Quarterly investment update
A difficult start to 2022: A tale of inflation, interest rate rises and Ukraine
Market update for the three months ended 31 March 2022 from Mercer
All returns in the following commentary are in local currency terms, unless stated otherwise.
Global equity markets had a volatile start to 2022 as they faced a number of headwinds; inflation remained at multi-decade highs as a tight labour market and soaring oil prices sustained pressures. In January, central banks around the world continued to pivot from earlier comments in 2021 that high inflation was transitory and projected more hawkish outlooks. Russian geo-political concerns began to enter the market vision as rhetoric from Russia, Ukraine and the US became bolder.
Financial markets were roiled in February as tensions between Russia and Ukraine escalated resulting in Russia’s invasion of Ukraine. Russian assets sold off sharply due to the widespread imposition of sanctions and restrictions on a number of Russian banks participation in the SWIFT international payments platform. Global markets struck a ‘risk-off’ or risk averse tone and traditional safe haven assets such as sovereign bonds and gold appreciated in value. Central banks were required to tread a fine line, navigating the initial wave of economic sanctions against Russia and the impact of those sanctions on the global economy in the medium term. Energy prices rose materially with Russia providing a considerable amount of natural gas to EU members, as well as other commodities such as wheat and palladium where Russia is a major producer.
March saw ongoing conflict in Ukraine; however, diplomatic talks between Russia and Ukraine began with the aim of a resolution to the conflict. Reports from these talks have outlined Ukraine’s request that Russian forces retreat to pre-invasion positions, and Russia’s demands that Ukraine provide assurances that it will remain a neutral bloc and will not become a NATO member in the future, as prerequisites to a ceasefire. March also saw the Federal Reserve (the Fed) increase the federal funds rate by 25 basis points (bp) – the first increase since Q4 2018. With many market participants opining that a 50bp hike would be required in order to begin tackling high inflation readings, the 25bp increase was less hawkish than it could have been, together with news of talks between Russia and Ukraine, set the stage for a strong market rally into the close of the quarter.
A build-up of Russian troops along the Ukrainian border led to US claims early in 2022 that a Russian invasion of Ukraine was imminent, and counter-claims from Russia that the troops were stationed for a training drill. On 21 February, Russian President Vladimir Putin announced that Russia would formally recognise the independence of two pro-Russian breakaway regions in eastern Ukraine. On 24 February, Putin announced a “special military operation”, which marked the official beginning of Russia’s invasion of Ukraine.
The global condemnation was swift with a wide range of sanctions including the freezing of assets held by President Putin, high-ranking officials and Russian oligarchs, as well as travel bans. A ‘select’ number of Russian banks were removed from the SWIFT international payments system in order to disconnect them from the international financial system and hinder their ability to operate globally. In addition, the US, UK, Canada and EU imposed “restrictive measures that will prevent the Russian Central Bank from deploying its international reserves in ways that undermine the impact of sanctions".
Russia and Ukraine have continued to hold ceasefire talks throughout the invasion with both nations stating their openness to diplomatic discourse. Russian state media has reported that Ukraine has provided their willingness to negotiate on the rejection of entry into NATO, fixing Ukraine’s bloc-free status, and a renunciation of nuclear weapons and other weapons of mass destruction. Although Russian forces have retreated from their positions around Kyiv, it appears that there is a long road ahead before a full and final ceasefire with Ukrainian reports that Russian forces are preparing to resume offensive operations, with their main efforts focussed on eastern Ukraine.
Inflation surged to 5.9% p.a. in New Zealand in the December 2021 quarter, as a tilt in messaging from central banks to inflation being more persistent going into 2022, paired with strong unemployment figures in New Zealand, paved the way for the RBNZ to continue to raise rates throughout the year. Globally, inflation readings remain high with the US CPI up 7.9% and the UK CPI (including owner occupiers’ housing costs) up 5.5%, for the year ended February 2022. Continued supply chain issues, as well as high energy prices as a result of the Russia/Ukraine conflict, have continued to keep inflation readings at multi-decade highs.
Rising interest rates
“It’s clearly time to raise interest rates and begin the balance sheet draining” stated Fed Chair, Jerome Powell. The federal funds rate, which has been at the zero-bound since March 2020, was increased by 25bp during March 2022. This marks the first increase in the Fed fund rate since Q4 2018.
As if rising rates were not enough for bond investors to contend with, the Fed alluded to draining liquidity and reducing the USD5tn in US Treasury securities and mortgage debt acquired by the central bank since the depths of the COVID pandemic as part of its Quantitative Easing program.
The first quarter of 2022 presented a number of headwinds to global equity markets in the form of inflationary pressures, a rising interest rate environment and the Russian invasion of Ukraine. How each of these factors interplay and develop will ultimately determine how 2022 plays out.
