Investment Review – January 2022
I was sitting in a presentation by one of the major UK wealth managers last week, to a group of charity trustees, and having listened to their rather gloomy outlook was expecting some sort of suggested changes to policy. But no – just a bit of this, a bit of that, diversification is the best precaution against downturns, some bonds here, some equities there, all will be for the best. It somehow did not seem entirely adequate.
Despite jitters in December, Q4 2021 was actually quite healthy for large cap markets. The FTSE100, still dominated by “old economy” shares rose from 7,086 to 7,384, and the S&P500 from 4,307 to 4,766. Since the beginning of the year they have continued to rise despite a deterioration of the bond markets: 10 year gilt yields went from 0.93% to 0.97% in the quarter and are now hovering around 1.19%, and 10 year Treasuries went from 1.487% to 1.514% and are now around 1.79%. Nasdaq also rose (14,448 to 15,654) but within that Nasdaq Healthcare was down 7.5%. AIM caught a bit of a cold, falling marginally, and within AIM healthcare caught the backwash from the US. In decarbonisation stocks there was clearly a hangover after the COP26 spate of interest (fuel cell companies for example have been weak on both sides of the Atlantic). But looking at the indexes there seems no reason to worry. After all, money remains cheap, savings high, and what could possibly go wrong. Private equity continues to buy heavily- last year was by a margin the largest year ever for buy-outs.
So – why might there be some reasons for concern?
There seem to be a number of big things to worry about. All of which are more important than the deportation of Novak Djokovic, Prince Andrew’s titles, or even Downing Street parties. Though those may come to bite investors. More importantly we now appear to have two of the Four Horsemen of the Apocalypse (Pestilence and War) to deal with. And through Climate Change we may also have Famine. Inflation does not appear in the Book of Revelations but that does not mean it is not a problem.
COVID and its aftereffects
The Pandemic is not over. It may be over in the UK to all intents and purposes, and probably in other Western countries soon. However, it is far from over in much of the third world, and it is still a big problem in China. The issue in the third world as far as the financial markets is concerned is the possibility that the pandemic pushes countries over the edge financially. Sri Lanka for example is reportedly close to bankruptcy, with the collapse of tourism having hit it very hard. High energy prices will also hit non-producing countries hard. It has been a while since we have had a proper Emerging Markets debt crisis. We are always told the banks are well prepared and fully reserved. Maybe this time they are.
The more important problem centres around China, where the attempt to maintain zero Covid continues to disrupt supply chains and logistics. The cost of shipping freight from China has risen ten-fold since Covid hit, and 90% of goods moved around the world come by sea. 20 million citizens are currently locked down in Anyang, Yuzhou and Xi’an. Shortages of key components are not going away. And the supply chain problems stretch around the world: containers are taking four weeks to unload at Long Beach, and longer on the East Coast. Things are not yet getting better.
We continue to see the ripple effect across all sectors. Medical trials being postponed or slowed due to issues around patient recruitment; government agencies working at glacial pace (the FDA notably); companies deferring decisions, systems upgrades (including on cybersecurity measures) and investments; civil aerospace investment having stopped knocking suppliers.
All these issues are contributing to the build-up of inflation. However, the large component of inflation is contributed by energy prices and rather more due to geopolitics and in particular Russia than Covid. It does not feel as if prices are going to reverse any time soon. Manufacturers are enjoying higher margins on what they can sell and will hang on to them for as long as they can. Hydrocarbon exporters are making the most of their pricing power. There is a comforting view that equities are inflation proof. Those of us with long memories know that that is not by any means always the case. Costs can accelerate faster than prices. As EdF found out a few days ago, governments can block price increases (particularly in areas where there is already price regulation). Higher interest rates can savage inventory costs. Price rises can damage demand. It is not a free ride. Index linked securities are the only pure hedge.
