What does the chart show?

This week we look at one of the top performing equity sub asset classes this year, namely listed infrastructure. Listed infrastructure encompasses companies that manage and operate critical infrastructure assets, from electric or water utilities networks, to gas pipelines, toll roads and telecommunication towers. Listed infrastructure is up around 5% year to date in US dollar terms, compared to the headline global equity index down 13%. Unsurprisingly, given the dynamics within the energy market at the moment, it has been the midstream energy (including oil and gas pipelines) names performing best, up near 20% in aggregate. Utilities have been surprisingly resilient in aggregate in the face of higher bond yields which have historically been a headwind. Nonetheless, the stability of their earnings profiles is attractive during stressed periods for markets. Furthermore, some utilities are able to pass through inflation relatively quickly which is beneficial in the current environment. 

 Why is this important?

Infrastructure has been one of our preferred asset classes for some time now given a combination of attractive relative valuations vs. many core equity and bond markets, strong longer term structural tailwinds, positive shorter term technical dynamics (none more prevalent that higher power prices benefitting certain renewable energy related assets) and inflation-linkage embedded into many of the underlying company revenues or individual projects. After a challenging couple of years for the asset class (the pandemic crippled a lot of transport infrastructure assets and it lacks the glamour of big tech) it has shown its worth this year and the benefits of owning it in a multi-asset portfolio. If we stretch returns back to pre-pandemic days, the S&P infrastructure index is still someway behind broader global equities, but the year-to-date outperformance has done a lot to ‘bridge’ this gap and over the last two years, listed infrastructure (as measured by this index) is now ahead of global equities. 

What does the chart show?

 This week’s chart shows the exchange rate of the Japanese yen against the US dollar (showing JPY per 1 USD). The yen’s recent depreciation (illustrated by an upward sloping line) started in early 2021 though it has recently depreciated against the dollar every day for 13 days up to 19 April – its longest losing streak since 1971* – and now sits at its weakest level since May 2002, as divergence between monetary policy paths weighs on the Japanese currency. Yen weakness has traditionally been beneficial for Japan’s export-driven economy (as their translated earnings are worth more in yen terms), but at these levels companies are more concerned about how it will further inflate fuel and raw material imports which are already surging due to the war in Ukraine. Japan is a large importer of oil and gas, and the big price rises in those markets pushed the country’s trade deficit to its widest point in eight years in January. 

Why is this important? 

Many investors have often owned the Japanese yen as a safe haven asset during periods of financial and geopolitical stress. Yet so far this year the currency has weakened over 10% against the dollar, leading some to question its traditional diversification role. On many metrics the yen looks cheap now. However, further hawkish comments from Fed officials have continued to widen the policy divergence between the Bank of Japan (BoJ) and the Fed. The BoJ’s pledge to continue stimulus measures in order to boost Japan’s economy and maintain interest rates of -0.1% massively differs from other key central banks, particularly the Fed, where policymakers have already started raising interest rates this year to combat surging inflation. Whilst US consumer inflation sits at 8.5% today, in Japan it is just 0.9%. The BoJ has also reaffirmed its commitment to yield curve control by purchasing Japanese Government Bonds (JGBs) without limit to keep 10-year yields near 0% which has widened the gap between yields on JBGs and US Treasuries. The surge in inflation across western countries has made central banks like the Fed increasingly hawkish and determined to push ahead with their rate rises despite uncertainties of the financial ramifications from the war in Ukraine whereas Japan’s central bank remains unwaveringly dovish.

*Bloomberg data only dates back to 1971

What does the chart show?

The chart shows the performance of the MSCI World sector indices year-to-date, in total return dollar terms. The notable outperformers so far this year have been the energy and metal sectors supported by higher underlying commodity prices, boosted by elevated demand and tight supply. Financials began the year outperforming most other sectors as the outlook for a higher interest rate environment benefits these companies through higher net interest income, however, Russia’s invasion of Ukraine spooked investors, sending most sectors into negative territory. 

The worst performing sectors this year have been information technology, consumer discretionary, and communication services. The prospect of higher interest rates has a greater negative impact on growth stocks as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings decreases. Furthermore, the consumer discretionary sector is more sensitive to prospects of lower growth and slower consumer spending.

