Russia has crossed the Rubicon

The evening after Julius Caesar led a legion across the river Rubicon in northern Italy in 49BC, breaking his own law against military movement, he uttered the famous phrase “ālea iacta est (the die is cast)”. Russia has crossed the Rubicon with their unprompted invasion of Ukraine. In doing so the die has been cast for the economic demise of Russian citizens for many years to come, if not a generation. It appears the only pathway for Russia’s return from the economic wilderness will be regime change.

The immediate economic consequences of Russia’s invasion are varied. Horrific for Ukraine, disastrous for Russia, and problematic for Europe. Europe’s energy reliance on Russia, some 40% of all its needs, makes decoupling painful. Russia and Ukraine’s withdrawal from commodity markets, pushing up raw material prices, also exacerbates inflation. Higher commodity prices may be a positive for commodity producing countries, like Australia, albeit for unwelcome reasons. Inflationary embers, already burning hot from COVID supply chain disruptions, government and monetary stimulus, and pent-up demand, have been given further oxygen.

Military pundits have many views on events unfolding, but all seem to agree that it is improbable for Ukraine to be fully overrun by Russia. Western unity is galvanised and when a Ukrainian recovery is feasible, a chorus of nations are likely to fund that recovery. Democratic egos will seek to ensure Ukraine’s prosperity far surpasses its violent neighbour’s. Ukraine and Russia’s medium term economic futures, although difficult to see clearly at this perilous juncture, seem set on two very different paths.

Economic update

Russia’s invasion has accelerated the schedule of central bank tightening. Markets were already moving forward rate rise expectations through the back end of 2021 and particularly in January 2022. Markets are now pricing ten 0.25% rate rises by the United States Federal Reserve in 2022.

Nearly all investment assets, but particularly bonds and growth-orientated businesses, performed negatively over the last 6 - 9 months, weighed down by the prospect of higher interest rates.

China

Anti-Russian sentiment is acerbic in Europe. The war dominates media coverage in a way incomparable to what we experience here in Australia. Anecdotal conversations with investment professionals based in Europe indicate that China’s equivocation has been a catalyst for frostier relations between China and the EU. China’s ‘balancing act’ has failed to appease Western nations (not that it mattered for the already soured relations with the US and Australia). This appears to be terrible timing for China. Xi Jinping sought to reset relations with EU bureaucrats in a recent meeting:

“The EU should form its own perception of China, adopt an independent China policy, and work with China to promote the steady and sustained growth of China-EU relations and add stabilising factors to a turbulent world” – Xi Jinping

And we thought it was Americans who were the great optimists! Such is the values gap between Xi Jinping and European leaders that China felt it might still be able to grow trade relations with the EU without condemning atrocities committed by Russia on a fellow European country. This is either a gross misunderstanding, miscalculation, or simply playing to a Chinese audience by Xi Jinping.

In addition, further to our previous newsletters, Chinese economic growth faces the continued headwind from its desire to deleverage a property bubble within its borders. China also continues to persevere with a near impossible ‘zero-COVID’ strategy in the face of the more contagious Omicron subvariant, stifling economic activity. In the wake of spiking cases, China has allowed home testing, forfeiting centralised COVID control. The alienation of COVID positive persons within China dissuades self-reporting, leading to poor control measures and continual transmission. Although the end of a ‘zero-COVID’ approach seems obvious to external viewers, with an apparent lower efficacy rates of Chinese made COVID vaccines and Xi Jinping seeking an unprecedented third term later this year, it is understandable Chinese leadership is persevering with its ‘zero-COVID’ strategy.

Large parts of the Chinese economy are in some form of lockdown. China’s central bank is lowering interest rates to soften economic conditions at home. Meanwhile, the West is raising interest rates. Capital flows out of China are accelerating. China, having sacrificed moral credibility with their equivocation on Russia, are now coupling this with the prospect of diminishing investment returns. This toxic combination may exacerbate a flight of capital out of China. If this accelerates, the Renminbi may face sustained devaluation pressure, which although good for their exporters, enhances inflationary pressure, curtailing the capacity for central bank support. Chinese leadership has got a battle on their hands. If further evidence were required, the Chinese Politburo was short on ideas in how they might meet these challenges, with their briefest ever Politburo policy statement.

Inflation

Outside of geopolitics, economic commentary is dominated by one factor, inflation. Inflation, talked up as transitory in 2021, is sticking around. Sticky inflation, driven by inflation expectations and tight labour markets, is emerging.

The labour market can only be described as abnormal in the US. In December 2021, there were 4.6 million more jobs available than unemployed persons. Presently, within the US, there are 1.7 jobs available for every unemployed person (BCA Research).

In Australia, where more effective vaccination, health care and better wage standards prevented any material exodus from employment markets, labour markets are very strong (but not abnormal). Within Australia, there remains a ‘war on talent’ (demonstrating employment demand for skilled labour). As labour markets continue to tighten, wage growth will follow.

Wage growth underpins cost push inflation, that is, businesses passing on higher operating costs to customers. In the US, where labour markets are tightest, wages make up approximately 55% of production costs (BCA Research).