As Russia invaded Ukraine, and a host of sanctions and restrictions were levied upon Russia designed to ostracise it from the global financial community and cripple its economy, market participants took notice of how this would influence global markets. European, Asian and emerging markets bore the brunt of the equity sell-off, as the wider risk-off sentiment dragged down global equity markets more broadly. While Russia does not have an outsized presence in financial markets, it is a key exporter of several commodities such as palladium (37% of global production), gas (17%), platinum (12%) and oil (11%). Notably, Russia and Ukraine’s combined wheat production accounts for roughly a quarter of total world production.
At a time when global supply chains are still trying to recover from the depths of the pandemic, the sanctions on Russia and the conflict itself are threatening some, if not all of this commodity supply. Understandably, this has resulted in key commodity prices spiking, with oil and natural gas up over 10%, and agricultural and soft commodities pushing towards a 10% increase.
These increases in prices have both direct and indirect impacts on consumers and the broader economy. While agricultural commodities may impact the general populace directly when we purchase the end product, other commodities such as those within the energy sector may have effects that are more indirect. While we feel the rising costs through petrol at the pump, higher costs of energy flow through and increase prices at every stage of the supply chain, resulting in lower production and higher prices.
We can already see the impact of lower production and higher prices beginning to manifest themselves in economists’ forecasts. Many economists have downgraded their forecasts for the first half of 2022, with the brunt of the downgrades being borne by Europe and Russia, with expectations that inflation readings will remain high for a little while longer yet.
Thankfully, most economic forecasters expect global economic growth to remain positive for 2022 (albeit slowing), due to solid momentum heading into the year. The International Monetary Fund (IMF) released its World Economic Outlook Update in January, which indicated that the global economy enters 2022 in a weaker position than previously expected, with global growth expected to moderate from 5.9% in 2021 to 4.4% in 2022. As a result of the Russian invasion of Ukraine and associated sanctions, the IMF is expected to lower its global growth forecast further. However, the risk of stagflation remains. Particularly if inflation readings remain high over longer than expected periods or if the conflict is drawn out over a protracted period.
Inflation is as much a psychological factor as it is about rising prices. The longer a bout of inflation lasts and the more severe the price rises, the more likely it is to become ingrained in society and manifest itself in that society’s actions. The Fed abandoned the word ‘transitory’ in reference to inflation towards the end of 2021 as it became clear that higher prices were being seen in ‘core’ inflation readings (which exclude food and energy prices due to their volatility).
CPI readings continue to come in at the highest level in decades all around the world (US: 7%, UK: 5%, NZ: 5.9% for the year to 31 December 2021). A driving force of these high headline inflation readings is the result of high energy and foods costs as a result of global supply chain issues, and these pressures are expected to subside in the medium term as supply chains gradually untangle as the pandemic moves into the rear view mirror. However, the emergence of the Russia/Ukraine conflict as a new driver of inflation puts additional pressure on central banks globally to ensure that the high CPI readings seen over the last 12 months can be brought under control.
Central banks in most developed economies have indicated the intention to raise interest rates, if not begun to raise them already, with the Fed announcing a 25bp increase in the Fed funds rate in March. Notably, discussion has centred on the pace of interest rate increases, with many market commentators expressing the view that the Fed is already ‘behind the curve’, and must raise rates faster than their forward guidance indicates, in order to quell inflation. However, with forecasts pointing towards a slowdown in global growth, the risk remains that increasing interest rates too quickly could choke economies which may not yet be ready to stand on their own feet.
It is this dynamic between monetary support for slowing global growth and the tightening of monetary conditions to contain inflation, which is forcing central banks to walk a tight rope into 2022.
NZE (NZ Equities); AE (Australian Equities Local Currency); GE (Global Equities Local Currency); GENZD (Global Equities NZ Dollars); EME (Emerging Market Equities Local Currency) GP (Global Listed Property Hedged); GLI (Global Listed Infrastructure); COM (Global Commodities Hedged); NZB (New Zealand Bonds); GB (Global Bonds Aggregate Hedged); C (New Zealand Cash); FC (Foreign Currency Effect). The Foreign Currency Effect is simply the difference between the local currency and unhedged overseas share returns.
