March 8—Twenty-four hours after Russia invaded Ukraine, Wilmington Trust’s Chief Investment Officer Tony Roth hosted a client webinar, “A Dark Day for Europe.” The World Reacts. Joined by Chief Economist Luke Tilley, Head of Investment Strategy Meghan Shue, and Senior Portfolio Manager Mark Horst, the team set out the critical issues at stake in this ever-fluid situation. Listen to learn what is expected for economies, inflation, and portfolios.

Please listen to important disclosures at the end of the podcast.

 

“A Dark Day for Europe.” The World Reacts

Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.

Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors, Inc.

Meghan Shue, Head of Investment Strategy, Wilmington Trust Investment Advisors, Inc.

Mark Horst, Senior Portfolio Manager and Energy Sector Analyst, Wilmington Trust Investment Advisors, Inc.

LUKE TILLEY: we know that Vladimir Putin is a very challenging person to predict, and he could restrict energy in terms of sending it overseas. But we also know that Russia relies very significantly on those exports and the foreign currency reserves that flow into Russia on their ability to manage their economy.  So, he would have an incentive to continue those exports.

TONY ROTH: That was Wilmington Trust’s Chief Economist Luke Tilley on the important role energy exports play in the response to the Russia/Ukraine conflict.

TONY ROTH: Welcome to Capital Considerations, the market and economic podcast that’s fully invested in your success. I’m your host, Tony Roth, chief investment officer of Wilmington Trust. 

Today we have a special edition of Capital Considerations.  We held a webinar on February 25th as Russia’s invasion into Ukraine were first unfolding.

I was joined by a number of Wilmington Trust’s brightest.  I spoke with with our Chief Economist, Luke Tilley, our Head of Investment Strategy, Meghan Shue, and Senior Portfolio Managers and energy sector analyst, Mark Horst.

We recorded this webinar in late February and this tragic situation has evolved significantly since then, but I hope you find some of our insights useful as you work to digest the implications of these events. We will be adding additional podcasts covering the situation in Ukraine over coming weeks and months

TONY ROTH:  Thank you and good afternoon, everybody.  We’re sorry not to be speaking to everybody under better circumstances in the world.  But we wanted to, after waking up yesterday and appreciating the evolution of the situation between Russia and Ukraine, given the geopolitical risk that this poses when we look at the context historically that this falls within in terms of the relationship between the Western countries and NATO on the one hand and Russia on the other hand, it seems very important to address this with you now to talk about the economic implications and then, lastly, to talk about markets and portfolios.

Myself, Meghan Shue, our head of Investment Strategy, Luke Tilley, our Chief Economist, and Mark Horst, our Senior Portfolio Manager, are going to be covering a few topics.  We’re going to start by talking about the conflict itself, make sure we level-set, we all understand the latest and what’s happening and provide a little bit about historical context.  And then, we’re going to talk about the economic impacts that we think the conflict is going to yield for both the global economy and the US economy given our couple of different scenarios. 

We’re going to hone in on the energy markets.  As we all know, we’re in an environment today in the world where there is heightened concern over inflation, headline inflation, which is the focus on food and energy, if you will, is a particular concern and energy markets are reacting in a way, as we would expect, that are show stress and volatility.  So, we want to get into some detail around what’s happening in the energy markets and where we expect them to go.

We want to focus in next on the market action that we’ve seen over the week.  The markets always tell us an awful lot around the significance of events and the markets have been probably a bit less volatile and more quiescent than we would’ve expected given the historical significance of the events.  But that tells us something.

And then, we want to place the events in context of a broader economic outlook, because at the end of the day while this is a very critical set of measures that have been taken by the Russians we do think that as we look out over a 12 to 24-month horizon that the call it legacy economic backdrop is going to continue to be the predominant predictor of where markets go and portfolios should be positioned,

It’s important, as I mentioned, to understand a bit around the historical context of Russia moving into Ukraine today.  President Putin came to power in Russia less than 20 years ago in fact.  And prior to Putin coming into power, there were a series of events and agreements

which culminated with NATO in 1997 between an agreement between Russia and NATO in 1997 called the 1997 Security Dispensation.  And in that agreement, there were commitments made by both sides, including NATO as to how far east they would expand by Russia in terms of not moving forward in – and invading countries that may or may not be in NATO. 

