What will be the impact of the war on raw materials and financial markets

23 May 20222 years ago babelfish

Three months of war in Ukraine: the balance sheet on the markets and asset allocation. The analysis by Filippo Casagrande, Head of Insurance Investment Solutions of Generali Asset & Wealth Management

Despite the escalating tensions surrounding the Ukrainian crisis, the prices of energy commodities have declined in the last month. While the price of Brent continued to fluctuate between $ 100 and $ 110 a barrel, the price of European gas delivered in June marked a sharp downward correction, returning to pre-invasion levels and marking a decline of almost 70%. from the peaks reached in early March.

However, the situation is less rosy looking at the longer maturities of the contracts traded on the financial markets. The prices of gas to be delivered at the end of 2022 are almost stable, while for those to be delivered in 2023 and the years to come, new highs are recorded, demonstrating that the market is repricing upwards the possibility of a prolonged phase of supply problems. Furthermore, tensions over gas prices are expanding outside Europe and are also affecting the United States to an ever-increasing extent. In fact, the price of gas delivered in June quoted in the United States rose up to 55% compared to the end of March and almost doubled compared to the levels prior to the start of the conflict, only to correct slightly in recent days.

In general, the pressure on commodity prices remains high. The prices of wheat and corn quoted in the United States continue to rise, now close to all-time highs after the increases of between 40% and 50% recorded since the beginning of the year. This is having serious repercussions on consumer food prices, putting the food security of millions of people around the world at risk.

The rush of inflation and monetary policies

Following the violent repricing of central bank hike estimates in recent months, the past two weeks have seen a slight downward correction. The comments of Fed Chairman Powell – who has currently ruled out the possibility of hikes from 75 basis points in the next Fed meeting – and fears about growth have, in fact, weighed on the estimates of the next moves by the Fed and on the future prospects of the inflation.

The outlook for inflation has not changed significantly, however, with energy shocks adding to an already complicated picture of underlying inflation fueled by the strength of the labor market and past fiscal and monetary stimuli.

In the United States, inflation fell slightly in April, but more contained than analysts' estimates: core inflation fell to + 6.2% year / year, while the overall index settled at +8 , 3%. However, this slowdown is driven by the more volatile components (in particular the decline in used car prices weighs), while the more structural components linked to the performance of the labor market (unemployment at 3.6% in April, practically at pre-existing levels -Covid) and the real estate market continue to record new highs. In the Eurozone, core inflation accelerated to 3.5% yoy in April (+ 7.5% overall inflation), clearly the highest level since the birth of the euro. Unemployment fell further, to 6.8% in March, the lowest level ever recorded in the Eurozone.

According to Bloomberg data, the average inflation estimate for 2022 in the United States rose to 7.0%, compared to 6.2% at the end of March, and to 6.5% in the Eurozone, from 5.6%. at the end of March. Comparisons with the estimates at the end of 2021 give an even clearer idea of the extent of the revisions: in fact, it started from 4.4% in the USA and 2.45% in the Eurozone. Estimates for average inflation in 2023 also continue to rise, reaching + 3.0% in the United States (+ 2.35% at the end of 2021) and + 2.4% in the Eurozone (+ 1.5% at end 2021).

Although inflation numbers have so far surprised constantly on the upside, it must be said that in the coming months we could begin to see a decline, due to the gradual reduction of the base effects linked to increases in energy prices and some volatile goods and services. . The moderate decline in inflation recorded in April in the United States points in this direction. However, it should be remembered that underlying inflation remains persistent and is not yet showing signs of slowing down. Indeed, it follows the dynamics of the labor market and the real estate market with a delay of 6-9 months, and at the moment these markets may not yet have reached the peak of the cycle.

Financial markets and prospects

After the heavy losses suffered during the month of April in both the bond and equity sectors, the month of May initially saw a continuation of this negative trend. Fears about growth and the rise in real rates pushed stock markets lower, while credit spreads hit new highs since the beginning of the year, exceeding those reached at the beginning of March in the days immediately following the outbreak of the war in Ukraine.

