This update should not be taken as advice. If you are unsure about any of the content please contact your financial adviser. Please remember that the value of stock market investments will fluctuate and investors may not get back the original amount invested. To assist, where appropriate, a glossary explaining some of the terms used has been provided at the end of this update.

As the atrocities perpetrated by the Russian forces in Ukraine unfold, there is some hope that the conflict may not be as open ended or as widespread as feared. Any extension of that hope would be very welcome. Meanwhile, the US and European Union are taking specific action to ease energy supply problems and the sanctions against Russia, as well as the oligarchs, continue to be enforced.

The economic fall-out was predictable; higher inflation (particularly in food and energy prices), supply chain issues, weaker business and consumer sentiment and weaker retail sales combining to cause serious concerns over economic growth prospects. This is the case, to one degree or another, in all regions.

And the solution is ……..

Over the last 30 years we have experienced many unexpected economic events on scales that have never been considered possible before. Policy makers have struggled to create policy actions to mitigate the problems, even though the sum of knowledge on the subject must be at all-time highs, given the research and brain power that goes into finding solutions.

The best examples of how policy makers have dealt with these extreme conditions have been in the way they have dealt with the recessions induced by the Global Financial Crisis (GFC) and COVID. The response that came out of governments and central banks was simple; throw money at it and keep doing so. The problem is; that approach is inflationary.

Combatting inflation had not been an agenda point for a long time, before appearing last year and rapidly heading to the top of the list. The only policy response can be; raise interest rates. But, it has been too slow, so now it must be; raise interest rates quickly and significantly. This is being confirmed by senior policy makers. Lael Brainard, who sits on the US Federal Reserve Bank’s (Fed) board of governors has said “It is of paramount importance to get inflation down,” and “Accordingly, the committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.” This latter point was a surprise; it means the Fed will start to reverse the asset purchasing programme it has had in place since the GFC. That is being said by a governor who was previously much more sanguine about the need for action. These words were backed up by the minutes of the March meeting of the Fed that have now been released.

The solution may just lead to another bigger problem

The risk is that steep rises in interest rates could lead to a contraction, possibly a sharp contraction, in economic activity. Whilst much of the economic data points to a robust economy, particularly jobs and wages data in the US and UK, there are contradictory indications. The German research body, the Kiel Institute for the World Economy, has said that the value of global trade fell 2.8% between February and March as Russia’s invasion of Ukraine led to a sharp drop in container ship traffic.

In the UK, new car sales in March fell to their lowest level in 20 years due to supply change problems hampering manufacturing. In the US, the much watched University of Michigan Consumer Sentiment Survey, which is considered to be a good indicator of consumer confidence, has fallen to a level below that of which it hit in the worst of COVID.

In my view there is a clear risk of economic activity slowing to such an extent that we move into recession. Financial markets take into account, or discount, future prospects and that risk is starting to be reflected in the prices of bonds, but probably not the share prices of companies (equities) yet. It is therefore appropriate to express some caution over the outlook for asset prices in the short to medium term.

There is enough uncertainty around to cause concern.

The market discounting mechanism is efficient

What does that mean?

Money markets and bond prices have moved quickly to take into account the need for central banks to put interest rates up. It is much more difficult to predict for equity markets. Regional, sector and industry variations are significant. The quality and size of companies are very influential on share prices as well. It is far from a homogeneous market.

I think there is greater risk to stock markets, but expectations are discounted. The risk is that as the future unfolds it is worse than currently expected.

Dealing with uncertainty

Being flexible and active are going to be crucial factors in managing funds through the coming months (although, in my opinion, that is always the case). Until there is more clarity over the conflict in Ukraine, the outlook for inflation, economic growth, central bank policy and, indeed, COVID (air flights being cancelled means lower economic activity), financial markets are likely to display some volatility; that provides opportunity as well as threat.

As active managers we look to take advantage of that.

The last word

It is easy to be pessimistic at present, particularly when thoughts turn to Ukraine and the appalling aggression of Russia. It will change the world and the economic landscape, particularly as it applies to energy.

However, and to sound rather insensitive, economies have a self-healing mechanism. That will kick in and the long term will provide hope, to which markets will react. The medium term may be more problematic.