And at this point, when we look back at that agreement 23-24 years later, it’s very evident that Putin does not believe in the spirit of that agreement and is essentially ripping it up.  And it’s clear that Putin is threatened and feels that the buffer countries that have existed for many, many years between the Russian empire, if you will, and what we think of Western Europe need to stay buffer countries, need to stay neutral to some degree.  And so, that’s essentially what Putin is accomplishing now with respect to Ukraine, having already brought a number of other key countries essentially within the direct sphere of control of Russia, including Moldova, Belarus, Kazakhstan, and others. 

And so, this is such a significant event, not just because of the potential direct economic implications today as it relates to where we’re going to focus today on energy, how we’re going to focus on other commodities that come out of both Ukraine and Russia, because those are the areas that stand to have a direct implication on the global economy as it relates to this activity, but also where this may lead us going forward, what a new world order might look like where you clearly have two poles developing with the US and Europe, Canada, Switzerland, Australia on one side and then China and Russia on the other and where will Russia try to take its, essentially its footprint within Asia and Eastern Europe as it relates to some of these others countries that we’re very concerned about, including NATO countries, and what might this mean potentially as a paradigm model for China as it relates to Taiwan?  So, that’s why this is so important for us. 

I’ll just say from a personal standpoint, I was born in 1967.  I grew up in Upstate New York and I remember, you know, hiding under the desks during the Cold War as a – some level of protection, if you will, from the nuclear bombs.  And this feels pretty scary in that context.  I don’t think there’s anything in my adult life from a geopolitical standpoint that feels this raw, this visceral and threatening on some level. 

And so, I think it’s important to acknowledge that before we move forward, because as we move forward, what we’re going to focus on is that the basic premise we believe that long-term investors should not really be trading portfolios based on geopolitical events and risk unless those events and risks meet two very important criteria.  Number one, the events and risks should have identifiable and important economic consequences, and we’re going to focus in on that today.  What are the economic consequences and how important are they?  And secondly, are those consequences priced into markets at a current time such that you may be able to trade in markets before they’re fully – those particular economic consequences are fully priced.

And when we look at what’s happening today, to give you the punch line of our conversation today, so far given some assumptions that we’re going to talk a lot about as it relates to where this is going, what additional actions could or could not come as it relates to other countries, but so far given those assumptions we believe that the identifiable economic consequences are not of sufficient magnitude to cause us to want to trade portfolios in a very volatile time when we know that when we trade portfolios when we’re emotional, when markets are moving quickly, we typically regret it.  And when I say we, I mean investors generally, even skilled and professional investors.

So, I do think it’s important to also recognize that geopolitical risk, of course, has spiked. We haven’t had geopolitical risk at these levels until we go back to, you know, around the 9/11 period and the Iraqi war.  So, it’s certainly quite a significant event and the participants, the players on the field, unlike the situation 9/11 and the Iraqi war, are nuclear states on sort of both sides of the equation given that you have Russia on one side and clearly you have the US as a very direct and important participant on the other side, which makes it sort of scary in the way that I discussed at the outset.

So, what we want to do today, right now, is we want to talk about those, as I talked about, those identifiable economic consequences and try to measure how important are they.  So, to do that we’ll bring in Luke, our Chief Economist.  So, Luke Tilley, welcome and thanks for joining us today.

LUKE TILLEY:  Hey, Tony.

TONY ROTH:  Luke, could you give us some perspective, dimensions for us what impact the conflict would have on the economies of the world on the far right, Russia itself, and then what we care most about of course, Eurozone, the UK, and the US across the center.  So, perhaps you could take us through that and give us some insight into, you know, why these numbers are dimensioned where they are.  Thank you.

