Autumn 2022 Economic Update

Posted on May 3, 2022

Headlines were dominated by the horrific war in Ukraine and the terrible humanitarian crisis continuing to unfold there. In pursuing this conflict, Vladimir Putin has surely etched his name amongst history’s most reviled.

The grave implications of the Ukraine conflict quickly fed through into increasingly volatile financial markets, with share markets declining and bond prices also generally falling over the quarter.

On the other hand, commodity prices soared. Russia is a key producer of several important commodities including oil and gas. Ukraine is an agricultural powerhouse and a significant global exporter of wheat, corn and sunflower oil. With the conflict impacting supplies from both countries, this magnified existing supply chain disruptions and added further unwanted impetus to surging global inflation.

Elsewhere, the Chinese market was negatively affected by renewed Covid-19 outbreaks in the region, leading to new lockdowns in several major Chinese cities.

Market turbulence, as unpleasant as it is, will eventually ease. In fact, to the extent that lower share prices now imply a higher expected return for owning shares, current market prices could eventually be regarded as a buying signal for longer-term investors.

Whatever the markets may have in store for us in the coming months, heightened market volatility looks set to continue for some time to come.

While it was undoubtedly a tough period for investors, this financial turbulence paled in significance when compared to the devastation and heartbreak being experienced by the Ukraine people, and by their friends, families and loved ones around the world.

Inflation outlook

Inflation has risen sharply over recent months and what was initially projected to be a transitory phenomenon has become much more widespread and persistent. Disturbingly, there are even signs that the recent acceleration in rising prices is increasingly being seen as the new norm.

That represents a real dilemma for policymakers. With inflation already much higher than forecast, central banks (including the Reserve Bank of New Zealand) have been backed into a corner and are now having to prioritise policy measures aimed at containing inflation. The primary tool at their disposal to achieve this is to raise interest rates.

The repercussions of this are already apparent in New Zealand with the Official Cash Rate (OCR) here having been raised three times (by a total of 0.75%) since 6 October 2021. With domestic interest rates already on the rise, and debt servicing costs rising along with them, this exacerbates the cost-of-living challenges already faced by many New Zealand families.

And, in a world still trying to consolidate after the last two Covid-impacted years, the immediate outlook for economic growth suddenly looks more fragile. Whilst this adds to uncertainties in the short term, investors should still be comforted that capitalism has a way of figuring out how to survive and thrive, even in challenging environments. We can further be comforted in the fact that markets react significantly faster than economic indicators.

The fall in share prices we saw during the most recent volatile period is a result of market participants demanding a lower price for the known risks involved in these investments. This uncertainty and bad news have already been priced in and as we ease through this difficult period, we can – as long as we don’t see any further surprises – expect our investments to deliver positive returns even if the economy is somewhat subdued.

Central bank policy

After more than two decades of successfully implementing monetary policy to carefully manage inflation expectations within a low and narrow band, central banks are now being compelled to act to ensure that inflation expectations don’t suddenly become unanchored.

However, this action is likely to have negative implications for economic activity. Central banks have become more determined to remove economic stimulus in recent weeks. In spite of acknowledging the many uncertainties within the economic outlook, including the Russian invasion, and the impact that tighter policy settings will inevitably have on growth, inflation has simply become too high for comfort.

The European Central Bank surprised markets during the quarter by presenting plans for a faster-than-expected reduction in their bond buying programme. Their policy response suggested their concerns about inflation prevailed over all other considerations, including the war in Ukraine, and the deteriorating outlook for economic growth.

The New Zealand situation is particularly acute. With inflation expectations now above the Reserve Bank’s 1% to 3% target band and inflation itself still yet to peak, the bank is expected to progressively move the OCR to almost 3.5%; potentially using 0.5 percentage point increments in at least one of the next two meetings. Unfortunately, if delivered completely, this could be akin to slamming the economic brakes on.

Consumer and business confidence is already at rock bottom. Household cashflow is being reduced by negative real wage growth, high inflation, and the sharp rise in mortgage rates. New Zealand house prices have become ‘wobbly’ over the past three months and salesto-listings data suggests a period of housing market weakness could lie ahead. Taken together, these factors make a compelling counter argument for why the Reserve Bank’s projected tightening cycle may not be able to be delivered completely, but for now this is the outlook being anticipated by the markets.

Is food the new gold?

Beyond the immense human suffering, the war in Ukraine and the sanctions imposed on Russia create broader issues related to global food production and supply.

At one end of the spectrum are countries with a significant dependency on essential commodities (including mineral products, chemicals, metals and soft commodities) that were imported from Russia and Ukraine.

At the opposite end, there are countries, many of them emerging markets, that could potentially position themselves to fill this gap by exporting more at higher prices.

Food prices and food availability will increasingly be a global economic and political issue. For example, the expected decrease in food production due to reduced spring plantings in Ukraine quickly lifted global wheat prices by over 15% since the start of the war.

Higher grain prices will have a disproportionate impact on low-income countries, particularly some countries in Africa, and even India, where spending on food makes up a relatively high proportion of their income. Pressure will mount on these countries to either find alternate sources of supply or to ramp up their domestic production.

But, as Russia and Ukraine had been significant suppliers of fertilizer to the world, ramping up production, even by other agricultural powerhouses, may be easier said than done. For example, Brazil, which is currently the leading exporter of soybeans, corn, sugar, meat and coffee, imports about 80-85% of its fertilizer needs, with almost a third of this coming from Russia, Belarus and Ukraine. Whilst Brazil is now launching a national fertilizer plan to reduce its dependency on fertilizer imports, this will likely take several years to make a significant difference.

And even if other regions recognise an opportunity to step up their own food production in an effort to fill the void, it can take considerable time to plan, sow, grow and harvest meaningful replacement crops. Quickly replacing the 40 million metric ton supply of Ukrainian wheat would be an astronomical feat.

What can we do? 

Maintain perspective and stay patient.

Uncertainty is a constant. We don’t know what the weather will be next week, and we certainly don’t know what might happen to change the current conflict in Ukraine, global travel and trade, supply chain pressures, concerns about inflation or the ongoing evolution of Covid-19. But we do know that all of these unknowns are factored into market prices.

And even though we may not know when or how, history tells us categorically that conflicts always end,
pandemics run their course, consumerism and trade generally flourish (on average), and inflation is more commonly able to be controlled within targeted ranges. We don’t see anything in the world to suggest that this time is any different.

In fact, if we took the Ukraine conflict out of the picture, we would have been looking at a world that was beginning to emerge from the Covid shadow, in which travel and trade were picking, up and people and businesses were making longer term spending and investment plans again. All of this will return, even if Vladimir Putin may have pushed the delivery date out a little.

While the returns this quarter have been poor, they (thankfully) bear no relation to the returns of the comparable quarter in March 2020 when Covid first arrived in the world.

It’s useful to look back at that time because the best strategy then was the same as it is today – ‘don’t panic and stick to your plan’.

We can quickly see the outcome of that approach from the table below:

The third column shows how three key market indices performed (in total returns in their local currencies) during that awful first quarter in 2020. Sadly, a number of unadvised investors unfortunately exited the markets at this point.

The fourth column shows the performance of those same indexes over a longer period (note: this longer period includes both the dismal returns in the first three months of 2020 and the poor returns in the recent quarter).

Holding on to your investments through these periods of heightened market volatility wouldn’t have felt like much fun, but the overall outcome was well worth the effort.

If history is any guide, that’s a conversation we will be having with you again in the future.