25 April 2022

Q1 2022 Market Commentary

Written by Ivan Sedgwick

Three months ago we expressed concerns about inflation, about Russian intentions in Ukraine, and about continuing supply-side disruption. All of which have proved correct - yet the FTSE 100 ended the first quarter flat year to date. Forecasting the future is a fool’s errand, but we can at least try to understand the present and to position ourselves for possible developments. And embark cautiously on that fool’s errand.

So firstly it is worth observing that the FTSE was atypical, and the big weighting in energy and mining stocks which had held it back in recent years have helped it this year. The S&P500 was down about 5%, the Nasdaq index another 10% (so off 20% at the end of March from its highs) - and rather strikingly the FT reported that prices for trades in private US companies were down about 20% in Q1 (albeit this is not a very precise measure). Which puts the AIM market’s 14% fall in Q1 in perspective.

Looking back at the big problems, we can see that inflation expectations have worsened sharply, that the Ukraine war is far from the surgical operation that many commentators anticipated as a worse case, and shows every sign of exacerbating supply side problems in a way that was not expected - plus of course the Chinese continuing pursuit of stringent lockdowns and a not-invented-here attitude to vaccines has also been painful. The sustained rise in hydrocarbon pricing is draining cash from consumers in all western economies (and of course many emerging market economies) and whilst in countries that are self-sufficient in energy (the US, for example) the windfall is staying at home this cannot help but have a recessionary effect given the redistribution of consumer budgets. The high costs of energy are largely ending up with the producers, both corporate and these days largely national oil companies, leading to an accumulation of what used to be called petrodollars in the Middle East and of course Russia. These will not (or will not be allowed to in the case of Russia) be recycled quickly enough to provide much of a countervailing stimulus. High energy costs are simply making energy consumers poorer.

The Ukraine war shows no sign of ending soon, even though some European governments would clearly like to return as they did after the Crimean and Donbas invasions to business as usual. It would be naïve to think that it could not take a turn for the worse.

It does seem that for now the central banks are not willing to adopt the sort of approach that they took in the 70s and 80s to squeeze inflation out of the system. Interest rates have risen, are rising, but nowhere near the extent needed to return us to a world of positive real interest rates. The central banks’ critics accuse them of groupthink and claim that they have consistently undershot in their inflation forecasts. Another view is that rates are being kept low through a desire to allow inflation to erode the stock of government debt built up through the pandemic, though this rather disregards central bank autonomy, or even that there is an unwillingness to see a hit to their own huge debt holdings accumulated through QE, which would be depressed by higher rates. It does not really matter what the truth is. At the moment it is clear that the sort of rises being discounted by the bond market are not intended to choke off inflation, but at best to allow some token stimulation of the economies if we do plunge into recession. Government bonds do seem to be all risk for no return. On the other hand high yield corporate debt should maintain its premium to government bond yields.

Supply-side shortages and inflation threaten in some cases to have political effects. Grain prices helped kick off the Arab Spring. Emerging market debt defaults are on the table again. Around the world incumbent governments will be blamed for price rises and deteriorating living standards. The mid-term elections in the US are anticipated to remove the Democrat majority which in turn would focus the world on the possibility of a second term for Donald Trump. Other countries may also see the overturning of incumbents.

The Ukraine war has arguably done more to accelerate the energy transition than COP 26. Nuclear power is back on the agenda - though not in Germany where the purchase of Russian oil and gas still seems to be the government’s top priority. We have seen continuing corporate interest in companies involved in decarbonisation, within AIM and beyond (for example, Reliant Industries paid $100m for a Sheffield Uni battery spinoff). The oil majors are now spending billions on renewables, and whilst the amounts remain dwarfed by their conventional investments, they are huge relatively to the size of the start-ups developing the technologies they will need. We continue to look for interesting investments in this area.

Labour shortages across many countries can only accelerate the need for digital transformation, and in particular within the health service and private medical systems the application of machine learning to diagnostics is showing promising results.There are opportunities to invest on AIM in software, cybersecurity and SaaS companies but they do tend to be niche and underpowered in their marketing functions. It will remain an interesting area. Consumer behaviour also seems to have changed in many ways, the high street is not going to come back, and successful direct-to-consumer businesses will continue to emerge.

Conventional drug discovery remains hard. Trials have been badly disrupted by Covid, and medical budgets redirected. On the other hand the speed of vaccine developments during the pandemic does seem to have prompted at least some regulators to consider how they can focus on important drugs. We are not seeing much in the way of M&A in this area. The US venture community has started to dip its toes in the water of the pool of UK life science companies, but the travails of Nasdaq will not be encouraging them to put too much work into this. Nor is the City on the Hill of a Nasdaq listing quite so alluring or indeed achievable for UK companies for now. Plus, we have had some reminders that drug trials do not always meet their endpoints, and scientific developments can bypass apparently exciting avenues of research.

Overall, we are faced with a worse macro outlook than three months ago. Small companies, however interesting their medium term prospects, will have to be agile and very aware of the need to live within their budgets, as they will not be able to take for granted that the equity markets will be open for them.

In this context, we continue to encourage our investors to be selective in their investments and to spread risks across a basket of stocks, particularly for investment in early stage companies. There may also be some bargains in the secondary market where share prices have fallen too far. We continue to encourage investors to build barbell portfolios, combining their equity investments with laddered portfolios of MTN issues at attractive yields. Please speak to your relationship manager if you would like to discuss further.

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