The “Great Rotation” out of interest rate sensitive stock markets and sectors
Aside from geopolitical uncertainty from the Russian invasion of Ukraine, stock markets have become increasingly choppy because of a changing in the broader economic backdrop. For the first time in 40 years, investors need to contend with a sharply rising cost of living. Take the US, for example: in January, headline CPI inflation rose 7.5% from year ago, its highest rate since 19821.
Food and fuel remain a key source of inflation globally. The UN Food and Agriculture Organisation’s price index is up nearly 50% since reaching a low in May 20202. Ongoing supply chain issues – including labour shortages, rising processing costs and delivery concerns – caused by the pandemic have contributed to higher food prices. Looking forward, John Allan, the chairman of the UK’s largest supermarket Tesco, warned in a recent BBC interview that food price inflation can be expected to accelerate further in the Spring3. Meanwhile, brewer Heineken’s CEO warned that the cost of a pint can be expected to rise due to “off the charts” cost inflation4.
Energy prices have been the public face of inflation. UK petrol and diesel pump prices at the forecourt are at record highs. Ofgem, the energy regulator, has already warned that the price cap will rise by 54% from 1 April 2022 following a surge in natural gas wholesale prices5.
Even before the Russian invasion of Ukraine, concerns about long-term European natural gas supplies were set to linger and keep energy prices up. The EU is reliant on Russia for 40% (two-thirds in Germany’s case) of its imported natural gas and 20% of its oil6. The issue is not that Russia is reneging on fulfilling its long-term contractual commitments to pipe gas to Europe, but that it is providing less to the global market currently. This creates competition between Europe and Asia for additional gas, which drives up the price in the process.
The problem of supplying natural gas to Europe goes back to a previous Ukraine-Russia gas pipeline dispute in 2009, which led to supply outages for some countries in the bloc. Back then, regulators decided to reform the gas market by moving Europe away from longterm contracts to one where prices are determined by current supply and demand.
However, by moving to a market-driven pricing structure, the continent is now vulnerable to large price swings from changing supply and demand. This situation has been exacerbated by rising natural gas demand used for electric power following the systematic retirement of coal and nuclear power plants across Europe. Low gas inventory in Europe and policy pressure to limit global fossil fuel capital investment as we move towards a greener energy mix has restricted available supply too. In short, energy (and food) prices could remain elevated and maintain upward pressure on inflation and particularly as the West has imposed financial sanctions on Russia.
Central bankers and money markets are now moving to mitigate inflation risk in the economy. The Bank of England raised interest rates by 0.25% to 0.5% last month, its first back-to-back meeting rate hike since 2004. In the US, the Fed is likely to hike rates when the Federal Open Market Committee (FOMC) meets on 16 March. The European Central Bank (ECB) is also concerned about rising inflation and has warned of monetary tightening ahead. Money markets are now anticipating the ECB’s policy interest rate will rise by the end of 2022. However, given recent events the ECB could be more cautious than the market consensus currently.
This change of mood from central banks has lifted bond yields. Stock markets and sectors that are sensitive to rising bond yields (notably US, growth and information technology-related stocks) are now underperforming year-to-date. Conversely, the less rate sensitive “old-world” markets and sectors have been the outperformers – including the UK, plus the energy and financials sectors. Given that bond yields typically rise as central banks raise rates, we expect capital to flow to these value areas of the market in this “Great Rotation” theme for 2022.
Make Asia Great Again
After lagging the market last year, emerging market Asian stocks could benefit from investor rotation in 2022. At the heart of Asia is China, which is an important determinant of regional equity returns. Recent events show that Beijing appears to be changing direction, moving to stimulate the economy through looser lending conditions – see our February Investment Outlook. For investors, an important fact to note is that China is seeing faster credit growth, which could potentially lift private consumption. There is plenty of available demand. HSBC estimates that China’s middleclass numbers around 340m people (larger than the entire US population) and is forecast to increase by over 45% by 2025 to more than 500m7. This expanding middle class provides support for China’s long-term economic growth.