LUKE TILLEY:  Yeah.  Absolutely, Tony.  And I think the main message here, is a lot of the impact that you’re going to see over the longer-term comes back to energy prices, as you just suggested.  Clearly there are some direct impacts, and they are larger for Russia and Russia is also going to be affected by the sanctions.  But as you and Mark are going to talk about a little bit, we have the Eurozone and really the globe relying pretty heavily on Russia’s exports.

So, what’s going on here is this assumes an oil price above $100 through pretty much the early stages of the second half of this year, so pretty much the first half of this year.  And we haven’t seen that.  We saw that initial spike in energy prices, and we’ll talk about that more, and they’ve come down since then.  But, obviously, they could move back up.

This also assumes that European gas prices remain pretty high, as high, a little bit higher than they have been til the end of this year and that is taking a bit out of Eurozone grown.  And then, the last component that goes in here in terms of the, sort of the exogenous assumptions is disruption to a lot of foodstuff.  The Ukraine is a very important exporter of wheat and corn and some other items and those play into a lot of food.  And so, as those start to play through the global economy and really the main transmission mechanism here is inflation, it starts to take percentage points off of growth.

You know, it’s not a massive scale and not a massive drag on growth when we think about, as you said.  Eurozone, UK, US it does hit growth.  But for the US where, as we’ll talk about later, we start the year with a pretty optimistic outlook of 3% GDP growth, we’re talking about taking, you know, 20 BPS off here.  So, it’s material in the sense that it’s affecting our economy.  But with those assumptions, and again we have to see how those assumptions play out, it’s not decimating to the global outlook and the growth outlook as we see it now, Tony.

TONY ROTH:  Yeah.  And, Luke, I think it’s important.  I neglected to provide a little bit more detail on what our reaction has been, we, the West, to the invasion or the incursion/invasion into Ukraine.  And obviously, we’ve had sanctions and what’s important to note are a few things.  Number one is the sanctions have essentially targeted financial institutions and individuals.  They have not generally targeted the energy space and that’s very important and foundational to what you’re about to talk to, which are the assumptions that go into these relatively unimpressive impacts that the conflict would have on economic growth in different parts of the world.

We’ve also seen today in the Eurozone essentially and directly of Vladimir Putin and Sergey Lavrov, who is the, their Foreign Minister, of course in the case of those individuals their wealth is not actually held directly in their names.  It’s held by a lot of the surrounding oligarchs and whatnot.  And so, we’re going to see over time the efficacy of these sanctions as it relates to the wealth and consequent behavior that it could have on these people, see how tight they’re able to make those.

The other thing that I would point out, which I think is important, two things.  One is that the Germans moved very quickly to suspend the certification of the Nord Stream 2 pipeline and that is so important because as we move through these steps, understanding the degree of alignment or solidarity, if you will, on the Western countries is very important as Putin gauges what else he can do, what else he can get away with, if you will.  And it was somewhat surprising that the Germans were willing to move so quickly with such unequiviality [sic] on the pipeline.

The second thing is that the Chinese, who I mentioned earlier are sort of aligned here with the Russians generally, have been very measured in their support of the Russians.  And I think what we’ll find here, only a couple percent of all China’s trade is with Russia.  So, it’s very small and very inconsequential from an economic matter.  And China is going to do what’s right for China from an economic standpoint at the end of the day and I think that describes to a large degree why their support for Russia here has been much more contained, which is important when we think about where the world is going and what this means with a new world order.  So, with those observations, Luke, maybe take us through a little bit more detail the assumptions that these economic impacts are based on, if you could, please.

LUKE TILLEY:  Yeah, absolutely.  And so, when we think about all of those, the oil prices that I described and the gas price forecast and all the foodstuffs, it really plays through to inflation.  Now, we know that there are high reliance on the Russian exports, but we don’t expect it to be, at least it doesn’t look right now as you were talking about the sanctions, to be completely derailing the overall energy complex.

