International equity markets were weak in Q1 2022, initially on poor inflation news and the Federal Reserve turning more hawkish, then in response to the Russian invasion of Ukraine. Markets hit a closing low on 8th March and recovered into the quarter end. The EAFE index fell 3.6% in local currency terms and 5.79% in US dollars. Energy was the strongest sector, gaining 17.22% as oil and gas prices rose sharply. IT, considered a long duration sector sensitive to interest rates in the short term, was the weakest, falling 16% as bond yields rose.
The invasion has united Western leaders in condemnation of President Putin’s regime and the world’s liberal democracies have responded with sanctions and military aid to Ukraine. The need to spend more on defence and reduce reliance on Russian commodities has become clear and Germany has had to reverse its policy of economic and business engagement with the Kremlin. The extraordinary bravery of the Ukrainian forces matched by a poorly performing Russian military have denied Putin a swift victory and a longer conflict has ensued. NATO leaders have avoided an escalation involving member nations so far. A negotiated peace settlement, however distasteful that process may be, will be the solution but Putin will come to the table seriously only when he believes he has enough gains to sell his actions to the Russian people as a victory. Given his autocratic control of the media that may come sooner than expected.
Economic growth expectations have been revised down across Europe as consumer confidence has fallen and real wages are squeezed by higher inflation. Monetary authorities have been behind the curve and are responding too late, probably making another policy mistake by tightening policy as the global economy slows sharply. President Macron’s attempts at diplomacy with Putin initially served him well in the polls for the French presidency but his ratings have since been slipping and he will face the right wing Marine Le Pen in the run-off, a repeat of the 2017 election. Eurozone real money growth has slowed significantly suggesting the economy could tip over into recession later this year or in 2023. In the United Kingdom the squeeze on real incomes is particularly acute as consumers experience significant rises in energy bills as the price cap rolls off exposing users to the surge in European gas prices. The invasion of Ukraine has reduced the pressure on Prime Minister Johnson from the ‘Partygate’ scandal but the cost of living crisis with higher taxes and higher prices may undermine his premiership further.
In Asia the Japanese yen was notably weaker as the Bank of Japan maintained its 25bp 10 year yield ceiling in its ongoing efforts to stimulate inflation. A higher oil price is bad for a country that imports most of its energy but the weaker currency should help competiveness. Another problem for Japan is the weakness of the Chinese economy which has had to instigate more lockdowns as Covid infections rise in many regions. The outlook improved for the beleaguered Chinese tech stocks, which had been under regulatory pressure in 2021. An announcement from China’s state council signalled a desire to keep its capital markets stable, an end to the regulatory clampdown on big tech soon and support for overseas stock listings. There remains a risk of a negative response from trading partners if China provides support for Russia but policy-makers now seem to realise that continuing to punish the big internet stocks is no way to build a cutting edge technology sector.
Our liquidity indicators continue to give a negative signal for the global economy and risk assets. The rise in inflation is probably peaking but tighter monetary policy implemented belatedly by central banks will continue to suppress real money growth. The negative excess liquidity signal usually coincides with relative underperformance by tech and other cyclical sectors while energy and other defensive sectors outperform. Normally high yield and quality outperform while momentum suffers. Higher bond yields due to stronger commodity prices have prevented the usual outperformance by quality which often trades at a valuation premium. The drag from the stockbuilding cycle should ease the upward pressure on commodity prices allowing bond yields to fall and quality stocks to reassert their usual pattern of outperformance in slow growth environments.
Transactions over the quarter reduced the underweight in Europe, moved Japan underweight, reduced emerging markets and moved Asia ex Japan overweight. At the sector level we have added to energy moving slightly overweight and are also now overweight communications. IT has been reduced and we have exited some UK domestically orientated stocks where we fear the economy faces a hard landing. The focus has been to add to defensive stocks reducing cyclical exposure. Stock and sector selection were both negative over the quarter with our preferred quality and growth factors lagging value and high yield. The average underweight in financials, energy and miners was negative as was the overweight in IT. Stock picks were negative across regions and most sectors the exceptions being energy and IT.
The Composite fell 9.42% (9.56% Net) versus a 5.91% fall for the benchmark.