07 Mar Uncertainty is the word, our changing world

As one twitter commentator quipped after the Russian attack on the Ukraine

“Young investors who only started investing 2-3 years ago now have been through a one in a lifetime pandemic, tech bubble 2.0 and Potential WW3. Not bad young bloods”.

Ongoing major flooding across NSW and Queensland has placed the debate around climate change back on the agenda.

Although many of us were hoping for a return to ‘normal’ in a post Covid world, 2022 has started with more shocks and dislocations to life as we knew it.

Macro factors dominating stock markets

 Stocks and markets are feeling the full brunt of an uncertain macro-economic backdrop (higher inflation, rising interest rates, supply chain shocks), combined with heightened geo-political risks and impacts.

With the spectre of another world war and nuclear threats from Putin, the US and western allies are employing a range of sanctions and financial restrictions to strangle and cripple the Russian economy. The west is effectively severing all ties with the Russia and their financial system, in what appears to be an unravelling of over three decades of openness with Russia, post the collapse of the Soviet Empire and the Berlin Wall in 1989.

The effects will not be short term in nature if the war drags on (which is looking like the most probably outcome) and the full impacts on the global financial system and supply chains remain an uncomfortable uncertainty for investors. Nor are there any short-term solutions, excluding a ceasefire. This is a war of attrition for both Russia and the Ukraine.

 Risks for Investors

• Supply constraints for hard and soft commodities such as oil, gas, metals (palladium and copper) and wheat will create inflationary pressures across supply chains, heating, transport, agricultural production (fertilisers) and basic foodstuffs.
• Higher energy prices can lead to demand destruction in economies and the prospect for an economic slowdown rises, i.e., a recession. Experts consider US$150/bbl as a key level.
• The most significant refugee crisis since WW2 in Europe.
• Investor losses estimated at US$170bn from exposure to Russian bonds, equities, and financial assets, according to the FT. The extent of exposure of global funds and banks to Russian financial assets, with elevated debt levels and lack of liquidity raises the spectre of a black swan financial stress event, such as the collapse of the hedge fund Long-term Capital Management in 1997.
• Mistakes in war with nuclear ramifications such as a missile hitting a nuclear power plant and an escalation in tensions.
• A tightening Federal Reserve into a slowing US economy and heightened geo-political tensions. This can be evidenced in a flattening of the US yield curve, where short-term rates are rising, and the longer end of the curve is falling (the US 10-year treasury). At the time of writing this piece, the 10-year bond yield had fallen from a high of 2.045% in mid-February to 1.698% in the second week of March. The falling 10-year yield in part reflects the risk-off sentiment of investors who are buying US long bonds, as well as the potential impacts on growth from slowing economies.
• Rising Australian dollar (rising price across the commodity complex) is negative for Australian exporters (excluding those denominated in USD such as material and energy suppliers) and those companies with USD earnings due to the currency translation effect, such as CSL, RMD, COH, JHX and ALL for example.
• Climate change risks remain an issue for insurers, banks, and property companies.
• Globally, geo-politics has the potential to shape supply chains. The days of cheap goods maybe over for now.

Opportunities for investors

• Cybersecurity is the new front of modern warfare with hackers and malware working across companies and countries. Protecting our digital systems against cyber-attacks is imperative for multiple industries that are key to social and economic stability, such as banks, infrastructure assets (water, electricity/power), information systems (media) and commerce platforms.
• Defence spending is now back on the global agenda and unlikely to revert to recent trends. Europe is re-arming and Australia is taking the Asia/Pacific threats from an expansionist China very seriously.
• Energy security and stability including increased investments in fossil fuels (rising prices may kick start years of under investment, despite ESG and decarbonisation economics). Much of the energy price rises are due to supply constraints (OPEC, under investment and Russia sanctions) not an increase in demand. The nuclear option for power generation is back on the table for discussion. Increased investment in alternative energy sources such as renewable energy, battery storage and electric vehicle mobility.

What should investors do?

 As the macro-economic backdrop has changed, investors may want to re-think their holdings. In situations as we are all experiencing, there are many unknowns and many narratives (noise) about what will or may happen to baskets of stocks, interest rates and inflation.

For example, ‘growth and tech stocks are dead forever and value is here to stay, particularly energy stocks’.

I prefer not to lump stocks into baskets at this stage. The stock markets in both Australia and the US are and will be very stock specific.

On balance, the risks for investors have risen substantially, so you need to assess what works for you to sleep well at night. I have moved over the last few weeks to 50% cash, which some may consider extreme, but capital preservation is important for my long-term savings.

There is always the possibility that the Russian/Ukraine situation resolves quickly, and markets would rally hard with a ceasefire. I just, personally, don’t happen to consider there to be a lot of upside risk at this stage and I am happy to miss the first 5% or so for capital preservation.

Being defensive and holding safe-haven stocks that are in part recession-proof, part resilient to supply chain problems, with strong balance sheets (low debt and high cash levels) will lower the volatility in your portfolio. Think healthcare companies, major secular winners in big technology, cyber security, inflation protected utilities, consumer staples and selective property trusts. Gold stocks and ETFs are back in favour; however, I caution that in major selloffs (a liquidity event) they won’t be immune.

Beware of cyclical stocks including banks (the yield curve and potential economic slowdowns – higher bad debts); higher risk smaller to midcap stocks unless they are special situations and potential takeover targets . Consumer discretionary has been under pressure and remains at risk, as are food producers and some parts of the service/tourism economy.

I would be careful of following the crowds too enthusiastically. In the same way as exuberance developed in loss-making technology and software stocks, the same FOMO is appearing in energy, grain and possibly uranium and defence stocks. This doesn’t mean don’t hold them, just don’t chase them, if these sectors work for you.

Remember, US retail investors have the highest exposure to equities, ever, some US$49trn; yet, we have not seen a rush for the exit, and maybe we won’t.  But I don’t think investors need to be brave in 2022, unless there is a big wash out in stock markets which we haven’t seen.

Central Banks will be in a conundrum if inflation continues to rise, and economies slow. How the 2022 playbook will pan out is anyone’s guess. But record debt and asset prices, make rising interest rates more problematic for financial stability.

On balance, cash will be king for buying opportunities. Continue to expect high levels of volatility.

I wish I could be more upbeat, but opportunities will arise for those who are patient.

None of this is advice, just my thoughts based on years of experience and recent research.

Stay well and safe.

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