A timid hint of recovery was then recorded in the second week of May, together with the reduction in expectations of a rise in central banks' rates and a drop in yields. Core rates, after rising by another 10-25 basis points (bps) in the first week, have returned to decline. Indeed, ten-year rates in Germany and the United States had largely exceeded 1% and 3% respectively, only to retrace and settle slightly below these thresholds.

More pronounced falls in short-term rates, especially in the UK (2 years at -37bps from the end of April) after the Bank of England signaled little conviction to indicate new hikes after driving rates to 1% in the meeting at the beginning of the month. However, the steepening of the curves should be temporary: the increase in ECB and Fed rates should favor a new flattening, with a possible re-inversion of the US curve.

Public and private spreads continued to move higher, but public spreads retraced more markedly in the second week. The BTP-Bund spread, after breaking through 200 bps, fell again to the 190 bp area. Conversely, credit spreads increased significantly: +17bps for European Investment Grade, +47bps for European High Yield. In the United States, HY rose sharply (+70 bps), which had held up well in relative terms so far.

As for the equity market, the MSCI World Index marked a further decline of 3.2% (in dollars) from its levels at the end of April. Leading the declines once again in the Growth sector (-5.4% in Europe vs a 1.1% decrease marked by Value), with the Nasdaq down 4.2% but up 6% from the lows marked in the month. China is also bad (MSCI China -6.9%), where the tough lockdown policies against Covid are weighing.

Looking to the future, compared to the scenario at the end of April, there is a certain degree of fatigue in the growth dynamics which is beginning to weigh on the expectations of rate hikes. Some indicators of this scenario, such as the ratio of copper to gold prices, appear to have peaked and are declining due to fears about growth.

This could translate into greater resistance for interest rates as they continue their rise, which began in January 2022. This could be a first major stabilization of government (at least US) rates and if we were to see a decrease in rate volatility, this could favor a return of flows in this asset class, thus stabilizing the government bond market.

As regards the riskiest assets, however, uncertainty remains high. The increase in real rates has indeed led to a reduction in stock market multiples, but so far we have not witnessed a correction in the growth estimates for companies' profits. If the signs of a slowdown in growth continue, this would translate into downward pressure on estimates, potentially weighing on equity markets and the higher beta sectors of the credit market.

With this in mind, we believe that the following are the main guidelines for managing tactical portfolio allocation:

We maintain an underweight in the equity component. Increased growth risks weigh on the attractiveness of this asset class, despite an already significant decline in market multiples. The greater correction of the Growth sector and of the American lists compared to the Value sector and the stock exchanges in Europe which took place in the last month was significant and suggests greater caution in relative positioning within this asset class.
Regarding the bond market, we believe that the psychological thresholds of 3% for the 10-year US Treasury rate and 1% for the German Bund rate represent a possible level to move towards a more constructive stance on government bonds. Indeed, the trade-off between restrictive monetary policies and the impact on growth is becoming increasingly evident, and this could discourage further upward pressure on yields. We maintain a preference for long parts over short parts, where yields can still move upwards due to the Fed and ECB's monetary policies.
At the same time, we continue to seek investment opportunities in the non-government bond world. In particular, new issues in quality Investment Grade credit, particularly at a discount and therefore at very attractive spreads, may be the best way to add credit exposure. With the same principle and attention to selection, some names in the less risky range of the European High Yield sector are attractive. We reiterate the greater caution on the American High Yield market, whose spreads are still compressed relative to the European and emerging world, despite the increases in recent days.
Likewise, we maintain our interest in the area of emerging bonds in local currency, where the yields offered are very high thanks to the preventive action of most of the emerging central banks. Many countries and their emerging markets have already faced very aggressive rate hike cycles by their central banks in recent months and quarters. Emerging local currency bonds are one of the few asset classes to show positive returns since the start of the year and we believe this can continue. Similarly, emerging equity markets are also better positioned to those of developed countries and relative valuations still close to all-time lows suggest that this is a good time to consider a larger allocation to this asset class.
Finally, we continue to allocate to private assets, debt and equity, however with a strong focus on specific sectors and geographies.

This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/impatto-guerra-mercati-materie-prime/ on Sun, 22 May 2022 06:38:19 +0000.