187. The war has put petrol on the inflation fire – it’s hard to see when it will come under control

7 April 2022 (pre-recorded 24 March 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Darius McDermott and Juliet Schooling Latter return to discuss the major issues impacting markets in the first quarter of 2022. 

[INTERVIEW]

Sam Slator (SS): I’m Sam Slator and today I’ve been joined by Darius McDermott and Juliet Schooling Latter. Thank you for coming along today guys. 

I suppose the place to start with now, unfortunately, is Russia and Ukraine. We won’t talk about the horrible humanitarian side of things, but from an investment point of view, we’ve obviously seen, I think all of the Russian equity funds have had to suspend their trading. But what’s happened with sort of the Eastern European funds or some of the GEM [Global Emerging Markets] funds. What’s the impact been on some of them?

Juliet Schooling Latter (JSL): Well, I mean, fortunately Russia’s actually quite a small part of the GEM index or rather was, when it was in it, at just sort of 2.8%. So those who’ve had holdings in Russia obviously had to write them down to zero. And it’s impossible to say at this stage if or when those holdings will be tradeable again. Russia was obviously a much bigger proportion of the Eastern European index at about over 70%. So again, Eastern European funds have largely had to suspend too.

Darius McDermott (DM): Yeah, I mean, Eastern European funds actually were very popular in the ‘00s as a decent chunk of the Eastern European block, Poland and Czech, entered the European Union and actually opened up their stock markets. And they were very popular with investors, but they haven’t been now for a long time because as Juliet says, Russia’s the biggest part of that index. And it’s just been very out of favour, not speaking about war and invasion of that, I just mean as a market. So yeah, it all terribly, terribly sad. 

And I don’t think the majority of retail investors will be hugely impacted unless you own a direct Russia fund of which there are a handful still going, but they have all obviously had to suspend because you can’t trade in Russian equities for the foreseeable, so yeah, worrying times, but not a huge impact on investing directly in Russia. 

Now, of course there has been lots of other fallout from the Russian invasion. Markets were very, very nervous for the first few days and they sort of gently bounced back and little bit, but the whole thing does leave huge amounts of questions over the whole geopolitical status and markets always tend to react to major geopolitical issues.

SS: And we’ve kind of seen that on the equity side but what about on the bonds side? Because I think Russian bonds were perhaps more popular among emerging market debt managers then perhaps the equities have been. Were bonds able to sell anything or were they in the same position as the equity market guys?

DM: My understanding is that they much were, again more government debt than company or investment grade corporate debt. But my understanding is, you know, from notes that I’ve read, people have had to write their Russian bond holdings to zero.

JSL: Again, you know, Russian debt was a relatively small proportion of the emerging market debt index at sort of 4.5% So slightly bigger than on the equity side, but still relatively small. And Ukraine was just 0.4% of the benchmark.

SS: Moving away from Russia and Ukraine. The other thing that’s been in the headlines has obviously has been inflation. We’ve been talking about it for the last few podcasts where we’ve been discussing things. Yesterday [23 March 2022] I think it came in at over 6% in the UK. What are your thoughts on it today?

DM: Well, it’s definitely been more persistent and higher than almost everybody expected. Even those who I would say a were very vocal about inflation. Maybe this time last year, I think probably would’ve been surprised on the upside. Central banks certainly have been surprised if you look, most people feel that particularly the Fed are behind the curve with respect to raising interest rates to try and counteract inflation. So if the central bankers with all their data have been getting it wrong, I think it leaves the question on it very difficult for the mere mortals like ourselves and retail investors who are trying to plan what investments they may buy to try and counteract that inflation.

JSL: Yeah, I think it’s been a very difficult situation because the sort of post COVID inflation you know, with supply chains we’re starting to normalise. And then of course, you know, the war in Ukraine has led to this hike in energy prices which has obviously exacerbated things, you know, with Russia supplying a lot of oil and gas to Europe, you know, it supplies 40% of Europe’s gas. So I think it is certainly a worry. 

I think food price inflation possibly as well. Ukraine is a large exporter of wheat. And UK farmers are struggling with inflation with higher wages, higher energy costs. The higher cost of fertiliser as well is one fallout from the war with Ukraine too. So it’s quite a difficult time to work out when inflation will come under control.

DM: Yeah. I mean, I think, having the Russia invasion of Ukraine, on top of the sort of the pandemic, really has put petrol on the inflation fire. And as we know, central banks pumped as much liquidity in very short order, post COVID as they did in the previous 10 years with the financial crisis. So, you know, where you put money into the system has to go somewhere. And that is definitely having inflationary forces.

SS: I mean, the consumer in all of this is obviously the one that’s being hurt at the moment. I think yesterday we had the Spring Statement from the Chancellor and he reduced petrol by 5p a litre, which I think takes us back to last week’s prices. And there’s a couple of other things, but really nothing that anyone has said is really going to help a lot with how much, you know, how far a pound goes these days. So presumably that’s going to feed through to the economy. 

Are we sort of, are we heading towards Stagflation, which is basically where you have high inflation and a slowing economy. It’s not an ideal situation for anything really, but…

DM: Well, no, exactly, exactly right. And what I think still remains to be seen is when inflation peaks. So it might be that inflation peaks in two or three or four months. And then even if it doesn’t come all the way back down to the 2% target, it might just stop going up. That’s the first thing that needs to happen. Is it needs to stop going up. But the cost of living for consumers is really hurtful at the moment. And a small token gesture by the chancellor yesterday hasn’t, well, it won’t have gone nearly far enough. 

