Market Insights Podcast – 7 MAR 2022
At the beginning of this year, expectations that the world’s major central banks, led by the Federal Reserve, would gradually withdraw the unprecedented stimulus measures announced at the beginning of the epidemic have led to a correction in global stock markets. The recent escalation of the conflict between Russia and Ukraine has hit the market again.
A week before the upcoming Federal Open Market Committee (FOMC) on 16 March, Powell expressed to the U.S. Senate Committee that Russia’s invasion of Ukraine will generate “upward pressure on inflation at least for a while.” He believed that 0.25% interest rate hikes are appropriate for now, starting this month but he also said that he is open to larger rate hikes if inflation worsens. Investors still do not fully trust that the Fed will be able to get inflation in check, without at least one 0.5% rate hike sometime this year. Powell added “In this very sensitive time at the moment, it’s important for us to be careful in the way that we conduct policy simply because things are so uncertain and we don’t want to add to that uncertainty”. Powell conceded that the Fed should have taken a more aggressive approach to fight inflation when there is an opportunity. He certainly did not strike a confident tone when addressing inflation, which could be particularly concerning given the role sentiment plays in driving prices higher. Oil shocks have triggered more economic recessions than any other catalysts in the past 50 years. Consumers have not yet balked at higher prices which is a positive for corporate earnings power but the Fed will also need to strike a better balance between demand and supply without hurting the current economic expansion, which may force to coexist with high inflation. Since aggressive monetary policy is to combat supply-driven inflation, this will only undermine economic activity that has not yet fully recovered.
Even though oil prices have gone up crazily, rising by over 50% year to date, Organization of the Petroleum Exporting Countries (OPEC) decided to increase production as currently planned, increasing oil production by 400,000 barrel per day in April. OPEC+ members have recently been under pressure from oil importers such as the U.S. to speed up oil production and help lower oil prices. The release of reserves is a drop in the bucket. There is no hope for OPEC+ to increase production. Fears of supply disruptions in Russia and poor progress in Iran’s nuclear talks have all added concerns about crude oil supply shortages.
A general rule of thumb states that for every USD10 increase in the price of an oil barrel, U.S. inflation will rise by 0.4 to 0.5%. That is hammering consumers at the pump, putting the world economy at risk during a fragile stage of the recovery. Today oil soared to USD125 on news that the U.S. and EU considering oil embargo on Russia. Bank of America believes that if most of Russia’s oil exports are cut off, there could still have an oil shortfall of 5 million barrels or more a day, even if the release of strategic reserves is offset by an increase in OPEC exports. That means that oil prices could double from USD 100 to USD 200 a barrel. JPMorgan also issued a report, saying that Brent crude oil is expected to reach USD 185 by the end of the year but this is JPMorgan’s outlook for extreme scenarios. The bank expects the average oil price to reach USD 115 in the second quarter, USD 105 in the third quarter and USD 95 in the fourth quarter if Iranian oil does not return to the market.
Over the weekend, even Tesla’s CEO Elon Musk called on the United States to increase its domestic oil output immediately in response to Russia’s invasion of Ukraine, despite that his electric car company would be negatively affected by that move. He expressed that extraordinary times demand extraordinary measures.
Lately, carbon credits prices also corrected sharply. Both Germany and France have begun to extend nuclear energy for 10 years and when the 2050 Convention expires. This war is blamed for delaying everyone’s net zero progress. The biggest concern for carbon credits traders is the carbon footprint of war cannot be neutralized or simply estimated.
As uncertainty about the global economic outlook increases, fund managers are looking for assets that can weather the storm. In geopolitical turmoil, we often see markets shift from risky assets to gold because the latter is historically less correlated with other financial assets and gold has extremely high market liquidity in times of crisis. The opportunity cost of holding gold remains attractive as inflation pushes US real yields further into negative territory.
The severe sanctions imposed by Western countries on Russia have put tremendous pressure on the country’s economy and financial markets. Safe haven assets play a role, the dollar and the Swiss franc rise strongly. However, bonds have reacted relatively mildly compared with equities, which may be due to upward pressure on inflation, especially in Europe, where inflation expectations for 2022 have been revised upwards because of high energy prices. In addition, North American energy stocks are likely to benefit from higher oil and gas prices, which have been among the top performers over the past years.
The conflict between Russia and Ukraine could accelerate the two factors that have depressed the market over the past few months, namely falling economic growth and rising inflation. It has pushed up global commodity prices, with oil and wheat future hitting the highest in more than a decade. Investors fear the war in Ukraine and sanctions on Russia could upend critical supply chains, given Russia’s status as a top supplier of commodities. Ukraine is also a major exporter of wheat. Even if the tensions eventually ease, investors may beware of long-term high commodity supply risks, the consequences of economic growth and inflation, rising European defence spending and long-term sanctions on Russian assets. The euro zone is higher than that in the United States, which will moderately increase the possibility that the European Central Bank will slow the pace of monetary tightening. It reflects on the recent weakness of Euro and Sterling.
