The investment outlook has become more challenging with the escalation of the Russian-Ukraine conflict which would lead to higher inflationary pressures and force central banks to turn even more hawkish. On a more positive note, China has signaled its commitment to defend its economic growth targets with the speech by Vice Premier Liu He on 16 March 2022. The correction in global equities in first quarter of this year amid the risk factors has lowered valuations with selective investment opportunities on the horizon.
Figure 1: MSCI Indices Percentage Returns in USD (%)
Note: ACWI – All Country World Index, 2022* as at 28 February 2022.
Source: MSCI 28 February 2022, Bloomberg 23 March 2022.
The 3 key events that happened in the first quarter of 2022 were i) the direct annexation of Ukraine by Russia, ii) interest rate hike announcement by the US Federal Reserve, and iii) the speech by Vice Premier Liu He on the 16 March 2022 leading to a strong rebound in Chinese equities.
RUSSIAN-UKRAINE CONFLICT
1. The main surprise this quarter was the direct annexation of Ukraine by Russia and the united response by the international community to sanction Russia. The key sanctions with implications to the global stock markets included reduced purchases of crude oil from Russia, blocking Russia’s access to the SWIFT (Society for Worldwide Interbank Financial Telecommunication) system and even freezing the foreign reserves of the Russian Central Bank. Obviously, there is no certainty how this conflict could end with many possibilities. The more negative scenarios could be an escalation of the conflict beyond Ukraine to the NATO (North Atlantic Treaty Organization) nations or even the use of Chemical or tactical nuclear weapons. While a more positive outcome could be successful negotiations between Russia and Ukraine leading to the withdrawal of troops with the removal of sanctions. Suffice to say, it is too early for us to discuss on the longer term investment implications.
2. That said, the conflict does have a direct and shorter term impact on market sentiments, consumer sentiments and inflation. Russia is a major producer of many important commodities like crude oil, natural gas, nickel, aluminum, wheat and many more. For example, the price of crude oil has spiked up to a high of US$120 per barrel with implications to inflation this year.
3. The effect of higher crude oil prices on US is manageable as the US does not import much crude oil from Russia. Inflationary pressures on Europe should be most acute as the European Union imports 40% of its natural gas from Russia. There are no short-term solutions as importing liquefied natural gas requires extensive infrastructure which Europe lacks. We have also earlier highlighted in a separate piece that the conflict generally negatively impact Asia except for Malaysia and Indonesia which benefit from higher crude palm oil prices.
CHINA COMMITTED TO ITS ECONOMIC GROWTH TARGETS
4. Chinese and the Hong Kong equities continue to correct lower in the first quarter of 2022. The intensified selling from the last week of February could be attributed to i) speculations that China would take sides with Russia leading to secondary sanctions on Chinese assets, ii) risks of delisting of the Chinese ADRs (American depositary receipt) as the U.S. Securities and Exchange Commission rules on auditing come into force, and iii) fears of further economic slowdown in China as Shenzhen and Shanghai announced lockdowns from increasing new Covid-19 cases.
5. On the risks of secondary sanctions, we are of the view that the Chinese would tread carefully to prevent secondary sanctions on their companies. Russia is a much smaller trading partner as compared to the US or Europe. Our base case is that a risk of a contagion to Chinese assets is low.
6. The China Securities Regulatory Commission issued conciliatory statements on the ADR issue after the US Security Exchange Commission released names of companies that did not switch to an approved auditor according to the Holding Foreign Companies Accountable Act. Our view is that it would be difficult to find a compromise and a more likely scenario would be these companies to be listed in Hong Kong instead.
7. The Chinese is slowly relaxing their zero-Covid-19 policy as demonstrated by the relaxation of lockdowns in Shenzhen after only one week and reduction of the quarantine period for discharged cases from 14 to 7 days. This is also significant in that market participants could be too negative on the risks of prolonged disruptions from Covid-19 in China.
8. The Chinese and Hong Kong stock markets subsequently rallied after the speech by Vice Premier Liu He on 16 March 2022. Our view is that the message reinforced the Chinese government’s stance during the Central Economic Work Conference last December to maintain economic stability in 2022. Comments from the speech to i) complete rectification work on the platform companies as soon as possible and ii) for regulations to be transparent and predictable, lends support to our view that we are likely close to peak regulatory risks in China which augurs well for Chinese equities. In short, the intention to support economic growth is a major factor why we are positive on Chinese equities in 2022.
Figure 2: Keywords / Phrases used during Central Economic Work Conference
Source: Lion Global Investors, December 2021.
MORE HAWKISH STANCE AT THE FEDERAL RESERVE
9. Lastly, we would like to highlight that the Federal Reserve finally announced a 0.25% hike to policy interest rates on 16 March with expectations for another 6 hikes this year. Chairman Powell also said that plans for Quantitative Tightening could be released as early as May to combat inflation. The significance being that the Federal Reserve has turned more hawkish in its communications as current inflation in the US reached a 40 year high in January and February of this year. We are of the view that the interest rate hikes and Quantitative Tightening are ultimately headwinds for equities market especially for US equities that had been lifted by the excess liquidity in the past.
CONCLUSION
10. Current valuations (Figure 3) are attractive relative to historical averages. We see short term trading opportunities for cyclical equities markets that are trading at a discount to historical valuations and that have decent earnings growth in 2022. Markets like the Singapore equities market which would benefit from further reopening. As explained above, we are also positive on Chinese equities as China is on an easing cycle.
Figure 3: Consensus earnings forecast strong for this year and next
Source: Thomson Reuters, 18 March 2022, Note: F – Consensus Forecast, x – excluding, P/E – Price to Earnings.
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