From an investor’s perspective. If we say, you know, rates are nearest down at 1%, at 75 basis points [0.75%] over here in UK at the moment, but they’re heading to 1% fairly shortly. And inflation is 6%. You are basically losing 5% of your asset just on purchasing parity. And it’s very difficult to know what to do with money. 

Gold is seen as a hedge for long term inflation. I think it’s more of a hedge against geopolitical uncertainty, but commodities generally, I mean, if you are buying an agriculture fund, which will invest across the food chain of agriculture, you might expect that inflationary power of their output to benefit them as a thematic investment to sort of try and offset the cost of a loaf of bread. But commodities generally have had quite a good run. And that’s to say, if we’ve got inflation at this level this time next year, I suspect they will be meaningfully higher.

SS: And you just mentioned commodities having a good run there. When I looked back over the best performing funds of the first quarter, commodity funds are up there, but also Latin American funds. What’s the reason behind that?

JSL: Well, I mean, most of the headlines have been about Russia supplying oil and gas, but it exports an awful lot of other commodities too: nickel, aluminium, copper, enriched uranium, wood, coal, platinum, palladium, steel, you can go on and on. So you know, whilst the prices of them have gone up, it benefits other regions that also export those commodities, such as Latin America.

DM: Yeah. I mean, Latin America has been a bit of a basket case. Their biggest market by a long way is Brazil. And it has been very out of favour. We’ve actually seen a number of sort of Latin American funds having to close down cause their asset sizes were dwindling. And sometimes as Juliet said this sort of commodity boost, you know, higher commodity prices based with extremely low valuations probably would be the simple answer to me on that one.

SS: And the other end of the scale, we’ve had technology funds, European smaller companies, funds and Chinese equity funds that have done really badly. Thinking possibly more about technology and in China. Do you think they’ve bottomed now or is there worse to come?

JSL: I mean, China’s quite interesting cause we’ve discussed their issues here before haven’t we with the property market. It but there’s also quite a lot of impact from their zero tolerance approach to COVID. So the recent wave of Omicron, which their vaccine hasn’t really worked against, has meant that almost 40 million people are currently locked down in China. And this obviously causes quite a lot of disruption to production. And then you add to that, the concern about China sort of possibly siding with Russia. And I think investors have just been a little bit wary of the region.

DM: Yeah. I mean, China certainly had a very poor 2021 from an investment perspective. I think we touched on it previously that India was a big winner in that sort of Asia, emerging markets and that left Chinese equities out favour, certainly looking at a more appealing value on a valuation perspective. I think everything that Juliet has said is absolutely correct. There’s definitely some read across from the Russia to China side. 

Technology and European smaller companies, well, European smaller companies tend to be growth focused funds. And the one thing which has been a really big retreat over the last three and six months is high growth funds have really underperformed. And I don’t mean a little bit, I mean, you know, really underperformed. 

Technology, yes, it is a growth sector. Of course it is. But if you look at the really, really big tech companies, they’re just cash generating machines. And if they sort of, that sort of bond like cash generation, has underperformed firstly into the rate rising cycle, but definitely it’s been more the cyclical and value sectors of markets globally, a la energy, a la commodities, obviously very big parts of the UK index which have done better in that environment.

SS: And then finally unrelated to anything else we’ve been talking about, but a development of sorts, Janus Henderson has announced that its closing its property fund. What do you think this means for other open ended property funds?

DM: Well open ended property funds have been under the microscope now for a number of years following a review by the regulator about having illiquid assets in open ended daily traded funds. Property being the biggest and most obvious of those illiquid assets. 

It has left a cloud over property funds. I speak to lots of the managers. I feel some of them will probably run what I call a hybrid situation where they will actually have 50% in property REITs or property companies and say 50% in actual bricks and mortar. We haven’t seen any other news and there are still around a dozen or so open-ended commercial property funds. 

We haven’t seen any fallout from the news from the Janus Henderson fund, which has closed, but it is closed for a very specific reason. They’ve taken the decision preempting maybe the regulator, that these funds don’t have a future and absolutely having clients and their client’s best interest at their core have decided to try and sell the whole fund to an institutional investor. 

And for a fund company to be as bullish as to say, as they hope that transaction will be done by the end of April, only a couple of weeks away, means I would suggest that those conversations have been ongoing and that they, you know, UK property funds have done pretty well. Certainly when we look at the REIT market in London off the COVID lows, if you like, some of those property funds have made really spectacular returns, not so much the open ended property funds. So you can see, they might be able to get a good institutional buyer for that asset and then return money to their unit holders. I have spoken directly to Janus Henderson on this subject and I’m very relaxed that client’s best interest is absolutely the cause of what they’ve done. 

SS: What does it mean for other property funds? 

DM: Very good question. As I say, the fact that nobody else has followed this course of action yet. I bet they’ve all sat up and taken notice, but I think it’s become quite apparent over the last decade. Property funds have had to close a number of times for varying reasons, Brexit, COVID, you know, people were unable to value property. So I think that mismatch of liquidity and open ended probably sees this as the starting move for the end of open ended property funds, as they are today.

SS: As always. That was really interesting. Thank you both very much.

SW: To get more insights from Darius, Juliet and the rest of the FundCalibre research team visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts. 

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.