Financial update from Brewin Dolphin on 18 March 2022

March 2022

The Weekly Round-up

Friday 18 March 2022

Guy Foster, our Chief Strategist, discusses market sentiment amid the ongoing Ukraine crisis and the re-emergence of Covid-19 in China.

This week has seen some dramatic moves in the markets – even by recent standards.

Most important, given its size, was the 6% rally in US stocks from Tuesday to Thursday (more than 8% for the NASDAQ). Right in the middle of that rally was a US interest rate hike which might surprise those who know that interest rates are the mortal enemy of equity market gains. Markets of course look forwards which means they had anticipated this rate hike during their sell off in January. Rates are expected to rise at each of the next six monetary policy meetings.

Triple-witching

Today of all days has the scope for even greater volatility due to the fabled triple-witching event. This is the day when index futures, index options and single stock options cease trading ahead of expiry. It is important because these investments are leveraged and the dealers who offer them have to try and cover their positions as markets move.

The ratio of put options to call options is one of several indicators which investors look at to test market sentiment. It has been distorted over the last year by the explosion of retail options trading in the US. What is perhaps most interesting is that back in 2021 call options, which provide geared exposure to market increases, were in vogue.

More recently the demand has been for put options. These are used by investors speculating that the market is going to fall. Typically, if an investor buys a put option that gives them the right to sell at a price close to today’s price, it will be very valuable if the market is 10% lower by the end of the option’s life. When buying a put option the dealer who sells it will be exposed to the risk of the market going down and will sell assets or futures to hedge themselves against that scenario. As the contract expires, the need for that hedge disappears and it can be unwound. That can provide a bit of a boost for the assets in question.

The higher ratio of puts to calls is normally seen as a contrarian indicator. If everyone is bearish should we be bullish? There are some compelling reasons for being so.

Market sentiment

Most fundamentally the phase of the economic cycle that we are in is normally a reasonably good phase for equities. It is the time when economic activity is positive but slowing. Inflation is picking up and interest rates are rising. Higher interest rates make investors nervous but more often than not stocks have risen during interest rate hiking cycles.

This week, for example, the US interest rate hike was greeted with positivity by the market. In particular, the NASDAQ soared after the press conference at which Federal Reserve chairman Jay Powell sounded determined to suppress inflation over the long term. That caused a sharp increase in shorter dated bond yields, but an outright drop in the longest dated bond yields. We’ll discuss the significance of that for the market at large in a moment, but the interpretation should be that the Fed is prepared to hike interest rates in the near term to control inflation for the long term – inflicting short-term pain to achieve a longer-term gain. The most long-term assets are often high-growth technology stocks, which rallied on this interpretation.

We saw a number of other interest rate decisions this week. The Bank of England hiked rates to 0.75%. Whilst most commentators expected this and it did seem the most probable result, there was still a reasonable case for hiking all the way to 1%. One of the considerations would be long-term inflation expectations, which seem noticeably higher in the UK than the US. At this week’s meeting though, the only dissent was from a memberwho felt the environment did not warrant any increase at all and the accompanying statement sounded distinctly dovish. Whilst high-cost inflation is likely to be a headwind for growth the booming labour market means that cost and wage inflation could become self-reinforcing unless the bank is prepared to nip them in the bud.

Yield curve

Whilst the process of raising interest rates is often good for markets, eventually after a series of hikes we tend to get a recession and that is the time that equities do badly. The question for investors is how long the interest rate hiking cycle goes on for before recession strikes. The best guide to that comes in the form of the spread (difference) between the yield on a two-year bond and the yield on a ten-year bond. This, put simply, is like saying what do you think the average interest rate will be over the next two years? And how does that compare to the average interest rate over the next ten years? When rates are higher in the short term than they are over the long term, then they will be hurting the economy and recession is likely. We call this the yield curve ‘inverting’ and normally recession strikes between six months and two years after it happens.