We think that these are really the most important things we think about as we go forward and that is that minimal disruption to the energy supply.  As you mentioned, Tony, the sanctions have not been directed at oil or natural gas, President Biden saying yesterday that they have specifically excluded that as of yesterday when he announced the sanctions in saying I know Americans are hurting and they’re – and working with other countries trying to ensure energy supplies.  And then earlier today, reports of a State Department official saying going forward they do not plan to attack in any way with the sanctions the global energy supply.  So, that’s really important.

We know that Vladimir Putin is a very challenging person to predict, and he could restrict energy in terms of sending it overseas.  But we also know that Russia relies very significantly on those exports and the foreign currency reserves that flow into Russia on their ability to manage their economy.  So, he would have an incentive to continue those exports.

And then another thing that doesn’t get as much attention as the energy but is so important right now because we have such an inflation and supply chain problem already are other commodities outside of the non-energy commodities, if you will.  Ukraine and Russia together produce 29% of global wheat.  Obviously, that would play through to food prices, which have already surged pretty high over the past year or so. 

I won’t go through all of them, but aluminum and copper.  Russia produces 43% of global palladium, which not everybody knew before this week but probably knows now, goes into catalytic converters and we already have issues with automobiles. 

So, the main transmission mechanisms that we’re thinking about here, Tony, again, do go to inflation.  We’re expecting some disruption there, but not for it to completely derail global commerce and that’s what we’re seeing out of those sanctions so far and what we expect going forward.

TONY ROTH:  Thank Luke.  So, again, just to summarize, the key takeaway from this part of our conversation is that we don’t believe the conflict, given what we know today, is likely to have very significant global economic implications with those two key assumptions.  The one assumption being that the Russians continue to allow the hydrocarbons to flow to Europe because it’s the – it’s in the mutual benefit of the two areas for that to happen for the reasons that you’ve just described.  And, secondly, that to some degree Ukraine does get back up on its feet as an economic zone and is able to start to export wheat, neon, all these different commodities that are important to the global economy. 

So, clearly the most important element in terms of what’s at play in the global economy is the supply of energy from Russia around the world.  So, I want to bring in Mark Horst, who’s the Senior Equity Analyst who covers the energy sector for us, both in the US and globally. Mark, we’ve seen even before this conflict a pretty significant amount of volatility in the energy market over the last year, even going back a couple years.  We’ve seen a run up in prices as the pandemic has waned and that supply and demand balance, certainly from a demand side, starts to really pick up again.

So, before we talk about the potential impact of the conflict on the equilibrium, if you will, in the global oil field, set the stage for us, if you could please, and just give us the baseline of how you saw the energy space and the oil market coming into the year.

MARK HORST:  Yeah.  Thanks, Tony, and thanks for including me in today’s conversation.  Oil’s been very volatile really over the past several years, and if we think back during the height of the pandemic, conversely, we saw energy prices dip to negative $35 and now we’re in excess of $100 as of yesterday.  And so, what we’ve seen in this supply/demand balance really coming out of the pandemic and if we think about March and April and the summer of 2020 when everyone across the globe was essentially on lockdown, we saw demand just erode.  Everybody was staying at home.  There was no fuel consumption, no jet fuel, no automotive fuel.  And just for context, automotive or transportation fuels account for about 70 to 75% of all oil demand.

So, at that point, markets were dramatically over-supplied, and the inventories had built up to levels unprecedented.  Since then, as the pandemic appears to be coming to the end, restrictions appear to be lifted, we’ve now moved to an under-supplied environment.  Today, global inventories for not only crude but for finished products, such as gasolines and diesel, are down 60 to 50% in some cases, at levels well below pre-pandemic period.

So, coming out of this the demand picture, our view was incredibly strong.  You know, a lot of us within the business community and even for leisure were ready to get back out, start traveling, driving, flying, and get back to living as we had pre-pandemically. 

Conversely on the supply side, you know, we’ve come out of this period with very low underinvestment in oil.  Really over the past four to five years, there’s been no significant investment in new projects.  And so, we’ve had this under-supply investment coupled with demand in excess of where we were.  We’re now at a point where our view was very positive for oil and energy markets entering 2022, even before we had any of these geopolitical tensions that are only additive to potential supply shocks to moving prices higher.

