Market Insights Podcast – 21 FEB 2022
With the rise in geopolitical risks, the risk aversion has pushed up gold and dollar indices and pushed down interest rates on US debt. It has also increased selling pressure on some risky assets such as Nasdaq growth stocks. Concerns about the risk of sanctions against Russia have pushed crude oil prices higher, which in turn has raised concerns about already high inflationary pressures and the pace of monetary tightening. Although we are unable to make an accurate judgment on the subsequent evolution of the situation (the recent mix of information makes the situation more complicated and confusing), this does not prevent us from combining the general characteristics of asset performance in previous geo-risks and local conflicts, as well as the possible differences of the situation, to sort out the possible evolution and impact in different scenarios in the future for reference.
The general law of geo-conflict: it causes short-term shock but the impact is limited and most of them are transient shocks, which does not change the original trend. For example, the higher-than-expected Consumer Price Index (CPI) in January triggered a rise in 10-year US bond interest rates last Thursday. US debt thus rose to 2% or even more at one point. However, due to the sudden tension between Russia and Ukraine on Friday, the 10-year US debt completely gave up all its gains and fell back to around 1.9%. The Volatility Index (VIX) surged 14.4% to 27.4%. After renewed tensions on Thursday, the VIX index climbed, with S&P and Nasdaq falling more than 2%; 10-year US bond interest rates fell again; price of gold rose 1.6% and at one point exceeded USD 1,900 an ounce. It can be seen that when the geo-conflict heats up, it is a general rule that risk-averse assets benefit while risk assets suffer.
In order to give a better understanding of the extent, breadth and duration of the impact, let’s compare the more typical local conflicts since the 1990s, especially the performance of global markets and assets involving major powers such as the United States and Russia, and sorted out some of the following historical events, such as the events of September 11, 2001, the subsequent war in Afghanistan and the war in Iraq in 2003. The conflict between Russia and Ukraine triggered by the Crimean crisis in 2014; the US military intervention in the Syrian civil war in 2014; US air strikes on Syria in 2017; the Korean Peninsula crisis in 2017 and US air strikes on Iran in January 2020.
First of all, without exception, the outbreak of geopolitical conflicts will dampen risk appetite in the short term, resulting in the benefit of safe-haven assets and the damage of risky assets. Judging from the historical experience we have summed up above, when conflicts occur (usually within a week to a month), global stock markets fall under some negative shocks, while safe-haven assets such as bonds, gold and the yen benefit relatively. In terms of impact and duration, the impact of local conflicts on major assets will not be particularly significant and relatively short-lived unless it is significantly higher than expected and there is a risk of contagion to a larger extent. In the above-mentioned cases, except for the September 11, 2001 incident that caused a broader panic because of the direct attack on the United States (developed stock markets fell by an average of approx. 5%, emerging markets fell by as much as 10%) and affected the market for a longer time. Other times were measured on a weekly basis and the market usually fell by about 5% during this period.
The “particularity” of the situation in Russia and Ukraine: disturbing the level of inflation and monetary tightening expectations through energy prices. Judging from the general law of geo-conflict above, if the tension between Russia and Ukraine is only local and short-term, the impact may only be more limited to short-term risk appetite. However, Russia plays an important role in the global supply of major resource goods, such as energy, natural gas and some agricultural products, contributed 12% and 21% of global oil and gas exports in 2021. Europe is more dependent on Russia’s oil and gas supply. Russia’s exports of European oil and gas accounted for 29% and 36% of global exports to Europe in 2021, and Russia’s pipeline gas to Europe accounted for about 35% of Europe’s total natural gas imports. Therefore, if the geopolitical conflict leads to subsequent sanctions, it may lead to the supply gap of some capital products, and the impact of the latter may be far greater than the impact caused by short-term risk appetite alone.
In the context of relatively low local inventories and improved epidemic conditions promoting border opening and travel demand, the “supply premium” that may be triggered by the situation in Russia and Ukraine has become a key variable in the trend of oil prices in the short term. According to International Energy Agency (IEA), Russia accounted for 11% (10.9 million barrels/day) of the world’s production of about 98 million barrels/day by the end of 2021. If the geo-risk turns into an actual supply shock and assumes that Russian oil supply is reduced by more than 2 million barrels/day, it could shift the oil market from balance to shortage. As a result, oil prices could generate a supply premium of USD 30 a barrel, as high as USD 120 a barrel.
In the context of the current high inflation, this will undoubtedly further push up inflation and increase the tightening pressure on the central bank. From a historical point of view, there is a high correlation between oil prices and overall inflation, especially the energy prices in Consumer Price Index (“CPI”) are highly synchronized. 2008 was a financial crisis and this is also a supply crisis. We lack everything, be it for oil, natural gas, coal, copper, aluminium and all commodities. The futures curve in several markets is currently in a state of extremely severe spot premiums, suggesting that traders are paying a large premium on immediate supply.
With the rise in geopolitical risks, the outlook for commodities has never been stronger. Oil and gold are the best hedging assets. While many commodities have been fundamentally affected by events in Ukraine, oil and gold provide the most effective hedge against this geopolitical risk.
Wall Street institutions are collectively bullish on oil prices, with Goldman Sachs Group and Morgan Stanley shouting that Brent crude will reach the USD 100 a barrel later this year, while Bank of America Corporation estimates that oil prices will reach USD 120 a barrel in the summer.
Although stock markets generally underperform in the face of high inflation, there are still opportunities in individual sectors at the industry level. Some sectors that benefit from rising prices and profits will benefit relatively under inflation expectations. Investors need to pay attention to offensive assets, that is, a kind of assets in which the price of the product can rise and the gross profit margin can expand. Also, investors should also pay attention to defensive assets. We can look for assets with high dividend yield, good stability of dividend rate in the market and that can offset the upward pressure of real interest rate through the strategy of high dividend yield, so as to maintain the stability of the portfolio. Meanwhile, investors also need to avoid companies with no earnings and still in the cash burning stage to grow their business as their financial cost will go up multiple times on rising rates which would put enormously pressure on their margins.
Generally speaking, commodities, agricultural products, financial stocks and real estate are the beneficiaries of the upward phase of inflation.
Hong Kong stocks, especially local financial stocks, public utilities are rebounding this year. The overseas operations of Hong Kong financial stocks will benefit from the interest rate rise cycle in developed countries such as the UK and the US and their performance will benefit from the expansion of spreads. In addition, higher dividend yields and buyback are expected to at provide a safe cushion for their share prices in the medium term. Banks in Hong Kong and high-interest stocks are expected to outperform. The potential room for a downgrade of the Hang Seng Index is limited, referring to the tightening policies of the Federal Reserve Board that may affect liquidity but the valuation of Hong Kong stocks has largely reflected the impact. MSCI Hong Kong forecasts earnings per share growth of about 11% to 13% in 2022 and 2023.
China: investors should focus on the political calendar commences with the start of the National People’s Congress (NPC) and Chinese People’s Political Consultative Conference (CPPCC) in early March and then will get a better clarity and effects of the policies imposed last year. China’s inflation rate continues to move lower in contrast to the rest of the world. In 2021, the China CPI rose 0.9% yoy, far below the central bank’s target of around 3% and much softer than a 2.5% gain in 2020. This should start to positively impact real incomes and the reach for yield within equities.
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