The UK’s National Institute of Economic and Social Research (NIESR) said that the conflict between Russia and Ukraine could trigger another supply chain crisis and cause the global economy to shrink by USD1 trillion in 2022 and increase global inflation by 3%. According to the agency’s researchers, supply problems will slow down economic growth and push up prices and global GDP levels will fall by about 1% by 2023. Since the parties to the conflict are the main sources of commodities and energy in Europe, Europe is more vulnerable than other regions.
Most U.S. companies have low direct exposure to Russia and Ukraine but indirect risks may be relatively large. These may include a slowdown in global economic growth and consumer spending due to rising oil and food prices, negative secondary effects through Europe, supply chain distortions, credit and asset impairment as well as possible cyber security risks. The sectors, where U.S. stocks are likely to outperform, are largely concentrated in the “energy and materials” sector, with specific products in the commodity category and some in the aerospace and defence industries.
The latest annual shareholders’ meeting of Berkshire Hathaway is inspiring. Warren Buffett is the greatest investor in history. His Berkshire Hathaway shares have seen an average annual return of 20% for shareholders since 1965 compared to the S&P 500’s 10.2% gain during that period. We have mentioned it a several times as Berkshire’s top holdings are combination of sustainable high growth tech giants and inflation beneficiaries. The company’s net earning to shareholders doubled in 2021 to nearly USD90 billion. Despite the current challenging market circumstances, its market value even reached an all-time high last week to USD720 billion and it still trades on 8.3x of Price to Earning ratio. This is a classic example of value investment.
Just to give some recent examples how Berkshire Hathaway was ahead the curve in investing than anyone else. In August 2020, Berkshire shocked the Japanese market by announcing a total capital injection of USD 6 billion into Japan’s five largest trading companies. At that time, these companies were still dealing with falling profits caused by reduced demand for fuel and raw materials as a result of the outbreak. In August 2021, as commodity prices soared, the total value of Berkshire’s shares in the five companies increased by about USD 2 billion, with a return of more than 30%, which is not included in dividend income. In 2022, the prices of commodities such as energy, metals and crops soared due to supply constraints and geopolitical tensions, coupled with a rebound in demand. Buffett’s holdings of these Japanese companies have been the biggest winners of the commodities boom. This also means that Buffett indirectly bought long commodities by holding these companies.
Berkshire Hathaway has purchased nearly 30 million shares of Occidental Petroleum (OXY) since end of 2021, adding to an existing large holding of 83.9 million warrants in the big energy company. In a filing late Friday, Berkshire said that it holds a total of 113.7 million shares of Occidental (OXY), including both the stock and warrants. The combined holding represents 11.2% of Occidental’s outstanding shares. Occidental stock has surged lately, outpacing a strong energy group. The shares gained 17.6% on Friday to USD 56.15 and have nearly doubled so far in 2022.
Speaking during the Two Sessions, one of China’s most important political gatherings of the year, Premier Li Keqiang said that China would target GDP growth of about 5.5% this year. The world’s second biggest economy grew 8.1% in 2021 but the pace of expansion slowed sharply in the final months of the year. Chinese policymakers face mounting challenges to keep growth steady, as the country contends with a real estate crisis and Beijing’ zero tolerance approach to the coronavirus. The fallout from the Ukrainian crisis could also slow down the growth by driving commodity prices higher. China would ensure food and energy security and step up oil exploration and development, Li added. Beijing would spend more on defence, while aiming for a budget deficit of 2.8%. China is still under a zero-Covid policy and consumption has been weak, while policy implications on the real estate and technology sectors linger on. Outside China, geopolitical tensions are high while supply chain disruption and semiconductor shortages continue.
The “Two Sessions” political gathering was also being watched for any sign that Beijing is preparing to relax its Covid curbs. Premier Li said on Saturday that Covid controls would continue to prevent inbound cases and tackle domestic outbreaks but China would also step up its study of the virus and accelerate the research and development of vaccines and medicines. China is the only major country still trying to implement a zero-Covid strategy, which involves mass mandatory testing, strict lockdowns and border controls. While the rest of the world is reopening and learning to live with COVID-19, China’s approach has weighed on its post-pandemic recovery and global supply chains. Consumer spending, for example, has dramatically weakened amid Covid-related disruptions, such as the outbreaks in Zhejiang and Xi’an in recent months that caused authorities to shut down factories and put thousands of people in quarantine. Tourist spending over the Lunar New Year holiday was 44% lower than in 2019.
Zeng Guang, a former chief epidemiologist of the Chinese Center for Disease Control and Prevention, wrote on his Weibo account this week that China could move away from its zero-Covid policy in the near future. He has participated in formulating China’s initial Covid policies. “In the near future, at the right time, the roadmap for Chinese-style co-existence with the virus should be presented,” he wrote. While the government is exploring ways to reopen, it is likely to move cautiously ahead of the 20th Party Congress in October or November. There are already hints that Beijing may have started thinking about relaxing its Covid grip.
The recent foreign capital inflows were largely driven by China’s inclusion in global indices, which prompted global investors to shift to index weights but active trading driven by market volatility remained low. At the same time, supported by strong balance of payments and high reserves, the renminbi has become one of the few currencies to appreciate against the dollar this year and last year. China’s 5.5% GDP target might be challenging to meet, however, policy makers may stabilize growth through fiscal stimulus with cautious on debt and inflation.
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