Has the yield curve inverted? Not yet. It did however flatten considerably after the Federal Reserve raised interest rates on Wednesday. It has shrunk from 1.5% to 0.25% over the last year and could give its fateful signal anytime within the next few weeks or months. Alternatively, though it might not. From 1997 to the end of 1999 the yield curve averaged 0.25% without inverting and the S&P500 doubled. Shortly afterwards it inverted and the S&P500 fell 40% (before ultimately recovering of course!)

While we certainly wouldn’t suggest the current market situation is at all close to that in the late 1990s, this does at least show how easy it would be to sell out early and ultimately do worse than you would have done staying invested and enduring one of the most punishing bear markets in history.

That was then, this is now

Bringing things up to date the market remains transfixed by newsflow emerging from Ukraine. All week speculation has rumbled on that Russia’s humiliating lack of progress might leave space for a deal to end this horrendous and needless conflict. Talks have continued but both sides have so far held their line while Russian advances have faltered and the Ukrainians remain extremely effective in repelling advances and inflicting casualties with the use of weapons supplied by western governments. In its current state there would be scope for this to remain a humanitarian crisis but cease to be a market one. It remains in the market’s focus for three reasons:

• As Putin becomes increasingly isolated and desperate will he choose to escalate the conflict? Nobody can know for sure what he is capable of, however his speech this week seeking a cleansing of “traitors and scum” suggests that he may be worried about growing internal opposition.
• Will Russia gain support from China? So far everyone seems to believe that China would benefit from a weakened, chastened and more dependent Russia. However, the US authorities are clearly concerned about China eventually offering aid which would then challenge western countries to broaden sanctions or appear weak.
• Will energy supplies be disrupted? This week saw a welcome fall in the oil price, partly reflecting hopes of a Ukrainian settlement, hopes of an Iranian supply deal and concerns that Chinese demand may drop due to other challenges China is facing.

Although the oil price dropped briefly below $100 per barrel this week, underlying sources of inflation persisted. For some time we have worried about the impact of China’s zero covid policy, whereby pockets of the disease are suppressed rather than being allowed to pass through the population at a controlled pace as has been attempted almost everywhere else.

China’s many challenges

This week saw a sharp increases in covid cases in a Chinese population that has virtually no natural immunity. The Sinovac vaccine that the Chinese population has been given seems to offer very little protection against the Omicron variant and only half the Chinese population over 80 has been vaccinated. State media has impressed upon the public how dangerous it would be for the virus to circulate, but now policymakers seem to be caught in two minds proclaiming that the zero-covid policy remains in place, but that its economic impact will be lessened, thus allowing factories to reopen in the locked down tech hub region of Shenzen while case numbers reach their highest since the original Wuhan outbreak. Zero-covid is such a departure from the policy followed throughout the rest of the world that it needs to be successful, otherwise its failure might not only seem like a strategic mistake, but also expose the weakness of the Chinese vaccine. These kinds of setbacks would be most unwelcome in the year in which President Xi Jinping will be re-elected as President of the People’s Republic (although that re-election does not seem to be in any doubt).

If China does indeed continue to try and completely suppress covid cases, the risk is that the economic impact will extend beyond its shores through supply chain linkages, further intensifying inflation concerns.

Chinese stocks listed in Hong Kong fell by 13% in the first two days of this week before rising by 20% over the next three days. In addition to fears over the economic impact of covid cases, tech company regulation remains a major source of anxiety and investors are far from relaxed about the Chinese property sector as well. But the anxiety was lifted by a government statement hinting that the regulatory pressure may be over soon; expressing a desire to see support for the property sector; and even hinting at further monetary accommodation. This endorsement sparked a remarkable two day rally.

Looking forwards

As always there has been plenty of news and as usual much of it has turned out to be meaningless noise. The technical condition of the market remains quite positive having broken a previously ominous downtrend; sentiment remains weak and while the yield curve is fairly flat, it is steep enough to suggest that equities have further gains to make. These factors are supportive of markets. All of that must however be put in the perspective of a persistently inflationary scenario, demanding higher interest rates. All else being equal it seems appropriate to edge portfolios towards a more cautious setting as the cycle grows older.

So it really has been a very eventful week even beyond the tragic and sickening events in Ukraine.

We continue to wish for some easing of the pain and suffering.