If you have watched Don’t Look Up, about an impending meteor strike, you will have seen a dark fable about humanity’s ability to ignore serious problems. The markets – outside of Russia itself, where the main equity index is down 6% so far this year- do not seem to be discounting war. Yet there are very clear indications that Vladimir Putin does intend using the materiel massed on Ukraine’s borders. At the end of a week of diplomacy that appears to have produced no progress, the US national security adviser, Jake Sullivan, said US had intelligence Russia was preparing to fabricate claims of an imminent Ukrainian attack on Russian forces as a pretext for invasion. The Polish government has said that Europe is closer to war than at any time in the last 30 years. Ben Wallace, the UK Defence Secretary, writing in the Times, said that the current Russian narrative “ provides the skewed and selective reasoning to justify, at best, the subjugation of Ukraine and, at worst, the forced unification of that sovereign country.” UK and US security advisors have been active in helping Ukrainian forces prepare, but there has been no commitment by the West of troops on the ground, and some countries, notably Germany have been resistant to any concrete help. We know Vladimir Putin is willing to use his armed forces. Georgia, Ukraine and most recently Kazakhstan have all seen the Russian army in action. The Russians clearly want to end Ukraine’s autonomy. They have made no secret of their willingness to use force.
A Russian attack would undoubtedly affect the equity markets. The effects would not be purely local even if the fighting could be localised. With Europe already dependent on Russian gas, disruption to gas supplies can only worsen pricing. The cyber attack on Ukrainian government sites last week might well be replicated more generally – it is not hard to find warnings from GCHQ and elsewhere as to Russian hostile intent in that sphere. So – if it happens, or if you believe if may happen, what to do? Firstly remember that institutional investment committees move slowly. The initial move is rarely the entire move. Secondly, there are relatively few safe harbours. Gold. Dollars. Maybe oil companies! (though they may find themselves being subject to tax raids...). Taking the longer term view has generally been right during flare-ups over the last 40 years (Tiananmen, the first Gulf War for example). Having cash to spend on favourite companies whose shares are particularly weak is never a bad thing – look at the opportunities in March 2020 when the pandemic hit.
The situation in the South China Sea also gives rise to continuing concerns, and since the Afghan withdrawal, both China and Russia must see the USA as a giant with a limited appetite for a fight.
Climate Change & Decarbonisation
Concern about climate change peaked around COP 26 and has, at least as far as the market is concerned, become less salient since. There had been some large moves over the previous year or so, e.g. amongst the fuel cell companies. There have been a number of new companies coming to the market since, absorbing some of the funds allocated. Many have long lead times till there is a pay-off. But the pace of technological change is gratifyingly fast, the rewards for success huge (witness Tesla!) and there are many new technologies, with specific applications – there is no one-size-fits all. To the extent that changes in food production are part of the same continuum of change and adaptation, the same applies. Beyond Meat has become one of the most shorted US shares, as investors fret about slow uptake. But there are other ways of skinning the cell-grown meat, and investors may find opportunities to invest in new foods during periods of weakness.
And Closer to Home
Lastly- a thought on UK politics. If the pundits are right and Boris Johnson’s time in 10 Downing Street is limited, we should think about what might come next. There is no reason to think the Conservative Party would precipitate an election given current polling. Who might come in next? Rishi Sunak would appear to offer a harder financial line, and perhaps a reduction of tax breaks. An ERG-backed candidate (Liz Truss?) might want to trigger Article 16 and a trade dispute with the EU as a distraction exercise. The current high spend politics in the UK might well end. What that looks like is unclear.
If I am right that we may be faced by a particularly choppy period, then there is no need to hurry into VCTs or make other moves driven by the tax year. We very much believe however that our core themes of decarbonisation, digitalisation, healthcare and new age consumer are long term irreversible trends and that companies well placed to benefit from these, with innovative solutions to problems and IP, will be able to thrive. We continue to encourage our investors to maintain balanced portfolios, favour companies with cash and be prepared for fundraisings by those with weak balance sheets. They should take some profits when available and be ready to make tough decisions to sell underperforming companies if necessary.