TONY ROTH:  So, when you say our view is positive, positive in the sense of price moving upwards, correct?

MARK HORST:  Yes.  So, when I say positive, positive for oil, positive for the energy sector, positive for stocks, that these prices that we saw will continue to climb higher and that stocks and commodities would both have positive returns. 

TONY ROTH:  So, there aren’t many statements that we can make that are appealing to both sides of our political spectrum here at home.  But one that we can is that we’ve seen two Administrations now work really hard and ironically unsuccessfully, but now the work has been done for them to try to convince the Germans not to build and accept the Nord Stream 2 pipeline.  And now they’ve, in fact, suspended it. Take us through how dependent Europe already is, indeed, on Russia for energy.

00:23:39

MARK HORST:  Russia is absolutely one of the third largest players in the energy market.  So, on the oil side, United States, Saudi Arabia, and Russia are the three largest producers of oil by a wide margin, each producing around 12 to 13 million barrels per day compared to the next largest with Iraq and others at six to seven.  And so, conversely to the natural gas market, Germany has really gone through a situation since the Fukushima crisis where they’ve eliminated their usage of nuclear power and have focused on renewables with wind and solar and then also the importation of natural gas. 

To this point, Russia is the largest single supplier of natural gas into Europe with over 30%.  We’ve also seen the US increase their supply into Europe through LNG shipments.  But those remain a very small portion today.  And while shipments are up over, almost double over the prior year, it’s still a small portion.  So, their reliance remains on those pipelines through the Ukraine and others into Germany and Europe for their natural gas.

TONY ROTH:  What is Putin were to calibrate differently and decide, you know what, I’m going to weaponize the supply of energy to Europe, which is to say I’m going to cut it off?  What would that do to the price of oil?  And we’ll talk a little bit later with Luke about what that would mean to the global economic environment, given that we’re already in a very heightened inflation environment and don’t have a lot of room for mistakes, if you will, as we manage the economy going forward from a price pressure standpoint.

MARK HORST:  It’s the elephant in the room question in that, you know, both sides, the West within terms of their sanctions with excluding energy and the payment of energy and Russia continuing to pump energy into these markets, both natural gas and oil, appears to be that will be fluid.  But if he were to change course and cease sending oil or turn the pipes off per se, we would see a pretty dramatic, we think a pretty dramatic spike in the commodities. 

In fact, oil, we think, could reach in excess of $150 at that point given their producer size in the market.  So, if that would be the case, we would see kind of instant inflation to what Luke alluded to.  But one of the challenges would be for other producers to offset the restriction of their supply and try to put oil in the market to offset that.  The challenges right now would be in terms of how quickly that could be done.  It takes time with the US being a rather quick market.  They’re still permitting.  We’re talking multiple months, at the earliest probably likely a couple quarters before you could supply back online to really off some of – offset some of that destruction. 

What would likely occur, though, would be demand destruction.  It would be situations where prices moved higher and that consumers are really impacted.  Consumers are really focused on the price of gasoline rather than the price of crude.  It’s because that’s how you and I and others feel those inputs. 

The last time we saw the $4 mark as the national average being a price where people started to change their consumption behavior.  We think that probably could be the case this year, potentially even higher given that there’s this pent-up demand.  So, it’s there but would likely result in demand destruction with substantial price spikes that could be, you know, elongated for months, if not quarters, depending how quickly we could increase the supply of the commodity.

TONY ROTH:  Mark, just to end this part of our conversation, why can’t we just go to the Saudis – you know, we provide all their defense effectively – and tell them that we want them to pump more oil or we’re going to take away their F16s, just to be very crass about it?  And what about Iran?  There’s a lot of conversation around us being on the brink of a new agreement with Iran, we being the Western countries, which would release not just incremental daily production but a lot of oil that’s in storage. 

MARK HORST:  In terms of the Saudis and our other Middle Eastern allies, the Saudis are really looking for the US to provide assurance in terms of defense if there were to be an agreement with Iran.

