The Great Inflection – Markets are not Done with Volatility as Risk Aversion Rises

  |   Geopolitics, Macro

The combination of ongoing economic consequences of the pandemic not only followed, but was massively amplified by Russia’s unprovoked war on Ukraine, has led to a simultaneous global cyclical economic downturn. The underlying forces are dislocations as well as structural process adjustments in politics, security, businesses and capital markets. 

The war in Ukraine is the ultimate wake-up call for Europe in particular, having largely wasted its post ‘Cold War’ peace dividend, taking international relations, economic prosperity and the free movement of goods, capital, services and people for granted. 

The end of globalization has not arrived, but the acceleration of a journey towards a more multipolar world and economy with all related challenges, costs and opportunities.

Geopolitics – the Turkey Comes Home to Roost

The current and ongoing geopolitical conflicts and fault lines pose a challenge to global sovereign states, as well as corporate and private actors, to come to terms with their respective legacies, actions and omissions.

The West was surprisingly quick to display cohesion, a refound sense of purpose and a commitment in joint action in the face of adversity in response to Russia’s invasion of Ukraine. Never underestimate the sheer resilience and superior adaptability of democracies and social market economies. 

In consequence, rising powers such as China and declining powers such as Russia will be forced to deliver to their citizens and future generations a credible perspective of free choice and prosperity – a hard task indeed.  

Unfortunately, too many political, economic and business leaders still remain behind the curve hoping in vain to either return to business as usual – status quo ex ante or even worse to extent the rule of unsustainable strategies and actions. 

Military Aggression Requires Military Response 

Throughout history Russia has only understood and respected facts, actions and hard power. Military aggression has to be met with superior military response – thus, expect a prolonged military confrontation and frozen conflict.

The direct and immediate result of Russia’s military aggression is the historically significant NATO enlargement, welcoming new members such as Finland and Sweden, and rearmament across Europe.

Western democracies have hopefully and finally learnt some painful lessons, namely, their geopolitical failures of appeasing Stalin at the Crimea Conference in 1945 and tolerating Putin’s unlawful annexation of Crimea in 2014 – soon publishing a commentary on the topic. 

Persistent Inflation and Simultaneous Downturn

World economies are currently confronted with persistent upward pressure on inflation rates, now reaching the wage front, and downward pressure on economic growth and corporate earnings. 

War developments, including related sanctions, and China’s failing COVID policy, are pointing to a worsening and simultaneous global economic downturn.

High and rising inflation cannot be controlled without raising interest rates despite the typical risk of recession, thus expect tightening monetary policy and deteriorating economic activity and volatile and declining capital markets. 

The FED remains behind the curve and is caught between a rock and a hard place facing painful trade-offs. The achievement of an economic soft landing is the exception to the rule and labor markets are a lagging indicator. Importantly, the US mid-term elections this fall will be decided on the domestic economy and the respective outlook is deteriorating. 

Russia – Failing and Falling

Russia’s invasion of Ukraine in late February and its subsequent humiliating failure to achieve the military goals Putin’s May 9th military parade speech was remarkably vague and defensive. 

Russia will pay a high and lasting political and economic price for its geopolitical revanchism and colossal miscalculations in Ukraine. Putin is already starting to smell the potential danger of growing domestic discontent. 

Western sanctions will stay in place and prove to be crippling until every last Russian soldier has left Ukraine, including the Crimea and the Eastern border, the Putin regime has been replaced and Russia will have paid for the reconstruction of Ukraine. 

China – the Stumbling and Rising Superpower

Surely, China envisioned an easy, and even glorious, 2022 starting with the Winter Olympics, the common prosperity policy and the crowning event of the 20th Party Congress later this year. However, Russia and COVID crossed all hopes and plans. 

China and its misguided and politicized COVID policy as well as its support of the Russian leadership – remember, the two countries share many historic grievances and aspirations – will be fast increasingly costly and stay under intense scrutiny. 

Deng Xiaoping is the indisputable hero of China’s unprecedented historic and meteoric rise from common poverty and not Xi Jinping.

China is an ancient, ambitious civilization and won’t accept the breaking of their social contract. At some stage, someone will have to take the blame for the current policy failures and free-falling economy and it certainly won’t be the People’s Republic of China nor the Communist Party of China.

Tightening Liquidity – Trashing the Hypes 

Media news and noise, tightening liquidity, rising interest rates, persistent inflation, escalating wage demands, ongoing war, stop-and-go pandemic, supply chain disruptions and demand destruction – they all take their toll on business, consumer and investors sentiment.

It is not surprising that the biggest casualties in global capital markets are either nonsensical, highly leveraged or over-hyped investments. Consequently, keep staying away from risky crypto projects, meme stocks, SPACS and firms with no value proposition – no assets, cash flow or profits.

Tech and Luxury are Leading Equity Indicators

High growth and consumer discretionary sectors such as tech and luxury are highly sensitive to the business cycle and are typically trending from overshooting to undershooting. 

The tech and luxury consumer sectors – although very distinct industries – are very good examples that have thrived for a long time on unlimited growth expectations and multiple expansion, yet are now suffering not only from falling demand but from multiple compression. 

Slumping Deal Making, IPOs and Fund-Raising

The 2022 year-to-date statistics and anecdotal evidences of slowing M&A activity, IPO listings, VC fortunes and fund-raising are worrisome and set to continue. 

Due to the tightening monetary policy backdrop, war and sanction developments and the highly uncertain economic outlook the risk appetite of institutional and private investors alike, has slumped.

The ongoing rush to safe haven assets, such as the USD, and reliable leading indicators, such as the widening corporate high yield spreads, credit insurance costs and increasing default rates, speak a clear language.

Markets in Upheaval – Focus on Capital Preservation

In the face of current events, we re-emphasize our defensive investment stance. We focus on cash, real assets and quality equity of firms with relevant and competitive market positions, superior growth opportunities and strong financials.

Favorite Sectors and Geographies 

Favorite sectors during rising inflation and declining growth environment remain energy, natural resources and the aerospace and defense sectors. They profit from massive rehabilitation and the upgrade of armed forces across Europe.

The geographies benefiting the most are natural resource exporters such as Canada, MidEast and Latin America. Speaking of sectors, energy transition, climate change and infrastructure spaces become ever more relevant. From a geographic perspective North America and Europe remain the favored investment regions. 

Revival of Active Investment Management 

Last but not least, we will see a revival of active investment management. The performance success in turbulent times will be on the side of those who strike the right balance between capital preservation and risk taking, requiring a resilient mind, professional skills and sometimes contrarian timing. 

Article by Beat Wittmann, Chief Investment Strategist at Key Family Partners SA.