Monthly Insights January 2022

“To Be or Not To Be”

(William Shakespeare’s Hamlet, Act 3, Scene1)

So much is riding on hope as we rapidly approach the end of Q1 of 2022. It truly is a question of, is it “To Be or Not To Be?’

Will Russia invade Ukraine? Will the supply chain bottleneck ease and return heated inflation back to some normalcy? Will China deviate from its zero-Covid policy? Will the Federal Reserve continue to keep the markets guessing as to its aggressive fight on inflation or will they relent?

In this month’s Monthly Insights edition, let us explore each of these headwinds in more detail and seek to best position ourselves for what lies ahead.

Russia & Ukraine

The world is focused on this seemingly red hot and tense situation between Russia and Ukraine. The threat of Russia invading Ukraine is real BUT Russia continues to denounce its intention of invasion. President Putin however has amassed an alarming number of ground forces and support personnel at the border of Ukraine and Russia, raising concerns of a looming invasion. So why, we ask openly, would Russia invade Ukraine? It seems to many that it is not because Putin dreams of resurrecting the Soviet Union or enlarging Russia’s territory by force but rather, Ukraine presents an opportunity for Russia to reassert its geopolitical relevance. The expansion of NATO eastward, the denial of a Russian veto on questions surrounding regional security appear to be the reason for this perceived act of aggression. If Ukraine were to join NATO, then Putin’s project would have failed. On the other hand if Ukraine is kept from doing so, Putin would have fulfilled his ‘historical’ role. Moscow is not blind to the fact that should Ukraine join NATO, nothing would stop Ukraine from hosting NATO and all its military might, including the US, which could directly threaten Russia. What complicates matters even more is the fact that over the last 10 years or so, and even to this day, during the last few elections, about half the nation of Ukraine are pro-Russia! In any scenario, the current standoff is Putin’s chance to overturn what he sees as an unjust post- Cold War order and create a new one instead in its wake. Just last week, according to The Associated Press, Ukraine’s leaders said the threat of a Russian invasion is real but it won’t happen as soon as some have feared. Defense Minister Reznikov was even quoted as saying, “Don’t worry, sleep well – No need to have your bags packed!” So, why then should investors care so much or for that matter, markets turn cold when search terms such as Ukraine or Russia is googled? For now, threats of further sanctions on Russia by some and split agreements by others, etc shows a dis-united front. Fears of gas supply and energy pipelines being interrupted has rocketed energy prices (probably, unjustifiably). Alternative exporters (US, Qatar) are jumping over hoops to ensure this supply remains ample. As Reznikov says it won’t happen soon but the fact that it could still happen, has kept gas and energy prices elevated. The largest importer in Europe is Germany, a core member of the EU. With demand already escalating in Europe prior to this ‘standoff’, any threat of further supply disruption will only prolong the elevation of energy prices.

Maintaining an ETF such as the iShares STOXX Europe 600 Oil & Gas ETF for a generic exposure to the sector should act as a buffer. However, expect prices to normalize the longer the episode runs with no action either way.

Supply Chains – Will it ease or worsen?

From Europe to the US and China, production and transportation have stayed bogged down in part, perhaps a big part because of the fast-spreading Omicron variant.

Global supply chains are nearing a turning point that is set to help determine whether logistics headwinds abate soon or keep restraining the global economy and hold up inflation well into 2022-23. One of the unknowns is whether perceived demands from consumers will loosen up and ease some supply bottlenecks. Indicators such as port traffic tracked by Bloomberg shows container congestion continues to fester the US supply chain. However, with the benefit of hindsight, since Omicron was first identified in November 2021, it is evidently clear that this variant is not as deadly as its predecessor, with hospitalization rates falling despite cases surging. Even with the latest variant of Omicron, which the WHO calls the ‘stealth’ Omicron BA.2, the effect of it remains just as mild as the original BA.1 version.