Trans-Tasman equities had a tough start to the 2022 year and the domestic market felt the bite of a rising interest rate environment faster than other economies. OCR hikes in the latter part of 2021 alongside high inflation figures pushed New Zealand equities lower in January. The New Zealand equity market benefitted from its defensive nature throughout the middle of the quarter as Russia/ Ukraine tensions ratcheted higher. Notably, electricity stocks surged, with the four largest electricity companies seeing their combined profit up nearly 60% in the second half of 2021. The domestic market faded towards the end of the quarter as it was left behind in a rally driven by growth stocks, while Fisher & Paykel Healthcare (which has a large weighting in the NZX 50) continued to slide after issuing a warning that its annual revenue would be down by about 13%, with the recent pandemic tailwind for medical equipment dissipating. The NZX 50 finished the quarter down -6.8%.
The ASX 200 fared much stronger over the quarter, returning 2.2% (in AUD). The Australian market was buoyed by strong energy and commodity prices as market participants assessed the risk of reduced commodity supply in the wake of Russia’s invasion.
A cloud hung over global equities as the sector moved into the New Year. This was driven by poor earnings sentiment, Omicron disruption and consistent hawkish views from the Fed. Volatility was exacerbated by the Russia and Ukraine conflict, as market participants took stock of the sanctions and restrictions placed on Russia and assessed their likely impacts on global growth and production. Global equities rebounded in March as speculation that a 50bp ‘double hike’ could be announced by the Fed in order to tame high inflation readings never eventuated and optimism was found in dialogue between Russian and Ukrainian diplomats. Despite a strong quarter end rally which recovered its post-invasion losses, the MSCI World Index ultimately finished the quarter down -4.6% (in local currency).
Despite an impressive close to the quarter, global property finished the quarter down -3.4%, as the headwind of a rising interest rate environment and hawkish Fed communications were enough to overpower the benefits the sector provides as a natural hedge against inflation, given the sector’s interest rate sensitivity.
Similar to property, listed infrastructure also had a difficult start to the year, despite parts of the listed infrastructure index benefitting from appreciating oil prices. As the Russia/Ukraine conflict escalated with the supply of commodities challenged, listed infrastructure rallied finishing the month up 3.3%.
New Zealand bonds and cash
New Zealand government and corporate bonds struggled in Q1 as continued high inflation alongside low unemployment signalled further interest rate hikes throughout 2022 placed downward pressure on New Zealand bonds. The Reserve Bank of New Zealand indicated that the decision to raise the OCR by 25bp or 50bp in February was finely balanced, however they ultimately decided on 25bp. Despite this, government bonds continued to slide and finished the quarter -4.3%. The 10-year NZ government bond yield finished the month 3.27%, up from 2.77% at the start of the quarter.
Much like the domestic situation, the market environment for global bonds was not friendly. With global central banks acknowledging that inflation is not as ‘transitory’ as they had originally believed and there is a need to raise interest rates to combat it. Unfortunately, this headwind meant that global bonds were not able to provide the defensive position many investors would have hoped for as Russia invaded Ukraine. The Bloomberg Global Aggregate (hedged to NZD) Index fell -4.8% over the March 2022 quarter. The US 10-year yield increased from 1.84% to finish the quarter at 2.33%.
Commodities proved to be one of the strongest performing sectors in Q1 2022, and global supply chain issues continued to drive scarcity in a number of raw materials, keeping upward pressure on inflation. Market participants took stock of the impact of the Russian invasion of Ukraine and the effect that sanctions and restrictions would have on the production and supply of commodities around the world. Oil prices rose materially, with Brent Crude breaching USD120 per barrel as questions were asked of Russia’s supply of energy to European countries. Other commodities where both Russia and Ukraine are significant producers (such as wheat and palladium) also saw sharps increases in price. The Bloomberg Commodity Index (NZD hedged) returned 25.5% for the March quarter.
Over the quarter the NZD appreciated against most of its major trading pairs as New Zealand was one of the first developed economies to embark on raising interest rates in the aftermath of the pandemic. The NZD performed strongly relative to the USD (1.6%), EUR (3.8%) and GBP (4.5%). The NZD gained 7.1% relative to the JPY as the Bank of Japan reiterated its commitment to easy financial and monetary conditions. A notable outlier was the AUD, as the NZD fell -1.6% over the quarter.
 Stagflation describes a period of high inflation coupled with high unemployment and stagnant demand.
 An index is a basket of securities that measures the performance of a particular market.
 Hedging is like an insurance policy used to protect returns from changes in foreign exchange rates. The trustee’s policy is to hedge fully the foreign currency exposure arising from all investments with the exception of investments in global shares which are 50% hedged.
This information has been prepared by Mercer (N.Z.) Limited (Mercer) for general information only. The information does not take into account your personal objectives, financial situation or needs. Before making any investment decision, you should take financial advice as to whether your intended action is appropriate in light of your particular investment needs, objectives and financial circumstances. Neither Mercer nor any related party accepts any responsibility for any inaccuracy. Past performance is no guarantee or indicator of future performance.