Central Banks and most market participants have already recalibrated to interest rates rising soon. The Fed, who raised rates in March, is now laser focussed on curbing inflation. The RBA dropped the ‘patience’ dialogue from its commentary in April. A June RBA rate rise is the current consensus bet, although specific forecasts should be taken with a grain of salt. However, not a week goes past in which our office doesn’t receive an email from a lender increasing mortgage rates. Fixed rates have been rising since late 2021 and continued rising through early 2022.

There is nothing nuanced about monetary policy. It is no Adam Smith ‘invisible hand’ subtly influencing decisions - it is a Keynesian sledgehammer, pounding changes to market psychology.

The challenge ahead for central banks stems from a misjudgement on transient inflation, which has led to an inflationary overshoot (above 7% in the US). High inflation erodes consumer confidence and now central banks are playing catch-up on interest rate rises and doing so while waning consumer confidence feeds into an economic slowdown. This combination of slowing economic growth with elevated inflation has raised the spectre of stagflation. Stagflation (growing inflation and slowing economic growth) is a tricky combination for central banks as these are opposing signals. Typically, a central bank is forced to tackle inflation, resulting in a tightening of credit conditions, exacerbating already weak economic growth. A misunderstanding of inflation by central banks has greatly increased the prospect of a policy misstep, leading to further economic downside.

As the outlook grows more bearish for investors, a glimmer of hope is that over the medium and long term, government and household debt burdens are so vast that a small change in interest rates has an amplified impact. Therefore, interest rates shouldn’t have to move too high to moderate inflationary pressures.

It follows that investors shouldn’t dramatically re-assess interest rate assumptions underpinning discount rates, as its likely these will reset to a lower natural rate of interest. If this does transpire, it would be congruent with a long-term (800 year) trend in the decline of the natural rate of interest.

Source: Schmelzin, 2017. Eight Centuries of the Risk-Free Rate: Bond Market Reversals from the Venetians to the ‘VaR Shock’

Investment Commentary

Investors will often use a central bank cash rate, or ten-year government bond rate, as a proxy for the ‘risk free rate’. A risk-free rate then forms an input into deriving a discount factor to calculate the value of a future set of investment asset income streams. With interest rates so low, small changes to risk-free rate assumptions have a magnified impact on valuations. This impact on valuations is particularly acute for ‘long duration’ assets, where discounting over an extended timeframe compounds a change to discount assumptions, increasing the change to valuation. A ‘long duration’ asset is one that provides the lion’s share of investment returns in the longer term. Think ten-year bonds, or the next great growth tech stock yet to turn a profit but set to rule the world in ten years.

Some of the more exuberantly valued sections of the market, much of which are the long duration growth hot stocks, have seen 40-90% reductions in value over the last 6 months. Rising government bond yields are also beginning to attract investors back down the risk curve.

Although the market zeitgeist is rising interest rates and higher inflation, markets are also signal a lower ceiling on how high interest rates will go. The yield curve has inverted, which sees some shorter duration assets (three & five year bonds) generating higher yields than a ten year bond. This is a signal that higher interest rates might not be sustained over the longer term.

The dramatic expansion of private and public debt means a modest rise in interest rates should be sufficient to curb household and government spending capacity. Further, we think there may even be some conversations behind policy maker’s closed doors, that allowing inflation to run a higher (so not going to hard on interest rates) might help governments out of a tight budgetary position (particularly in Japan, the EU and US).

So, as investors, this means inflation risks are on the upside, interest rates mightn’t rise as high as expected (but they’re rising), and capital allocations to price setting business and real assets are an investor’s best protection from inflation.

We continue to favour infrastructure assets, many of which have taken the opportunity over the last few years to lock in debt funding on very attractive terms, some for as long as 10-14 years. True infrastructure assets are akin to regulated monopolies, they generate a regulated return and can pass on rising costs (inflation). Customers of a monopolistic service provider (toll-road, bridge, pipeline etc.) have little choice but to accept the price. You are unlikely to ever get dazzling 20%+ returns, but in a more bearish investment world, investors should be comfortable settling for a 6-8% return (if investments are held through the medium term).

Many investors also like commodity businesses through inflationary cycles. Although not price setters, commodity producers sell output at the prevailing price, which is seen as a good inflation hedge. However, investors should be cautious as the commodities market is volatile and entry now would be at record high commodity prices. Risks aside, Woodside Petroleum looks set to be a beneficiary from a global underinvestment in dispatchable energy.

“Bond market carnage” was a recent news headline. The quicker than expected update in interest rate tightening has been tough for bond investors. Losses across this traditionally ‘safe’ asset class demonstrate the challenge of balancing portfolio risk through a rate rising cycle.

Finally, the thought of leaving capital in cash, albeit comforting, is even more economically unsound than it was previously. Inflation at 3-7%, depending on where you are in the world, means your real return on cash is now -3 to -7% guaranteed as cash deposits still generate negligible returns.

Although the investment environment is tricky, it’s not without opportunity, and the recent correction through the first quarter of 2022 is a net positive for new investors.