Politically, there is also reason to juice up the economy ahead of China’s 20th National Party Congress in October, when President Xi is expected to be handed an unprecedented third term. With the Beijing Winter Olympics over, and providing the COVID outbreak remains contained, there is room for China to open its economy and for firms to deliver on company earnings expectations. China (and Asia) could surprise investors in a positive way in the Year of the Tiger.
1,2 Refinitiv, 28 February 2022
3 https://www.bbc.co.uk/news/business-60279019, BBC, “Worst to come for food price rises, Tesco boss says” 6 February 2022
4 https://www.ft.com/content/345f9779-b455-46af-aece-70b27fcd75df, FT, “Heineken chief warns cost inflation is ‘off the charts’”16 February 2022
5 https://www.ofgem.gov.uk/publications/price-cap-increase-ps693-april, Ofgem, “Price cap increase” 3 February 2022
6 Russia/Ukraine: Assessing the risks to the European economy, 15 February 2022, Deutsche Bank
7 China in the Year of the Tiger, February 2022, HSBC
Year to date the MSCI All Country World Value Index has outperformed its Growth equivalent by around 9%. This trend manifested itself geographically in outperformance of the UK market and as the Ukraine situation became more serious, the UK was one of the few markets to have positive returns. The UK has relatively high weightings in energy, financials and consumer staples which all have ‘value’ attributes. It has low weightings to areas of the market which generally have higher levels of earnings growth like information technology and consumer discretionary. These sectors are present in high weights in the US equity market, and led that to be one of the global equity markets biggest underperformers this year.
In the US, a shift in monetary policy is underway as the Federal Reserve is preparing to raise interest rates at their 16 March 2022 meeting. At the end of November 2021, in a Senate testimony, Federal Reserve Chairman Jerome Powell said that it was probably time to retire the use of the word “transitory” which the Fed had been using to describe current inflation. This arguably marked the beginning of a significant tightening in interest rate expectations over the following months, which pushed the 2-year treasury yield to around 150bps. This is the highest level it has been since January 2020, before the Federal Reserve cut interest rates to 0% in response to the global pandemic.
One of the main risks to the European economy posed by the Russia-Ukraine crisis comes from the natural gas market. The chart to the right shows that gas prices have increased fivefold since the start of 2020. Prices have been particularly volatile over the last year because of three factors. First, last winter was colder than usual which led to higher demand and, in turn, resulted in reduced supply. Second, renewable energy output in 2021 was disappointing, which increased dependence on gas and limited the ability of countries to rebuild energy supplies. Third, in the final quarter of 2021, Russia reduced supply via its pipelines ahead of the military build-up on the border of Ukraine. This has left Europe exposed to any potential disruption in the natural gas market. The European Union is most exposed given that Russia supplies around 40% of its natural gas. By comparison, the UK only imports around 4% of its gas from Russia. But that doesn’t mean it will escape higher prices if there’s disruption to supply. If prices rise on European wholesale markets, British consumers are likely to face even higher energy bills over the coming quarters.
Distressing geopolitical developments have taken market participants’ immediate focus away from inflation, monetary policy, and mega cap valuations as war broke out between Ukraine and invading Russian forces on 24 February. Global equities fell 2.6% over the month, with Europe ex UK underperforming global peers due to the proximity of the war in Ukraine and the greater headwind of higher gas prices. The main channel through which the crisis has impacted global markets to date is via commodities. The price of Brent crude oil moved above $100 in the face of elevated geopolitical tensions. The UK was one of the few markets to turn a positive performance owing to the sectoral make up of the UK market. It is, of course, exceedingly difficult to anticipate market reaction to changes in such ongoing crises, however, focusing on the fundamentals should see markets resume their upward trend when the immediate volatility subsides.
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