So, if Iran would sign a nuclear agreement and be allowed to enrich uranium again, the Saudis are concerned that they may attack Saudi Arabia.  So, they want this assurance would come from the US government before they would be willing to pump any additional products or oil back into the market.

The other element besides the assurance is their true additional resources that are available.  So, there are a lot of questions out there in terms of what is the true spare capacity for the Saudis?  We think the spare capacity is less than what they would indicate.  We think spare capacity is probably today around two million barrels maximum.  So, they don’t have a lot of existing capacity that they could turn on today to alleviate potential spikes.

Now, conversely, Iran now is in the driver’s seat in terms of negotiating power.  They want to make sure that if any agreement were to be reached, that the next Administration couldn’t just tear it up, which is a challenge, as we’ve seen previously. 

But if Iran were to come back into the market, the challenge is, again, their production we think today could only add an additional 1 to 1.5 million barrels back in the market.  So, if we’re taking away 11 to 12 from Russia, only adding back one to two or two to three from both Saudi and Iran, we’re still at a meaningful deficit.

TONY ROTH:  All right.  Thanks very much, Mark.  So, let’s pivot and talk about the markets, not just the oil market but the equity market, the bond market.  The ten year is at 2% now, which indicates that there’s less flight to safety at the US dollar and US treasuries than there was earlier in the week.  And so, Meghan, our head of Investment Strategy, thanks for joining us today.

MEGHAN SHUE:  Thanks, Tony.

TONY ROTH:  Meghan, when you look at the activity in the market are the markets just smart enough to see what Luke took us through in the outset, that this is a relatively small economic impact and that Putin is going to, the market really believes that Putin is not going to roll the dice on turning off energy to Europe or how are you reading things?

MEGHAN SHUE:  Yeah.  Well, I think the markets have been, to be fair I guess on the whole it looks like market action has been fairly orderly.  But there have been periods that certainly looks like panic with the market actually did reach on the S&P 500 a drawdown of about 12% and volatility has spiked with the VIX index, which is a common measure of volatility in the S&P 500, reaching the highest that we’ve seen in over a year outside of the most recent one in January.  So, very high volatility, a lot of swings in the market.  

But I do think that there’s been an inclination to sell first, ask questions later.  And then, when they’re asking questions, investors are coming to similar conclusions and we’re getting more information.  It’s so fluid. 

But one thing that we are watching that I think is really important to keep an eye on going forward is high yield corporate credit spreads.  We’ve seen a fairly significant increase in credit spreads so far this year, almost about 90 basis points by this measure.  But we see that relative to history and actually if you were to take the average between 2017 and 2019, we’re basically just back down to average spreads.

So, this is a really good measure in terms of what the fixed income and the credit markets are signaling in terms of potential economic spillover and weakness.  And while it is ticking up and it’s something we’re going to be watching, I think on the whole the market is coming to a similar conclusion, which is that the economic spillover is likely to be modest over a 12-month timeframe.

TONY ROTH:  Thanks, Meghan.  And it’s interesting that on our Bloomberg screens while we’re speaking a story popped up to one of my earlier points that both the Bank of China and the Industrial Commercial Bank of China, which are two of the three largest banks in China, are now restricting financing of commodities sourced from Russia.  And so, you can see here that China is resisting being categorized, if you will, as wholly aligned with Russia on one pole set apart from its other much more trading – much more important trading partners like the US, Germany, Europe, etcetera, and that’s bad for Putin.

So, Luke, let’s go back to you and talk about – I mentioned at the outset that it’s very important to spend a lot of time and attention on the conflict.  But it’s also important to contextualize it, and we have a economic environment that we’re pretty instructive on where we come into the year, we had 7% GDP growth annualized in the fourth quarter of last year.  It was just revised up earlier this week.  We had earlier today consumer expenditures, which were quite solid.  You had inflation starting we think to maybe level off.

So, sort of take us through that backdrop again, because as I said at the outset, as investors we can’t react just to the events in front of us at the moment from a geopolitical standpoint or otherwise.  We’ve got to make sure we’re looking at the overall economic picture and how are these events likely to affect the economy. 