Why is this important?

The first quarter of 2022 was driven by two powerful shocks: Russia’s invasion of Ukraine and the Fed’s sharp hawkish shift in policy. The immediate consequences of the war produced surges in energy and other commodity prices and further disruptions to key commodity markets and supply chains, exacerbating the damage inflicted by the pandemic. It is now the indirect consequences of the war that are increasingly driving financial markets and are likely to do so in the months ahead. 

The focus has shifted to the inflationary implications, the surge in commodity prices, damage to supply chains, the risk of shortages, and the extent to which central banks will tighten policy to combat this more persistent inflation. The large-cap UK equity index has been a standout performer year to date, buoyed by its significant weight to energy and miners. A lot of ‘value’ managers have benefitted from long-standing overweights to these sectors. On the other hand, the technology dominant US market has endured a more challenging period, as have ‘growth-focused managers with overweights in tech and consumer discretionary stocks.  

What does the chart show? 

The first quarter of 2022 saw the worst quarterly performance of US Treasuries (government bonds) on record as the Fed moved to tackle soaring consumer prices by withdrawing stimulus and hiking interest rates. Markets now see a strong possibility that the Fed will increase rates by 50bps at its May meeting. The expectations for a more hawkish Fed led to a sell-off in Treasuries across all maturities. Given the inverse relationship between bond prices and yields, the first three months of 2022 has seen yields rise sharply with shorter-dated debt bearing the brunt of the Fed’s more hawkish stance.  

 Why is this important?

 Driven by fears that central banks will have to be more aggressive in suppressing multi-decade high inflation, global bond markets have experienced heightened volatility so far this year. Fed Chair Powell recently signalled his willingness to support a 50bps hike at May’s Federal Open Market Committee (FOMC), with other Fed officials also echoing his stance. Fed policymakers have expressed that combatting rising inflation is their top priority and they may be willing to risk slower growth in order to reach the Fed’s 2% target. Shorter-dated debt has especially suffered with 2-year Treasury yields rising the most in one quarter since 1984 and last week, the 2-year yield exceeded the 10-year yield for the first time since 2019 (a yield curve inversion is seen by many as an indicator of a recession), reinforcing the view that these steeper rate hikes by the Fed may cause a recession due to demand destruction. Investors have become accustomed to Treasuries playing a reliably defensive role in portfolios in recent decades, and whilst they might continue to do so at times, particularly at points of market crisis, high inflation and low bond yields pose a key risk and we anticipate more volatile periods ahead for the world’s favoured safe-haven asset class.  

What does the chart show? 

This chart shows the calendar year total returns for the MSCI Europe ex UK index and the maximum drawdown the index experienced over each calendar year since 2000. Maximum drawdown reflects the greatest peak-to-trough fall over the period (the worst possible loss an investor could have made if they had bought at the peak and sold at the trough in the same calendar year). European equity markets have experienced heightened volatility in the past two months and uncertainty around the ramifications of the war in Ukraine which has weakened market sentiment. In light of the rapidly evolving situation, investors are finding a level which discounts the heightened risks and the financial consequences (which will be felt more in Europe given its higher dependence on Russian gas). Despite recent volatility, this year’s maximum drawdown (so far) of -21.4% is only marginally worse than the average calendar year maximum drawdown of -20.9% since 2000. 

Why is this important? 

Even during the strongest years for markets, there are always periods where markets fall. Volatility and capital loss are part of investing in any financial market and should be anticipated. Europe is more exposed to the financial consequences of the war than other regions and some of these financial implications are yet to become apparent. There are also other factors spooking the market at the moment: most notably Eurozone inflation reaching a record high of 5.9% in February – implying that tighter monetary policy and potentially slower economic growth lie ahead. After their sizeable falls, markets are rapidly discounting these risks and are offering some longer-term buying opportunities. Times like this tend to lead to a compression of investor time horizons. Now, more than ever, is a time for longer term perspective, riding out the short-term volatility, to participate in the recovery whose timing is unpredictable, but which surely lies ahead.

What does the chart show?