So much so that Denmark announced that from February the 1st, it will remove almost all Covid-19 restrictions as it no longer considers the virus to be a “socially critical disease”. Switzerland just today, began erasing some pandemic restrictions such as having to quarantine for people who come into contact with an infected person, and proposed further easing measures later this month. China on the other hand poses a major headwind to an otherwise easing bias as far as restrictions are concerned. China continues to maintain its formal zero-Covid 19 policy even as 85% of its population is fully vaccinated (ourworldindata.org quote). Beijing continues to impose strict lockdowns and quarantines quickly when any cases are detected. This contributes directly to global supply chain disruptions and price inflation with China remaining closed to the world. The inability or delays to enter ports, offload or pick up cargo has left ships waiting, stranded months on end. Ships move about 90% of the world’s trade and Chinese ports account for some 40% of the world’s containerized trade. Even as we hope that the Beijing Winter Olympics might bring some candour to the mainland, there are little signs that indicate otherwise. To this end, we should expect supply chain constraints to continue probably well into the year. Or, should we? Since it was the virus that started this chaos when the world economy practically shut down at the onset of the pandemic, it is now going the opposite way ie. rapidly reopening, bar a few (China being one of them) we ought to be ‘practically un-shutting down’ at the onset of nations like Denmark, calling the virus non-critical. As more nations come to this same conclusion, we should get exactly that. Some sort of normalcy on the horizon…….one’s conviction here is that the virus has now settled into one dominant variant and chooses to live with its host and not otherwise.

Glimmers of hope can be found in recent economic reports particularly in the US where backlog orders are down in the ISM manufacturing surveys, Tesla miraculously delivering as promised in spite of semi shortages, and various other national indexes showing time to delivery of goods falling. Congestions at ports in the US eased after Biden made a concerted effort to ease pressure on ports including moving to 24/7 operations. With the effect of the Omicron being mild, you can expect more of these sorts of bottleneck easing to continue. One major and key indicator is the labor force. Labor is needed to run machines, ports, nations, the world and will determine if (certain) supply chain blockages will clear in the near term. Keep close attention to participation rates in employment data releases to capture a more accurate picture of the state of the labor force and be ready to act accordingly. Moving further along that same trajectory, elevated inflation is for the most part, a direct result of this blockage.

The Fed

There is no doubt that the Fed’s policy will take on a hawkish stance beginning in March. It is all but a foregone conclusion, that the Fed Funds rate will be raised by at least 25 bps to 50 bps. The forward curves have flattened considerably since the beginning of the end of its QE program back in November 2021. There are now 2 unknowns confronting markets causing it sleepless nights:

  1. How many more hikes will there be for the year? And,
  2. Quantitative Tightening (QT) – when will it start and by how much?

Whilst there is no clarity to the 2 questions above yet, it is implied that we would see a less accommodative Fed. But even at the most aggressive of forecasts at 25 bps a pop for 6 hikes this year, it would still only bring the Fed Funds rate to 1.75%. History shows us that over the last 50 years, the US has not had a recession when the Fed Funds rate was below 4%, barring March 2020’s virus-induced disruption. By any stretch of economics imagination, 1.75% or even 2% tells us that rates are still low. The aim here and indeed endorsed by the President, is to fight inflation. The Fed is actually not in a bad situation or being forced its hand to raise rates. It is doing so because it is time to do so. Growth in the US with GDP at 6.9% QoQ is at decades-high levels supported by earnings growth which it still derives from a relatively accommodative environment. The anxiety in markets stem from unjust comparisons to dizzying inflation heights of the 70’s. There is little in common to that era except for perhaps an elevated energy price given transitional reasons for a clean energy substitute that is still nascent. The message that is being conveyed by various Fed members of late, is that the Fed is cognizant of effects on markets of policy changes and that they will tread carefully. The wild card on the Fed’s deck is that inflation will start to ease by the end of Q2. With that in mind, we do not think the Fed will be as aggressive as the street thinks.

Positioning oneself in the current environment would be to, unless proven otherwise, take it on face value that inflation will stay elevated until then. Staying long in commodities, ones that form key components to semis and industries would be prudent. Increasing exposure to real assets, pillars of society if you will, is another.

In conclusion, we would like to think that it is more “To Be” than “Not to Be” as far as easing in supply chain constraints are concerned and a Fed that is not too far behind the curve in tackling what appears to be a ‘controllable’ inflation, and a China that will eventually reopen but not in the next quarter or so.

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