Why inflation and slow growth, not the Ukraine war, will drive markets

Even as the Covid-19 pandemic and the war in Ukraine continue, expect the global transition to high inflation and rising interest rates to shape the market narrative
The threat of stagflation and recession loom on the horizon, but there is still time to fix things

Richard Harris

Published: 3:30am, 1 Apr 2022

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If anyone had predicted what would happen in the first quarter of 2022, you would have been forgiven for thinking it was an April Fool’s Day joke. It is as if the Four Horsemen of the Apocalypse had finally arrived. They brought pestilence via Covid-19, famine through soaring food prices, a declaration of war, and death – but enough about Hong Kong.

The pandemic was reduced to a sideshow in many parts of the world following Russia’s invasion of Ukraine, but it still has a sting. Mainland China and Hong Kong’s pursuit of severe “zero-Covid” policies – including, almost unbelievably, a lockdown of Shanghai – are reflected in the struggles of the stock indices in Shanghai and Shenzhen.

By contrast, the S&P 500 is only down slightly and up more than 60 per cent in the past three years. The performance of the Hang Seng Index has been respectable, down only around 5 per cent.

We can’t celebrate too fast, though, as the Hong Kong market has fallen by nearly a quarter in the past three years. That is second only to Russia among the recognised markets, which was down almost 40 per cent in the first quarter of 2022.

Famine has been real in Ukraine, where food and water have been cut off in some cities, recalling a tactic used in medieval times. We saw grocery shelves in Hong Kong cleared by panic buying, revealing the fragility of supply chains and poor messaging.

04:22

‘Large-scale lockdown’ expected when Hong Kong launches universal Covid-19 testing, source says

Commodities prices have leapt this quarter, with natural gas, oil and wheat all rising sharply. Commodity prices were rising anyway, but a full-on war shocked the markets.

Markets tend to be easily shocked, though, and the narrative machine went into overdrive. Extrapolations were made to possible invasions of other European countries, assisted by some nuclear missile wagging by Russian President Vladimir Putin. Markets react to rates of change in narratives, and that was a big change. A month later, Russia is licking its wounds after having forgotten how hard people will fight to defend their homes and families.

Despite talk of a potential ceasefire, the base scenario is that the war will degrade into attrition. Ukraine will keep going because it cannot afford to stop, and Russia is unwilling to give up its ill-gotten gains. The solution of ceding some Russian-occupied parts of eastern Ukraine is unlikely to be enough to keep Putin in power after his show of poor judgment.

The narrative, however, will not see such a rate of change. A tumble in the rouble and rubble in Mariupol will cause deep distress to innocent civilians, but they have fewer implications for the world at large. Wanton destruction becomes unsustainable even to the destroyer.

01:33

Ukrainian city of Mariupol descends into despair with over 2,000 people killed since start of war

This column has previously noted that wars, while shocking, are not necessarily bad for investments. Traders now know that oil and food supplies will be reduced, supply chains will fracture and tensions will remain, but the rate of change in those expectations has fallen dramatically. What will affect markets in the next quarter? To quote Bill Clinton’s 1992 US presidential campaign, “It’s the economy, stupid.”

Global economies are in transition from medium growth, high liquidity, low interest rates, almost non-existent inflation and strong global supply chains to the opposite. The most likely narrative to change soon is that of inflation, with the US Federal Reserve now expected to double its five-year forecast to 3.6 per cent.

These expectations are lowballing. The narrative has more to go. One indicator of inflation, the US benchmark 10-year bond, fell a huge 8.2 per cent in the quarter; bond yields (which move in reverse to bond prices) rose from 1.5 per cent in December to the current level of around 2.3 per cent. It may not seem much, but that’s a 50 per cent increase in interest bills.

The narrative change that dares not speak its name is how missteps in policy by all governments could affect markets. Covid-19 brought about a new activism as governments took charge. Now there is a danger of governments tinkering just because they can. Why else would Japan inject liquidity into the market and risk crushing the yen just because it has a dated policy limit on its long bond?

Yields are rising globally, so let it go. The next step is that Japan will intervene to support a currency made weak by its own misguided policies. It’s like when I try to fix my golf swing multiple times before becoming completely contorted.

China is also contorting, having to ease liquidity to counter the economic slowdown amid its lockdowns. In Hong Kong, we have experienced micromanagement of the pandemic, with policies announced and quickly abandoned.

Policy aside, the equity market is still consuming the vast liquidity injected during the pandemic while economies try to sustain recovery. Longer-term, the US bond yield curve – an indicator of recession, albeit a rather unreliable one – is teetering on becoming negative. Stagflation and recession are coming, but they are some way off.

The lesson for investors is that the roof needs to be repaired while the sun is shining. However, there is a silver lining while you are planning for stagflation. Despite the apocalyptic quarter, at least robusta coffee future prices have fallen nearly 15 per cent on the London exchange. We might need it.

Richard Harris is chief executive of Port Shelter Investment and is a veteran investment manager, banker, writer and broadcaster and financial expert witness