And so, the bigger risk for us continues to be, in our view, inflation and the Fed’s management of inflation.  So, maybe let’s just start quickly with the projection for economic growth for the year.

LUKE TILLEY: 

So, the outlook for the US was for a deceleration in growth compared to last year.  You just mentioned that the fourth quarter came in at 7% annualized and that brought the full year growth to the 5.7% obviously bouncing pretty significantly out of the shutdown years of 2020.  And our expectation for this year was for continued steady growth, 3%.  Obviously a deceleration from that 5.7, but still better or at least matching but mostly better than any of the years that we had in the previous expansion and that’s predicated on consumers that still have high levels of savings.  We see strong job growth that’s averaging around 500,000 jobs per month over the past six months, and we know that employers are still looking to hire. 

A lot of the fiscal stimulus is wearing off.  People do still have those savings, but they are being drawn down.  But it’s still a high level of savings. And as any of our clients know who have attended a Capital Markets Forecast or seen that document, we also expect a lot of restocking of inventory. 

So, there’s a lot of drivers of growth here.  Clearly, it could be a little bit challenged by higher energy prices or more supply chain challenges.  But we’re pretty positive. 

Not shown here but also that we wrote about earlier this week, and we have other materials, Europe, we expect Europe to have even a relatively stronger year, not just in stronger growth closer to 4% this year, but not as much of a deceleration and above their normal levels of growth, which are lower than the US.  So, the US had large stimulus last year and Europe did not.  Europe is scheduled to get a large $800 billion, I’m sorry, 800-billion-euro package later this year.  It helps the southern countries more than the northern, but it should really boost growth in Europe for the rest of this year.  And Japan has their foot on the gas.

So, what we were looking at – oh, and the other thing I should mention is we just got numbers earlier this week that show that Europe had bounced pretty strongly after the Omicron shutdowns in January.  So, albeit, you know, heading into the Russia/Ukraine situation, it’s a positive outlook for Europe as well.

And then, the last thing I’ll say about the global growth picture is China, which had sort of tightened the reins and started to bring things in a lot last year, both from a regulatory sense on some specific companies but also with monetary policy and fiscal policy.  They were starting to tighten things down.  But near the end of last year, it looked like maybe they had gone a little bit too far and they’ve moved to a spot where they’re encouraging growth again and reducing some interest rates.

So, when you bring the global growth picture together as we consider the impacts of this crisis, it is pretty positive.  And I think everybody’s pretty familiar with it that we’ve had this higher inflation.  You mentioned the new numbers from this morning.  The PCE inflation, There are two major measures of inflation we happen to forecast, CPI the other one.

And but where the takeaway here is that we are expecting inflation to slow down.  As you mentioned at the top, Tony, this morning’s numbers give us a little bit more encouragement that we’re seeing it starting to top out and we do think that we will be moving back down.  That’s predicated on a little bit less consumer spending on goods, a little bit the supply chains being improved.  We see the continued improvement in supply chains before factoring in these Russia/Ukraine impacts. 

The other thing, of course, that we’re keeping our eye on here and that we talk about a lot is central banks and how are central banks going to react to what we see going on in Russia and Ukraine.  Before the events of this week, central banks were clearly moving into a tightening posture, the Federal Reserve expected to hike interest rates in about 2.5 weeks from now, March 16th, for the first time.  We’ve already seen the Bank of England hiking rates.  And, importantly, the ECB, the European Central Bank, has moved towards more of a tightening posture as well.  They’re still farther behind in time, but they were starting to move rate hike expectations into this calendar year, 2022. 

And those are important steps to be taking to get inflation under control.  And as we said when we talked about, first about the impacts of this conflict is that it would play out through inflation.  So, central banks are really going to have challenges in front of them to the degree that this pushes inflation higher.  But we still think that the inflation backdrop and the expectations that we have on balance would keep central bank tightening this year with higher interest rates and then they’ll have to gauge the growth versus the inflation impacts that come out of this crisis, Tony.

