in USD terms over the quarter. We also retain a position in Platinum, not only because it is extremely rare and therefore provides an intrinsic store of value, but also because of its increasing commercial uses within the clean energy complex, including hydrogen. Speaking of clean energy, our exposure to an ETF tracking carbon futures has also been a stellar, if at time quite volatile, performer within portfolios. Whilst the conflict in Ukraine has required a temporary slowdown in the move to net zero this trajectory is now set in stone, and we believe carbon futures will continue to play an important role in achieving these long-term objectives.
Also, within the clean energy theme our exposure to the Trium Emissions Impact Fund (a long/short equity fund) generated a positive return of +3.4% over the quarter. In fact, our hedge fund and relative value exposures collectively delivered a return of 4% over the quarter, which is in itself commendable given the extreme volatility witnessed over the period.
On a less positive note, our exposure to Listed Private Equity, through[KG1] two investment trusts proved costly over the period as high volatility and reduced market liquidity weighed on the asset class with Chrysalis and RTW both down around 25% over quarter. One small silver lining to this is that Chrysalis now trades on close to a 25% discount to NAV. Whilst we see ourselves as contrarian investors, the risks in higher discount rates, tightening monetary conditions, and the economic outlook more broadly, meant we have not increased or rebalanced these exposures. The time will come to do so, but that time is not now!
We are in the process of increasing our exposure to Market Neutral funds via a China focused, Long/Short equity product. Arbitrage strategies benefit from market inefficiencies. Whilst the Chinese equity market is deep and liquid there is a very large contingent of retail investors who trade on a daily basis. This heavy retail component adds to market mispricing’s which the strategy seeks to identify and profit from.
“Whilst Fixed Income markets have been deeply affected by the prospect of higher interest rates in the months ahead, security specific opportunities remain for those that are willing to look further afield!”
Having reached yield levels that in effect provided only “return-free-risk”, we have had a significant underweight exposure to fixed income markets relative to our peers for some time. However, there have been small pockets within the fixed income allocation which have proved profitable in an otherwise hostile global interest rate environment.
One of these is a London-listed US Credit strategy, focused on the healthcare universe. Biopharma Credit PLC was up 7.7% in USD-terms, with sterling investors benefitting a further 3% from USD appreciation. Another strong performer has been our allocation to Chinese Government Bonds. As with most major central banks, China cut interest rates at the onset of the Covid pandemic. Unlike most other central banks however they removed this added stimulus relatively quickly. Having cut rates from 3% to 1.5% during Q1 of 2020 they quickly raised rates back to 3% during Q2. By contrast the US Federal Reserve cut rates from 2.5% to 0.25%…and left them there for 2 years! As a result, the pickup in yield provided by Chinese Government bonds compared to US Treasuries proved very attractive, particularly when factoring in a good entry level for the Chinese Renminbi and the long volatility profile of Chinese Treasuries. As the graph below shows over the period, we have owned Chinese Government bonds, the CNY has strengthened by about 9% adding to the total return of the position.
Given the recent sell-off in Emerging Market hard currency bonds we have taken the opportunity to increase exposure to this sector. We have done this partly through exposure to an ETF which provides exposure to government and supranational issuers heavily exposed to the oil and gas sector (excluding Russia) and partly through an active manager who very much focuses on short duration exposure to EM corporates.
As well as switching part of our exposure in Government bonds from the 2 Year maturity range to the 10 Year maturity range, reflecting our view that the risk of recession has risen over the last few months, we have also divided exposure between inflation linked and conventional bonds whilst we wait for confirmation, one way or the other, of the prospects for a global recession towards the end of this year or early next.
“Notwithstanding the recent broad sell-off in global equity markets valuations in many cases are still challenging given a rising interest rate and high inflation environment.”
We continue to run an underweight equity exposure relative to our peers. Whilst we have an instinctive bias towards undervalued, higher quality companies with pricing power, we also have a definite small and midcap bias across portfolios where we find greater long-term inefficiencies. Over the quarter this smaller cap bias faced a considerable headwind.
We also run some longer-term thematic exposures, focused on opportunities that will likely benefit from structural tailwinds over the next decade. These include healthcare, technology, emerging consumption, digitalisation and smart infrastructure. Perhaps more driven by sentiment, these exposures are typically associated with growth-orientated companies, which sold-off in the face of rising interest rates and geopolitical uncertainty. Similar to our private equity exposure, there will be a time to increase our long-term thematic exposures, as the themes themselves and the structural tailwinds remain intact, but that time is not now.
Regionally we retain our overweight towards Asia, including Japan, which has proved to be a detractor over the short term. We also remain structurally underweight the US, with no exposure to Europe, the latter due to our negative outlook for the economy and the Euro in the face of negative demographics, rising inflation, and now further deteriorating in the face of events in the Ukraine.
Whilst we believe the US to be one of the most attractive markets for high quality companies, with pricing power and sustainable margins, these characteristics are already reflected in valuations, and hence our UW position at present. Both our UW exposure to the US and lack of European exposure both contributed positively over the last quarter.
To conclude:
We started this Quarterly by observing that the benefits of globalisation, which has had a pronounced disinflationary effect on the global economy for the last 30 years, was likely to slow. However, the extent and implications were materially impacted by Russian aggression in Ukraine, allied to China’s more domestically focused agenda. We believe the impact of these events on food and energy prices will result in inflationary pressures becoming a more structural issue in the years ahead. At a headline level that is undoubtedly true but, as we have also mentioned in this report, an overly prolonged period of negative real interest rates has not only resulted in unprecedented levels of debt globally but has also led to extremely high valuations across most asset classes. So, is the supply side inflationary shock that we now face the pin which eventually bursts the “bubble in everything” which central banks have overseen over the last two decades?
We believe that is a very real risk, but then again, privately, so do central banks which means they are likely to react very quickly to any sign that higher rates are beginning to damage the real economy and/or cause stress within financial markets.
The next few months might turn out to be like watching a movie in slow motion where, the longer you watch, the more you feel sure you’ve seen it before, and you think you know the mistakes the protagonists are going to make…but there’s not much you can do to let them know. In these circumstances all you can do is hope for the best but prepare for the worst.
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