Until a few weeks ago, confidence was steadily recovering after a two-year global pandemic caused unprecedented disruption to the global economy. We now find the world plunged into another crisis and capital market volatility has returned. Like the first few weeks of the pandemic, the Russian invasion of Ukraine has pushed the uncertainty barometer to extreme levels once again, but its implications could echo much longer into the future.
As we navigate through this crisis that was considered highly unlikely because of how irrational it is, our intention is to remain rational in our decision-making and maintain focus on balancing the need to preserve capital in the short-term while generating investment returns over the medium-term. While it is our duty to constantly assess economic and political conditions and make portfolio decisions accordingly, we feel heartbroken for those whose lives are being impacted in much more profound ways.
Even as the fighting continues in Ukraine and the outcome remains uncertain, the political and economic norms that have evolved over the past several decades are being overhauled in short order. Among the major themes we think will undergo accelerated change is deglobalization, energy independence, shift to alternative energy sources, increased military spending, commodity price inflation, sub-par economic growth, and continued pressure to raise interest rates.
Dismantling of political and trade barriers since the early 1990s ushered in a wave of globalization that extended prosperity to new regions while reducing the price of goods and services across the world. The pandemic highlighted the vulnerabilities of globalization as supply chain disruptions had serious ripple effects across many regions and industries. We think the conflict in Ukraine and the threat of others around the world will hasten the move to shorten supply chains by “re-shoring” of production to domestic and friendlier regions. This trend should be positive for domestic economies but could prove to be inflationary.
The global oil and gas market was also upended by the pandemic and is now being further hampered by Russia’s aggressive military foray into Ukraine. A consequence of the global economic shutdown during the early months of the pandemic was a sudden drop in oil demand, resulting in lower prices and a rapid decline in drilling activity. As global economic activity and oil demand have been rebounding, lagging production has placed upward pressure on oil prices.
The potential curtailment or embargo of Russian fossil fuels has added further speculative premium to spot oil prices (the “spot” price of oil and most other commodities quoted in the media refers to delivery in the next month). Despite the uncertain outcome of the current conflict, we note that crude oil contracted for delivery six months from now is 16% lower than spot prices and 20% lower for delivery contracts 12 months from now. This pricing structure indicates market expectation for spot prices to fall in the coming months.
However, like the aftermath of the 1970s oil crisis that resulted in rapid gains in fuel efficiency in transportation and heating applications, we expect the current spike in oil prices to speed the adoption of alternative energy that was already being motivated by climate change. We expect this shift to be most profound in Europe, where the determination to diversify away from Russian supply has never been higher.
Broad inflationary pressures triggered by the pandemic are also being aggravated by the sudden disconnection of Russia and Ukraine from global supply chains of other commodities and industries, suggesting that higher rates of inflation may persist beyond 2022. Despite the heightened atmosphere of economic uncertainty, we believe most central banks will likely continue raising interest rates this year. Indeed, market expectations for interest rate hikes in Canada and the U.S. have not changed materially since the war started on February 24. At the time of writing, the Bank of Canada is expected to raise its short-term rate to 1.75% by the end of 2022 (vs. 0.5% currently) and the U.S. Federal Reserve rate is expected to rise to 1.5% by the end of the year (vs. 0.25% currently).
Steering portfolios during the fog of war
During Q4 of 2021, asset allocation in our model portfolios had become defensive as the combination of high equity valuation, impending interest rate hiking cycle, and omicron uncertainties created an unfavourable backdrop. Equity market weakness in the period leading up to the war, particularly in the technology sector, was due mainly to asset mix adjustments by investors to reflect a faster pace of interest rate hikes. Our defensive positioning and increased weighting in alternative investments have resulted in a better outcome relative to most market indices and benchmarks, but our YTD portfolio performance is, nevertheless, in negative territory. Intra-year declines are inherent when investing in equity markets as sentiment sways from greed (i.e. high valuation) to fear (i.e. low valuation). Since the January 3, 2022, all-time high for the S&P500 Index, the forward 12-month price/earnings ratio has declined to 18.9x from 21.6x at the high, a 12.5% reduction that has returned the valuation closer in line with the five-year average of 18.6x.
The commencement of war in Ukraine has resulted in further equity market volatility. While Russia and Ukraine collectively account for a modest 3%-4% of the global economy, their outsized role as commodity suppliers has resulted in a further spike in commodity prices on fears of supply constraints. These strong inflationary forces are threatening the nascent post-pandemic economic recovery as consumers tend to reduce spending during periods of high inflation.
The trajectory of the war is highly uncertain, and the economic outlook has become cloudier. With the pandemic slowly fading, we had been positioning for a recovery in economically cyclical sectors that were expected to benefit from a return to more normal consumer spending patterns. Since some of the implications of the war may be long-lasting, we are re-evaluating our current positioning and expect to continue making adjustments. Just like in the initial weeks of the pandemic, we expect markets to remain volatile in the short term. However, by remaining disciplined in our analysis and basing decisions on a longer-term horizon, we are confident we can navigate through these turbulent times.
