David Bowie’s vast contribution to the soundscape of modern rock was built on a parade of changing personas and well-timed creative pivots. Yet one of his earliest hits, the 1969 avant-garde track “Space Oddity”, proved to be his most enduring work. In the song, Bowie’s alter-ego Major Tom blasts off into space, loses connection with ground control and, ultimately, is left alone and adrift in a dark, unfolding cosmos.  

Investors may be feeling like Major Tom lately. It’s early days in 2022 but already the year has begun with a bang. New market trends are surfacing. The ground beneath us is shifting. Familiar sightings, like low and stable inflation, are rapidly vanishing. Last week, media outlets breathlessly reported a 7.5% jump in consumer prices. 

Clearly, a connection to the recent past has been lost.  

Meanwhile, after two draining years, many may look back wistfully on the pre-pandemic world. Of course, it is easy to forget the so-called New Normal of the 2010s was one of history’s blander, muddle-through interludes. Yet that decade was, if not a paradise lost, then the last “normal” time people remember.  

Where to from here? Unsurprisingly, our inbox is exploding with client questions about the future trajectory of financial markets. Below, we respond to 3 questions with the most impactful outcomes: 

What are your thoughts on the Fed’s recent hawkish pivot?

It is no surprise that the last few months have been jarring for financial markets. The Fed, initially believing price spikes were short-term, were caught in an almost cartoon-like backpedal as inflation instead accelerated to a 40-year high. A big hole was blown in their narrative. When Chairman Powell was asked in late 2021 about the Fed’s colossal miss, rather than fumbling around for an articulate response, he was plain spoken: “We can begin to see that the post-pandemic economy is likely to be different in some respects.” Aha! 

It was always obvious to us that the Fed had neglected a crucial component in their inflation analysis — over-playing the supply side (bottlenecks and such) and under-playing the demand side (rising household wealth, stronger capital spending and a structurally looser fiscal stance.). Adding in the demand part radically changed the calculus: inflation would be stickier as a boom in global aggregate demand would keep prices elevated (for more on this topic, see our May 2021 report entitled Global Inflation: Has The Force Awakened?). 

Still, there is a real danger in leaning too heavily on this analysis. The world has just witnessed a huge shift in consensus. Most now expect inflation to be far stickier and far higher than only a few months ago. 

But some inflationary dynamics were always bound to be (whisper it) transitory. Why is this? First, base effects. Inflation started accelerating last March, which argues for a peaking out in the next few months. Secondly, growing evidence points toward easing of lockdown-triggered bottleneck issues. The supply side is catching up and shortages are being resolved (albeit at varying speeds). In fact, rather than scarcity, overcapacity lies ahead for some sectors. 

All of this will tug prices lower in the period ahead, even as inflation stays more elevated than the last decade. Still, markets react to changes in the margin. A directional change in prices will restore confidence in central bank credibility. 

Yet markets remain on edge, concerned that the Fed will tighten too much and short-circuit the recovery. To be sure, that will occur at some point. Monetary tightening is the leading cause of recessions. But some perspective is in order here. At the risk of stating the obvious, interest rates are insanely low relative to the growth and inflation backdrop. The Fed is nowhere close to recession-inducing rates. 

The real issue is that most investors are still anchored to the secular stagnation period after 2008 — they simply do not believe the economy can ever escape low rates. But in the 2010s, the need for consumers to repair balance sheets necessitated a far lower interest rate. Today, the US economy is on far firmer footing. What’s more, global demand is set to be supported this year by a large part of the world soon to be cutting rates. Consider that most central banks in the developing world have already had some of the most aggressive monetary tightening campaigns on record. Brazil has lifted its policy rate from 2% to 10.5% over the last year. Most crucially, the contrast between American and Chinese monetary cycles has become crystal clear this year: the latter is now in full-blown reflationary mode. All of this has created ample room for policy easing as inflation moderates. With global demand surging, a recession is not yet on the horizon.

Is the saber-rattling along the Russia/Ukraine border a buying opportunity?

What danger does Russia present for global investors? Rather than going down a rabbit hole of geopolitical game theory, consider the track record of major events: most are false alarms. Remember Brexit, North Korea’s threat of firing missiles across the Pacific or, even further back, Saddam Hussein’s so-called “weapons of mass destruction”? None of these widely-feared threats materialized or they delivered benign outcomes. 

This is not to minimize the gravity of these situations. Yet, from an investment perspective, geopolitical events almost always create opportunity. Rummaging through past post-crisis periods produces a long list of stellar market returns after the worst of the event. For example, the Cuban Missile Crisis in October 1962 was a 13-day confrontation between the US and the Soviet Union, widely considered the closest the Cold War came to full-scale nuclear warfare. However, after the crisis subsided, the Dow went on to gain more than 10% that year. Or take the Korean War, when the North invaded the South. This conflict lasted from June 1950 — July 1953. During that time, the Dow was up an annualized 13.6%. History is brimming with similar examples.

The question for the intrepid investor, then, is what is priced into markets. In other words, are worst case scenarios reflected in low valuations? Broadly, the recent flare up has contributed to an extreme downturn in global equity sentiment, which is now as bearish as the 2020 Covid lockdown.

Russian equities themselves have other-worldly valuations, trading at a near-70% valuation discount to their global peers and offer massive dividend yields (Gazprom will pay you a rate of 17% to hold its stock). It’s hard for something worse to happen than what is already priced in.

Still, markets can remain depressed for long periods. The Russian stock market itself could be a so-called value trap — cheap but destined to stay cheap as the domestic economy languishes. That was the case in 2014-2015 when Russia annexed Crimea and was hit with widespread sanctions. At the time, we argued that Russia was indeed a value trap simply because the peaking out of the oil super-cycle would be a steady, multi-year headwind for the commodity-intensive domestic economy (the media even covered our investment team’s view and positioning). 

Today, Russia’s macro conditions are completely different. Corporate profits are soaring. The Russian economy is flush with cash. Its current and budget accounts have long been running a surplus. Russian interest rates have been jacked up over the last year which means there is plenty of room for easing. A debt crisis is a low probability. Most importantly, a commodity-driven economy is especially attractive now. And, for global markets, an easing of tensions will bolster risk appetite.

Does the stock market sell-off and rotations have further to run?

Market correlations forged in the Covid laboratory are now breaking down. Technology stocks have been particularly damaged, sparked by the now near-certainty of rising interest rates and a slowdown in digital demand after a pandemic-induced spike. A “great rotation” is underway, favouring the less glamorous, out-of-favour international value stocks at the expense of US growth stocks.

This is new terrain to navigate. And these trends have further to run. But all of this is consistent with an ongoing investment regime change, from the slow growth and low inflation era of the 2010s to the higher-altitude inflationary boom we now inhabit. 

Along with this macroeconomic transition, investment leadership will also change. This is always bumpy as markets attempt to discern the durable trends ahead. But make no mistake, a big shift is here. Strap yourself in — and don’t forget to take your protein pills and put your helmet on.