From stagflation to growth concerns
In 2Q 2022, global risks shifted towards a possible recession, as stock markets struggled to recover from the setbacks triggered by inflation and Federal Reserve rate hikes. Downward pressures prevail as investors watch for signs of consumer driven slowdown. A four-decade-high rate of inflation is the number one issue in many countries. The overriding challenge for central banks is whether they can rein in and re-anchor inflationary expectations without causing a recession. In the short-term, it is clear that price stability remains a key priority for the FED, meaning more rate hikes are on the way, threatening growth. The European economy and core inflation are less heated by a weaker labour market. Only in the case of a major gas supply disruption would a deeper recession scenario be likely in Europe. The EU is already receiving 55% less gas from Russia than it averaged before the war and has increased LNG gas imports from the U.S. Nevertheless, if Russia takes further measures and fully cuts off European gas supplies, the economic impact will be substantial.
The mood in emerging markets (EMs) is slightly more positive and EMs outperformed developed markets in 2Q 2022 by almost 5 percentage points. This was largely due to the reversal of the trend in China, as prolonged lockdowns were lifted in some major cities and significant support measures were added by the government. In general, we see the Chinese economy at a very different, and more positive point, in the cycle compared to developed markets due to its lower inflation, lower 10y yields and rising PMIs. Eastern European countries are also supporting spending by announcing unprecedented measures to protect consumers from high inflation and peaking high interest rates, which is keeping the growth momentum high. Last quarter we visited the majority of the larger countries in emerging Europe and concluded that, despite some sectors being hurt by interventions and increasing risks of slowdown, Eastern European economies continue to outperform developed markets and continental Europe.
Rebound in chinese market
China was a bright spot on the global markets landscape, with the Chinese market gaining 20% since the peak of Covid cases in Shanghai, and after gaining control of the outbreak in Beijing in May. The lifting of the lockdown in Shanghai in June, and easing of restrictions in other cities, have allowed a gradual return to a certain level of normalcy, even if Covid test requirements continue as a new norm across the nation. Economic activities are picking up from April’s trough, as evidenced by the latest economic data in May and June. However, judging from the nature of the coronavirus variants and macroeconomic fundamentals, we believe the road to recovery will be more gradual and bumpier than the V-shaped return in 2020, if policy makers refrain from taking further actions. Although there are uncertainties, we still see the potential for Chinese GDP growth to be close to the 5.5% target announced by the central government, with more aggressive fiscal and monetary policies, more supportive consumption and property policies, as well as the fine-tuning of China’s dynamic Covid-zero strategy. Investors returned to the China market, as indicated by the increasing activities and greater net inflow through Connect, leading to outperformance of all major Chinese indices vs. peers globally.
Renewables value chain investments outperform in Emerging Markets
The Chinese renewables sector continued to show strong potential. As we have been pointing out, China plays a major role in the long-term secular growth of the sector. The positive outlook for renewables was also confirmed during our visit to one of the world’s largest solar conferences in Munich, further increasing our conviction regarding polysilicon prices and the very strong focus on energy storage. We believe the renewables sector will continue to generate alpha in the second half of 2022 as well, with more policy tailwinds expected. Overall, we consider Q2 to be a quarter where the Chinese market has come through the worst of it and is now heading towards a stronger 2H 2022.
Russian market remains closed for western investors
The horrific war in Ukraine continued, with Russia retreating from Kyiv to focus its efforts on the eastern part of the country. Globally, concerns shifted to the impact on commodity prices, particularly grain and other food stuffs, where Russia and Ukraine represent significant shares in global markets. The EU announced an oil embargo and gradual phase out of Russian gas, although the timing of the implementation (6-8 months) means the main effects will be felt by Russia and the world towards the end of this year. From a European perspective, the alarming fall in Russian gas supplies to Europe in June could make it a very difficult winter unless Russia boosts these supplies again. The IEA estimates that recent Russian supply cuts and a fire at a large US LNG plant could reduce gas supplies to Europe by 35 bcm from June-December 2022. This is compared to some 155 bcm of Russian exports last year, which was 40% of total European gas consumption.
The Russian market was due to open on 27 June to non-resident investors such as us, but this was postponed. We understand this was in part due to the surprising sanctions from the EU on the National Settlement Depository, which creates significant obstacles for EU- based funds trading local shares in Russia. At the same time, we have entered a dialogue with various stakeholders within the EU in an attempt to initiate certain exemptions, which would facilitate the transfer of shares and ensure that EU investors do not get punished by the EU sanctions targeting the Russian state.
ESG work continues with focus on energy transition
ESG matters and sustainability remain a core focus for us, and are key to market development as well, with the war in Ukraine putting the spotlight on energy security and food security issues. During the quarter we became a supporter to the Transition Pathway Initiative (TPI), a global initiative led by asset owners and supported by asset managers. The TPI tool assesses companies’ preparedness for the transition to a low-carbon economy, supporting efforts to address climate change. We also published our yearly Sustainable Investment Report which describes in detail our approach and outcomes, fully aligned with our purpose of working for positive change.
Outlook
Uncertainty in the markets remains highly elevated and inflation pressure has not yet abated. However, we see a brightening outlook for Emerging Markets. Valuations are low, which protects the downside, while the improving outlook in China offers alpha opportunities in sectors with structural growth. We see that Chinese increasing PMIs, signs of reopening, policy easing, and “lighter touch” regulation could mean increasing flows into China and positive market performance. We expect the Eastern European region to experience a slow-down as well; however, due to the unprecedented fiscal stimulus supporting consumption and strong inflows of EU funds, we expect Eastern European economies to outperform developed markets and continental Europe. Moreover, emerging markets remain considerably cheaper than developed markets, at 11.1x 2022 P/E compared to 15.0x 2022 P/E - especially in Eastern Europe (2022e P/E 6.3x), topping the lists of the cheapest global markets – and remain supportive for the stock market.
It is still difficult to predict developments in the Russia/Ukraine conflict. Our focus remains on serving the best interest of our clients and ensuring that when we are able to open the funds, we have done everything we can to maximise value for our unitholders. However, in order to do so, we will likely need to have the ability not only to trade stocks locally in Russia, but also to transfer the proceeds out of the country. So far, we can do neither of these, although we will continue to lobby the various stakeholders for this to happen.
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