Financial Update from Brewin Dolphin 11 March 2022

March 2022

The Weekly Round-up

Friday 11 March 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the escalating conflict in Ukraine, sanctions, and renewed controversy around Chinese stocks.

The factors that have been driving markets this week remain closely tied to Ukraine. Just as when Covid struck it was not the illness, but the lockdown designed to contain it, that did the economic damage; so with Ukraine, it is sanctions rather than gunfire that causes fluctuations in the markets.

This week saw yet more companies disentangling themselves from Russia as an end market, a supplier or an intermediate step. Sanctions have been a controversial topic over the years. As with all forms of conflict, there are questions over how deserving the population of the sanctioned country is of the economic hardship that is about to be delivered upon them. There’s also the more immediate controversy of the economic hardship inflicted on consumers of the sanctioning country (or countries). And finally, there is the chequered track record of sanctions in achieving the ambitions set out for them. Typically, they should serve as a bargaining tool with which a rogue state can be punished for misdeeds or rewarded for better behaviour.

Sanctions: what are they good for?

Will sanctions bring about a military capitulation or regime change that might release Ukraine from this bloody war? Tragically, few seem to believe so. Experts on Russian history tell us of the near unending ability of Russians to endure suffering in the name of nationalism. Economists do not believe the Russian economy will be rendered economically unable to wage war due to the imposition of sanctions as it is, for the immediate term, fairly self-sufficient in the essentials required for war.

Instead, the enforced transfer of power in Russia is more commonly triggered by military failure or events which would diminish Russia’s stature as a great nation. These teachings would suggest that much hinges on the dogged resistance of Ukrainians, whose defensive effectiveness has exposed Russia’s ineffectiveness.

De-escalation?

Discussion continues about the prospect of a no-fly zone or humanitarian corridors which could be protected from the air. However, a very strong consensus exists that the West should not test the Russian doctrine of escalate to de-escalate, whereby if they were outmatched by an enemy in conventional warfare, they would launch a pre-emptive tactical nuclear attack to de-escalate the situation.

Hence, we should brace for a drawn-out conflict which may result in a partial Russian victory, but then seems likely to suffer from debilitating insurgency. Eventually, a realistic and measured appraisal of the failed Ukrainian project may ultimately trigger the end of Putin’s two decades of rule.

Negotiations

Iran nuclear talks were suspended in the latest in a series of twists and turns dictating fluctuations in energy prices. Since Wednesday, prices have been retreating despite pledges from the US and UK to eliminate Russian energy imports, albeit those pledges have little immediate impact on current supplies and demand. Russia pumps around eight million barrels of oil per day, for which there is strong demand from countries that have resisted sanctioning Russian supplies. For oil, which is at least somewhat fungible, if China and India accept more Russian oil, their demand for non-Russian oil subsides, leaving more for those countries that have sanctioned Russia.

Resolve will be needed on the part of Western consumers to show a willingness to endure economic hardship, which will seem trivial compared to that being visited upon Ukrainians or even Russians. The susceptibility of Western leaders to political backlash over such things is seen as one of the weaknesses of democratic government relative to autocrats like Putin.

Inflation

In other news this week, US inflation soared to an annual rate of 7.9% in February. But beyond this headline number, the data wasn’t quite as strong as other reports in recent months. On a month-on-month basis, core, sticky, median and trimmed mean CPI were all strong, but they rose at a slightly lower pace compared to the previous month.

It does still seem correct to believe that US inflation will moderate as we progress through the year. Supply bottlenecks should continue to improve, the impact of last year’s fiscal stimulus should wane, monetary policy will tighten, and the strong dollar should weigh on import price inflation.

That said, inflation is likely to remain uncomfortably high throughout the year due to the strength of commodity prices such as food and energy, the incredibly tight labour marketand strong gains in house prices.

ECB meeting

The day before yesterday’s European Central Bank (ECB) governing council meeting, Otmar Issing, who was the first ever chief economist at the ECB, said in an interview that the biggest risk would be repeating the experience of the 1970s. He said the ECB should concentrate on containing inflation, starting with a cutback in asset purchases.

With the war in Ukraine having an outsized negative impact on the eurozone, the ECB was expected to stick with its previous quantitative easing (QE) plan, and buy more bonds for longer. The retired German economist got what he wanted because the ECB revised its QE plans down. Monthly net purchases will amount to €40bn in April, €30bn in May and €20bn in June. From then on, the ECB said that any additional QE would be data dependent. But if things progress in line with its expectations, it plans to stop buying bonds altogether in the third quarter. As a result of this hawkish surprise, German bond yields jumped and periphery yield spreads widened.

This was also one of the four annual meetings in which the ECB updates its economic projections. Compared to its December projections, it revised its forecast for 2022 gross domestic product (GDP) down and inflation up. Previously, it expected inflation this year to come in at 3.2%. It now expects inflation to be 5.1%. A negative growth surprise, at a time when inflation is projected to accelerate from an already elevated level, is a tough spot to be in for a central bank whose policy rate is at the rock bottom level of -0.5%.

The market is betting that we are at a stage where the ECB will prioritise reining in inflation ahead of supporting growth. Based on the ECB’s actions yesterday, that certainly looks like the correct interpretation and probably the right policy. The crucial thing for central banks in the current environment is to retain their credibility and restock their growth-boosting armoury. Allowing inflationary expectations to get too high for too long would only mean a more painful adjustment process at a later date.

Controversy around Chinese stocks

At the time of writing, this week seems set to end with European stocks having bounced back from the worst of their post-invasion collapse. In Asia, things have been more difficult, with Covid still taking a heavy toll in some regions, while Chinese stocks remain tainted by controversy.

Chinese Uber-equivalent DiDi is understood to have suspended its plans to list in Hong Kong after failing to satisfy Chinese regulators that it had resolved its handling of sensitive user data. The company was seeking to move its listing to Hong Kong as many Chinese firms that listed in the US are unable to comply with audit requirements. Norway’s $1.3trn sovereign wealth fund announced it was divesting from Chinese apparel firm Li Ning due to concerns that it contributes to serious human rights violations in Xinjiang.

And the flood of investment into Chinese sovereign debt, perceived as a higher yielding and yet less inflation prone market for 2022, started to reverse. February saw the biggest ever outflow of foreign capital, albeit a reflection of the rapid inward investment that had proceeded it. Chinese bonds are in focus as companies will be very careful about what they can invest in having been burnt by sanctions on Russian assets, while buying Chinese government bonds does require explicitly funding the Chinese state and thereby accepting some complicity in its more controversial activities. It is a debate that is sure to run and run.