TONY ROTH:  Thanks very much, Luke.  So, Meghan, our investment committee has been very, very busy this week.  We’ve had three formal meetings.  We’ve had lots and lots of conversation in subgroups of the committee.  So, we’ve been very busy, but we haven’t been very active, which is to say we haven’t changed anything in our portfolios yet.  We may change up some of the various solutions that we use, some of the active managers and some of the balance among the active managers in our portfolios as they have different exposures to different sectors and such.  And we’ve, that committee that manages that, the portfolio management committee, has also been very busy but not active.

Talk to us, if you can, Meghan, around, you know, you’d think there’d be something that we would do given this conflict.  Talk about why we feel certainly not certain but that our best thinking continues to be for the portfolio that we have now.  Tell us what that is and why we feel that it’s the best place to be for the time being.

MEGHAN SHUE:  Yeah.  Tony, I think in these types of situations it’s important to be constantly challenging and reassessing, but ultimately sticking to what is our base case.  There’s clearly, as a former statistician there’s what we call fat tails.  There’s a low probability of some high impact events occurring, certainly.  But that doesn’t mean that we should be adjusting portfolios according to some of those outsized or outside risks. 

As you heard from Luke, the sturdy economic backdrop that we have and that we expect and the fairly modest economic impact over a 12-month time horizon and that time horizon is critical as well and we do invest and tactically adjust portfolios looking at nine to 12 months.  When you put that together, assuming within the base case that energy is not weaponized by either side, we still feel constructive on equities and even with a modest reduction in our growth outlook, we think stocks will outperform bonds. So, we are overweight to equities in our portfolio and underweight to fixed income, where we think that, you know, when the dust settles and the, some of the panic selling that we have seen this week in markets subsides, we do think equities will move higher on balance.

One thing that we didn’t talk about is what happens when volatility spikes.  And in those periods, it’s easier to do more harm to your portfolio than benefits.  We’ve talked in different forums, Tony, about how hard it is to get out and then back in when the markets are trading so volatile and so violently.  And in that particular scenario, we think patience is warranted and that’s why we’re sticking with our current positioning.  And just constantly reevaluating it, as you said, Tony, meeting much more frequently than we would in a calmer market without these geopolitical risks present.

TONY ROTH:  We understand the overweight to equities given the economic environment, given where interest rates are going, given that raising – rising rates for bond prices that bond spreads are fairly tight and going to widen as we get deeper into the economic cycle.  That all makes a lot of sense. How can we justify having an overweight in Europe right now?  You, one would think that that would be the last place you’d want to be overweight given their potential exposure to this conflict and what it means from an energy standpoint.

MEGHAN SHUE:  Yeah.  And I think that’s where the assumptions come into play.  Clearly, Europe has the most exposure to Russia’s energy market.  They have the most risk, I think, of spillover into economic sentiment, particularly if this is something that is not resolved one way or another in fairly short order.  I think the longer that this persists and that there’s uncertainty, you could see some spillover, in fact, to European sentiment. 

But given our base case and our economic assumptions and what we’re leading with on that front, we do think that European, Japanese, UK, and emerging market equities are better positioned from a valuation standpoint, which is to say that not only do we have a still constructive economic outlook but the central bank and monetary policy backdrop is more favorable, the fiscal stimulus backdrop is more favorable, and valuations are more attractive.  So, there’s just better risk versus reward in that market compared to US large cap, for example, where we are still constructive but there is a lot of optimism already priced in and that’s evident from valuation levels that we see in that market.

TONY ROTH:  So, thank you all so much for joining today.  We’re really pleased that you did.  And thank you to Luke, Meghan, and Mark for your terrific insights today.

I hope you found the insights from the Webinar useful. We will continue to closely monitor the situation and keep clients informed of our best thinking. For a full roundup of our investment and planning content, I encourage you to visit wilmigntontrust.com.  You can subscribe to Capital Considerations on Apple Podcasts or your favorite podcast channel to ensure you get updates on future episodes.  Thank you again for listening.

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