Inflation and invasions: the problems facing investors in 2022
While the chief investment officers of most private banks and asset managers bombard clients with stories of ‘megatrends’ – apparently unstoppable investment themes which will shape finance, business and society for years to come – there is increasing recognition that each of these seismic shifts generates parallel risks for every opportunity created.
The first priority at UBS, a leading proponent of promoting investible trends, is the return from a high growth, inflationary environment to a more “normal” post-pandemic era. Second is technology, including AI, big data and cyber security innovations and how this plays into growth valuations. Third is sustainability, detailing the road to net carbon zero goals, taking into account pricing, as governments balance climate targets with their economic impact.
“When people ask us what 2022 is all about, we tell them: it’s about the inflation question,” says Kiran Ganesh, head of investment communications at UBS Global Wealth Management. His comments came just days before a pronouncement from the head of the world’s largest sovereign wealth fund, the $1.3tn Norwegian oil fund, predicting that asset managers face years of return-sapping inflation.
Understanding the risk/return dynamics of this trend has become the top priority for private banks and their clients. Identifying those sectors immune to inflation and rate increases has been central to the work of investment strategists at UBS, with healthcare, financials and the energy sector – currently benefiting from inflated tariffs – expected to prosper.
Pre-empting recent market corrections in technology stocks, relationship managers at UBS have been scaling back exposure to the biggest names, while mixing in “smaller pure players in cyber security” to support portfolios, requiring insulation from interest rate rises and valuation turns. “We have been recommending clients reallocate to these areas away from tech megacaps and semiconductors,” reveals Mr Ganesh.
The climate change theme has included investing in renewables and companies providing cleantech solutions. This has been balanced with positions in traditional energy companies and commodities, not necessarily associated with green trends.
“In the energy space, you have to look at the whole picture, it’s not just about investing in the leaders, it’s about investing in improvers,” says Mr Ganesh, keen to engage with fuel providers and automotive infrastructure builders. “We need to make sure we are not neglecting large parts of the market.”
Digitalisation and Asian consumer power are the investment stories Citi is sharing with ultra-high net worth clients. “Digitalisation has been a long-running theme and perhaps one of those things not affected by central bank policies or cost of debt servicing,” says Guillaume Menuet, Emea head of investment strategy and economics at Citi Private Bank. A sub-theme is the burgeoning payments industry, expanding to include central banks issuing digital currencies, in addition to the big techs and start-ups that have joined the fray.
But it is the ‘Asian century’ narrative which Citi finds most persuasive. “The rise of the east Asian consumer warrants a lot of attention in portfolio construction and exposure,” maintains Mr Menuet.
“The middle classes is where the money will be made by corporates and if you think about population density plus rising standards of living, that will be the primary target for institutions in terms of managing wealth.”
Healthcare spending will be central to this equation, as demographics suggest this will grow in importance as people live longer.
More nuanced picture
Smaller wealth managers provide a more nuanced account of opportunities. “In the past 10 years, Europe has been very bad at digitalisation,” with German politicians waking up to their continent’s backwardness, confesses Bobby Vedral, partner at multi-asset firm Toscafund Asset Management.
“But today, I am excited about it, as Europe has automation, robotics and life sciences. Now if they digitise this, it becomes very powerful. While Europe may not have created Facebook, it does have the industrial machinery.”
The pandemic has been the catalyst for a Europe emerging from a decade of underperformance towards an interesting confluence of lifestyle and scientific trends across the Nordics, Switzerland, the UK and the continent’s eastern fringes. “If you combine the big trends of environment, climate, technology, biosciences, life sciences, pharma, lifestyle, automation and robotics, Europe is a very interesting location for that,” adds Mr Vedral.
As well as looking at technology as a broader trend, specialist wealth managers recommend breaking it down into constituent parts. “The metaverse is no longer the stuff of sci-fi movies. It will have a significant impact on entertainment, travel, gaming and education sectors on how consumers spend and on the whole retail spending experience,” says Sharmila Whelan, deputy chief economist at emerging markets specialists Aletheia Capital.
“Blockchain technology is the most important tech megatrend to emerge in the 21st century with wide reaching transformative implications for businesses across the board, from the art industry to the financial sector.”
Commodities, including inflation-hedging metals, energy generators necessary for fast economic growth, and agriculture may also be attractive. “Agricultural commodities are an interesting topic to play, not least because in a portfolio, their correlation with other asset classes is very low,” believes Daniel Egger, chief investment officer at Swiss wealth house St Gotthard Fund Management.
“Climate inputs, special weather events and low prices of past years have led to not much supply coming. Whenever that happens, this can correlate with strong prices.”
All eyes on conflict zones
Metals such as nickel, known for their conductivity, which can be adapted for use in electric vehicles and heating systems, are likely to be in demand. “We saw nickel skyrocket over the last two months,” says Mr Egger. “The driver is what is happening with Russia, one of the major producers. Should we see outright military conflict and expected sanctions from the West, then nickel supply could get scarce and several market participants are already placing their bets on that.”