The chart shows the returns of various mainstream bond indices rebased to 100 from December 2019. Markets reacted as the Federal Reserve lifted interest rates by 25 basis points last week, as it faces the highest level of inflation in forty years, with a sell-off in US Treasuries (blue line) and US (inflation-linked) TIPS (red line). Rising inflation reduces the appeal of low-yielding debt where the purchasing power of principal and coupon payments are depleted as consumer prices surge. The bond sell-off (and subsequent rise in yields) has been seen worldwide as central banks wind back pandemic-era stimulus to combat rapidly elevating consumer prices and rapidly switch to monetary tightening. The steep sell-off emphasises the degree to which some investors have underestimated how far central banks are willing to go in order to tackle rising inflation (just three rate hikes of 0.25% were priced in at the start of the year in the US, a long way from current expectations, covered below).

 Why is this important? 

US consumer price inflation soared to 7.9% last month, with Russia’s invasion of Ukraine prompting sharp jumps in commodity prices, exacerbating existing inflationary pressures. Fed Chair Powell’s comments reinforced the view that the key concern from the war in Ukraine is that it will add fuel to rising inflation, leaving it more persistent in the economy, opening the door to tightening monetary policy at a faster rate than initially anticipated. Markets have priced in a further 190 basis points worth of rises at the remaining six FOMC meetings this year, effectively provisioning for at least one rise above 25 basis points. Powell’s remarks sparked a sell-off in government debt, sending yields higher with the moves particularly sharper for short-maturities. Government bonds are offering little or no downside protection amidst geopolitical turmoil. US Treasuries are currently set for one of, if not their worst, quarter ever. They are certainly not a source of risk-free return they were perhaps once perceived to be! 

It is also noticeable how poorly (dollar denominated) emerging market sovereign debt has performed this year. This, in part, is explained by direct Russia exposure but that was never really more than low single digits. We think there is likely an element of ‘baby out with the bathwater’ here and so it is an asset class we have spent more time on recently and have recently added to in some portfolios.

What does the chart show?

The chart shows the price-to-earnings (P/E) ratio for the MSCI China index (Chinese equities) relative to the MSCI ACWI index (global equities). The P/E ratio measures the relationship between a company’s stock price and its earnings per share (EPS), giving investors a sense of the valuation of the company, or broader market, and how much investors are paying for the earnings of a business. Companies with high P/E ratios are often growth stocks and can, at times, be overvalued compared to their current fundamentals. Similarly, companies with low P/E ratios are referred to as value stocks and are sometimes considered as undervalued. Over the last twelve months, the valuation of Chinese equities relative to broader global equities has declined to sit at historic lows.

Why is this important?

Investors in Chinese equities — both onshore and offshore listed names — have been spooked by the long-running crackdown by President Xi’s administration on companies in the technology, property and education sectors; default concerns in the property sector; lockdowns in wealthy cities, including tech-focused Shenzhen, as the country grapples with rising Covid cases; slowing economic growth and more recently, concerns over China’s support for Russia in Ukraine, which it denies. MSCI China’s relative valuation sat at its lowest level in over fifteen years this week as US regulators threatened to delist several Chinese companies (listed in the US) unless they provided detailed audit documents that supported their financial statements. However, Chinese stocks performed a major U-turn on Wednesday and rebounded very strongly (the Hang Seng rose +9% with tech stocks up significantly more) as China’s top economic official intervened to reassure investors. The State Council said Beijing will take strong measures to boost the economy this quarter, would take steps to prevent further risks building in the property market and will keep the stock market stable, though details of such stimulus measures didn’t appear to be provided. There is certainly a lot of bad news already in the price of Chinese equities. These historically low relative valuation levels certainly warrant a closer look at the region.

What does the chart show?

The chart shows the German 10-year inflation breakeven rate, derived from the difference between conventional nominal and inflation adjusted government bond yields of the same maturity. Its value indicates what market participants expect inflation to average annually over the next 10 years. It is coined the breakeven rate as it refers to the average level of inflation that would need to be achieved to make an investor indifferent from buying an inflation linked bond or a nominal bond. If you think inflation will exceed this breakeven rate over the period, buy the inflation linked bond; if you think inflation will fail to hit this level, buy the nominal bond. Germany’s 10-year breakeven rate has risen materially in recent weeks amidst soaring commodity prices leading to further rises in inflation expectations. The rate has recently surged as much as 43 basis points since the beginning of March to an all-time high of 2.62%, in a sign that investors are moving to price in higher, persistent inflation for the years ahead.

