Financial update from Brewin Dolphin on 25 March 2022

March 2022

The Weekly Round-up

Friday 25 March 2022

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, explores why equities are rebounding despite geopolitical uncertainty and soaring inflation.

Amid the war in Ukraine, sky-high inflation, surging bond yields and the Federal Reserve signalling an interest rate hike at every remaining meeting this year, analysts are scrambling to find explanations for why risk assets are rebounding so strongly.

The MSCI World, S&P 500 and Nasdaq Composite rallied over the past two weeks and are now well above the levels seen before Russia’s invasion of Ukraine. The Euro STOXX 50, which temporarily entered into bear market territory, has recouped most of its losses. The FTSE 100 remains an outperformer this year and is up +1.3% year-to-date; the energy sector comprises almost 12% of index’s market capitalisation and has seen double digit gains so far this year.

The S&P 500 is down by about 5% year-to-date. This is a very resilient performance in the context of a much more hawkish Federal Reserve. Markets are expecting another eight rate hikes of 25bps each; since there are only six meetings left in 2022, this means a 50bps rise at some meetings.

US ten-year Treasury yields have touched 2.38% this week, the highest level since around May 2019. US two-year Treasury yields have reached 2.16% – that’s the level that the ten-year yield was at just a week ago. These represent very sharp moves in bond markets. In fact, global bond markets have suffered their worst drawdown on record as global central banks turn decisively more hawkish. The Bloomberg Global Aggregate Index, a benchmark of government and corporate debt total returns, has fallen 11% from a high in January 2021. That is the biggest decline from a peak in data stretching back to 1990. Our view is that bond yields have room to increase further as, historically, they don’t tend to peak until the Fed has almost finished its interest rate hiking cycle. This is clearly just starting.

Reasons for the equity rebound

So back to the question, why are equities bouncing higher and where do we go from here? First of all, there could be technical factors at play, such as short-covering and some dip-buying activity. As the war rages on, traders are assessing the situation and economists are busy updating their macro models. One possible conclusion is that increases in energy prices are not forceful enough to tilt the US economy into a recession soon, albeit growth is likely to slow when compared with the baseline.

With regards to a more hawkish Fed, the markets have largely digested the news and for now may interpret that as a good thing; a determined Fed prioritising fighting inflation is absolutely the right way to go. This makes sense when the risk of recession is still judged to be low. Fed chair Jay Powell is, in fact, ever more confident about the strength of the labour market.

Another vote of confidence for markets is that equity analysts have been revising up their earnings estimates, suggesting they think corporate America can succeed in passing on higher prices. Nominal gross domestic product (GDP) growth is likely to exceed 8% this year, which is actually helpful from a top-line perspective.

But we cannot be complacent. Plenty of risks still abound and market sentiment can flip easily. Volatility will be with us for much of this year as markets continue to work out what the Fed may do, the impact of higher energy prices on the economy, the risk of recession and, of course, developments in geopolitics, which are highly uncertain.

One thing we are closely monitoring is the shape of the yield curve – i.e. the spread between yields on two and ten-year Treasury notes. Currently, it is very narrow at about 20bps. It may well invert at some point this year, or it may hover at these low levels for a prolonged period of time. Our view is that at this stage of the cycle, it makes sense to position more defensively.

US-EU liquefied natural gas deal

Energy remains a wild card, and Europe is at the mercy of Russian gas given that 40% of its supply comes from Russia. While Europe’s sanctions on Russia so far are calibrated to carve out energy and to minimise disruption to the flow of gas, it is impractical and inhumane to be seen as indirectly financing Russia’s warfare.

A milestone was reached between the US and the EU this week, as Europe will get at least 15bn cubic metres of additional liquefied natural gas (LNG) supplies by the end of the year. There is a target of sourcing 50bn cubic metres of US LNG until at least 2030. 15bn cubic metres of LNG is just about 10% of the 150bn cubic metres that Europe sources from Russian every year. It is a first step in the right direction of diversifying from Russian energy, but it will take a long time to get the infrastructure in place for a more sustainable supply. Meanwhile, the risk of disruption to gas supplies has not gone away. There will also be intensifying efforts to transition to green energy and weaning off fossil fuels altogether – that is, of course, an ambitious target that demands even more investment and time. But it is absolutely critical that leaders are coming together to accelerate the transition for long-term good.

Spring statement

The cost of energy is front and centre of the cost-of-living crisis. In the spring statement, chancellor Rishi Sunak introduced some short-term measures to ease the pain for households. Fuel duty has been reduced by 5p a litre for the next 12 months. In addition, VAT on the installation of energy saving materials will fall from 5% to 0% for five years from April in England, Scotland and Wales, giving more reasons for households to go green. While the chancellor did not cave in to pressure to delay the upcoming increase in National Insurance (NI), he announced that the threshold at which earners start paying NI would increase by £3,000 to £12,570 – bringing it in line with the personal income tax allowance. However, as the Office for Budget Responsibility (OBR) noted, the increase in the rate of NI and the freezing of income tax thresholds mean that aggregate post-tax incomes will fall by more than the NI threshold increase raises them.

Economic data

With UK inflation hitting a 30-year high of 6.2% in February, people are feeling the pain of higher shopping bills. Inflation is going to get worse before it gets better – the OBR has forecast that inflation will average 7.4% this year, exacerbated by the impact of the Russia-Ukraine war on energy costs. As households’ real income is eroded by inflation, we expect to see a slowdown in household spending.

This week we got two updates in relation to UK consumers. Firstly, the GfK consumer confidence survey fell to -31 in March from -26 in February, below the consensus of -30. It is unsurprising that the mood of households is gloomy, given the bombardment of negative news headlines and the pain of higher bills. Official retail sales figures show momentum is slowing, with sales volumes down -0.3% MoM in February, or -0.7% excluding motor fuel. The data in February was disrupted by storm Eunice and there were some positive aspects, such as the jump in clothing sales due to more socialising as the economy reopened. But with the intensifying cost-of-living crisis and slump in consumer confidence, it is fair to expect a downward trend in retail sales in the next couple of months.

In other economic data, we had the latest purchasing managers’ indices (PMIs) for March, which are often a good indication of economic momentum. The UK services PMI rose from 60.5 to 61.0, ahead of consensus forecasts. This is quite surprising given the higher cost of energy, but it seems the economic reopening continues to offer a supportive cushion in the form of pent-up demand for services. Meanwhile, the UK manufacturing PMI slowed from 58.0 to 55.5 in March, below consensus estimates. This suggests manufacturers are feeling the pain of higher commodity prices and the shift in demand from physical goods to services consumption. In the eurozone, both the services and manufacturing PMIs declined MoM in March, but remained comfortably in expansion territory. This resilience is welcome for investors and traders as they are highly valued indicators. They may add to some economic optimism that, at least for now, we are not heading into a recession.