But it is this notion of marrying opportunities with inherent risks which is increasingly dominating dialogue with clients, who do not want to be caught on the wrong side of long-running trends.
When it comes to risk modelling, there are even commentators suggesting China and Russia will co-ordinate respective military actions against Taiwan and Ukraine to maximise geopolitical concessions from a weakened US.
“The US would definitely be stretched. To be involved at the same time in two different theatres would make it quite difficult,” says Mr Egger, who doubts this scenario will take effect. “I think the risks are rising, considering statements from Chinese government officials, but I would doubt that China is going all in at this time in the decade, as they need to further build up their military in order to feel invincible to take such a step.”
Few portfolio managers have such confidence about Russia’s intentions, with most believing the likelihood of an invasion of Ukraine is an important consideration. While most see this as a downside geopolitical risk, the question they ask is how this will affect portfolio returns.
“The situation in Kazakhstan has showed us there is still a backyard of Russia,” says Mr Egger, referring to the enlisting of Russian troops to brutally quell street protests. “The question is what belongs in this backyard? Kazakshtan still does, to our understanding. With Ukraine, it’s probably more difficult to say.”
Economic impact
It is crucial as an investor to distinguish a wrong political move from the economic impact, according to Mr Ganesh at UBS. “We always need to ask: where is the economic impact coming from?” For UBS the two key geopolitical risks to watch – Taiwan and Ukraine’s relationship with their respective, belligerent neighbours – need to be carefully assessed.
“Will Russia restrict energy output to Europe, which is the key transmission mechanism in terms of where natural gas comes from, or can the effects be more localised to assets in Russia and Ukraine? Sanctions against individuals and parts of the Russian financial system would be a more localised event, whereas the energy market can have more of an effect on the European economy with inflation,” suggests Mr Ganesh.
Chinese military action in Taiwan would, however, have stronger global market ramifications, according to UBS. “The key factor is the semiconductor industry, which is vital to both economies and shown to be crucial to all global economies during the coronavirus crisis,” says Mr Ganesh. “Any consideration of military intervention would consider the impact on semiconductor production facilities. This is a complex industry requiring expertise and high tech manufacturing and their presence in Taiwan means both sides are likely to avoid a military solution.”
While both China and the US have been looking to reduce semiconductor dependency on Taiwan, which in the long-run may increase risks of military confrontation, the current tendency will be for peaceful pressures, believes Mr Ganesh. “In the near-term, given the level of dependence both the US and China have on Taiwan-produced semiconductors, we feel a military solution is a last resort requirement to provocation.”
Geopolitical risk
Geopolitical risk remains strongest for directly invested clients, with heavily weighted positions in markets, such as Ukraine and Russia, according to UBS, which recommends widespread diversification to neutralise this.
“For the majority of clients, inflation staying higher for longer is the key risk, which may have an impact right across the portfolio, regardless of sectors,” says Mr Ganesh. “But it’s still worth thinking about geopolitical risk, as clients can be heavily invested in individual regions, such as Russia, Taiwan and China and then they may be more impacted.”
Analysts who follow regional events closely offer the bleakest prognosis. “Europe is entering a really worrying time,” says Timothy Ash, senior emerging market sovereign analyst at BlueBay Asset Management.
“Europe faces the biggest risk of major conflict since the Balkan wars in the mid 90s. And the biggest risk of Russia – Nato clashes since the end of the cold war.”
But this is not where the risk stops. If US president Joe Biden fails to confront Russian counterpart Vladimir Putin over his intentions in Ukraine, broader American foreign policy objectives could be threatened. “The Biden team realises that if Mr Putin is allowed to get away with an attack on Ukraine, this would be a green light to Xi over Taiwan. So in recent weeks, as this realisation has dawned, we have seen a noticeable hardening in the US response,” says Mr Ash.
“Facing down Mr Putin over Ukraine is now seen as part of the China strategy, signalling to Mr Xi that the US might have made a strategic decision to withdraw from Afghanistan, but it is not going to be pushed around elsewhere in the world.”
There are others, however, who believe geopolitical risk is of secondary consideration to equity investors, used to regular central bank bailouts, especially during the pandemic. “The markets are relying on Uncle Sam and central bank carrots,” says Amin Rajan, CEO of the Create-Research consultancy. “They know there will be massive liquidity pumped in.”
The nervousness of investors in previous eras has been replaced by an in-built fear among central bankers, he believes. “Central banks have made so many people so wealthy,” he says. “If the markets tank and we see destruction of value, they are asking themselves: what will be the effect on the rest of the economy? Geopolitical risk is a consideration, but you can easily overwhelm it by pumping in more liquidity.”
