Pomona Wealth Market Comment April 2022 - War and inflation

The main topics driving the markets now are the war in Ukraine and the fear of inflation. These two distinct topics get more intertwined in the common press narratives to build an alarmist backdrop that even central banks may not be able to ignore.

News from the war in Ukraine is moving the markets: when Russia talks of a de-escalation which is not the same as a ceasefire and may be the result of a tactical decision given Russia’s lack of progress around Kiev, financial markets eager to react to headlines send the oil price lower a little bit and equity markets rally on the news. While any progress towards peace is of course to be welcomed, trading financial markets is not quite the same thing as military tactics, so this should probably be regarded yet as another volatility episode and not necessarily extrapolated into a new trend.

Russia’s actions may be outrageous, but its economic weight is limited. The economic flows which the war put at risk are in commodities (wheat, corn, etc.) and energy. As far as supply chains are concerned, the most dramatic disruption is to the provision of wiring harnesses from Ukrainian factories to German carmakers BMW and Mercedes. Important components, no doubt, but hardly the marker of an imminent collapse of European production.

News from US GDP data gets a lot less attention. The data of the fourth quarter was revised which is not noteworthy as data is always revised, but more importantly which part has been revised most: the consumer spending number was revised down quite sharply. For the second quarter in a row, spending on things like furniture fell. This fits with the story that lower income US households have spent their pandemic related savings and are starting to live within their incomes. Demand in the fourth quarter in other words was in the process of normalizing.

The supply of goods, on the other hand, was hitting record highs at the same time. Indeed, the February industrial production data from South Korea was stronger than expected. These numbers indicate that the world keeps producing ‘stuff’ at record levels. The normalization of demand in the US and record production means that the excess supply has nowhere else to go but the warehouse and we are seeing a build-up of inventory. Interestingly, this phenomenon is repeated in the UK and in the major economies of the EU.

This demand story should not be lost amidst the noise about inflation or the fog of war. Inventory building could indicate a slow-down in production which could be exacerbated by consumers spending less on ‘stuff’ and more on energy. The price shock we are seeing with higher energy prices has deflationary effects on consumption. This could indicate a slowing down of economic growth and inflation. More importantly, this would relieve some of the pressure from the central banks to increase rates and engineer a soft landing of the economy. If central banks keep a level head and a steady hand, we will see less interest rate hikes than the markets currently expect. This should bode well for equities and a prolonged upswing in valuations especially in secular trend sectors of the economy. Having retraced about half of its losses this year, the markets could be poised for a sustained rally in the coming weeks and months.

Geneva, April 1st, 2022