Why is this important?

Prior to events in Ukraine, the ECB had been widely expected to draw back stimulus at a faster pace in an attempt to tame inflation – with the Euro Area flash CPI print for February coming in at 5.8%, its highest level since the formation of the single currency. Now, Russia’s invasion of Ukraine has unleashed significant uncertainty since the EU relies on Russia for some 40% of its gas supplies. In the last few days the EU has committed to cut Russian gas imports by two-thirds within a year, and we have also seen the US and UK move to ban Russian oil imports. Energy prices are a key component of inflation baskets and thus these developments are expected to push inflation sharply and rapidly higher. These risks surrounding higher energy prices are unlikely to dissipate in the short term and remain a threat to short-term market stability. The ECB is now widely expected to keep its monetary policy settings unchanged at its March meeting (which will have been announced by the time this note is published) a 180-degree turn since its shift to a more hawkish stance at the February meeting. With the price of oil and gas soaring in a very short space of time, economies have little time to react to absorb those jumps and its impact on consumer spending and confidence could instead tip economies into recession and prove to be deflationary over the long-term. Who would want to be a central banker now?!

What does the chart show?

Given recent events, we thought it would be a good opportunity to examine past wars/conflicts and analyse the drawdowns of the US equity market (as measured by the Dow Jones Industrial Average index) and how long it took for the index to return to its prior peak. Major wars clearly impact stock markets by creating uncertainty, hitting investor sentiment, and potentially damaging economic activity. However, analysing past military conflicts shows that permanent damage wasn’t inflicted on markets, and they eventually recover. The Dow Jones initially sold off around 6% from 10th February but has rebounded since. For most events we have charted, markets returned to their prior peak in less than 60 trading days (3 months). The exceptions are the Cold War and the Gulf War which took 107 and 137 trading days respectively to recover. Whilst these might look significantly longer than the other events charted, during WWII it took the Dow 1,368 trading days to recover and throughout the Global Financial Crisis it took 1,359 trading days. In all of the conflicts charted, the US equity market never fell more than 20%.

Why is this important?

The rapid and alarming turn of events in Ukraine has shaken markets and compounds an already uncertain environment due to high inflation and central bank monetary tightening. We expect the direct global economic impact to be limited as Ukraine and Russia are smaller economies compared to more developed economies. This unwelcome turn of events in Eastern Europe is unlikely to cause a major bear market but rather a short-term shock. We do not underestimate the disaster that this brings but wars do end and this one is expected to be of limited duration and spread. It comes at a time when the global economy and corporate sector are recovering robustly from the Covid-19 pandemic and while there is likely to be some knock to confidence, directly from the escalation in Ukraine and from second order effects including higher energy prices, the broader impact should be limited.

What does the chart show?

The chart shows the quarterly net flows and total assets in sustainable or ESG (environmental, social and governance) funds since 2011. The last two years have seen a stark increase in demand for these funds, accelerated by the pandemic as well as events such as COP26 which have put issues around sustainability into the spotlight. 

With total assets of $2.4trn in Q1 2020 more than doubling to $4.6trn by the end of 2021 it highlights the greater consideration that investors are giving to responsible and sustainable investing. Whilst rising markets over the period have supported the increase in assets, the extent of the rise has also been helped by much higher flows, with these sustainable funds recording net flows of close to $190bn in Q4 2021.

Why is this important?

Coinciding with a heightened focus on sustainability, there has been a proliferation of ESG-labelled strategies in the last two years. Issues of greenwashing (where managers’ marketing material and disclosures paint an impressive picture of the level of ESG integration that masks the reality within) are becoming more prominent. Morningstar recently announced the culling of 1,200 funds, totalling $1.4trn in assets, from its sustainable fund universe after an investigation into fund manager disclosures. 

Taking time to properly research, meet and understand managers’ approaches and processes is integral in navigating this issue. It is also crucial that investors never lose sight of the fundamentals. It is easy to be swayed by positive sustainable messaging made by companies and fund managers, but business fundamentals might not necessarily stack up. We advocate an integrated approach, whereby one considers the ESG risks, or indeed opportunities, as part of a broader appraisal of company fundamentals.