The competition between different social and economic systems for resources, trade, technological leadership and geopolitical influence – in which the U.S. and China had been the main protagonists over recent years – has now seen Russia and Europe take centre stage. The recent escalation in the Russia-Ukraine conflict, when Russia launched a full-scale invasion of Ukraine, has seen extensive sanctions imposed by the international community. Following the decisions made at the government level, businesses started to sever their ties with Russia. Corporate-level exposures to Russia and Russian assets are under review and in several cases are due to be divested. The financing of Russian commodities is often subject to restrictions as there are often uncertainties around their consequences. The scale of further sanctions is expected to depend on how the war develops. Prices of Russian and Ukrainian export goods like energy, metals and wheat have been rising in recent months, pushing inflationary pressures even higher and prompting additional fiscal measures.

Meanwhile, the competition between the U.S. and China continues with the U.S. administration currently reviewing the results of its Phase One deal with China. Although Chinese purchases did not meet the agreed targets, a new round of tariffs appears unlikely as U.S. demand is high and additional sanctions or tariffs would increase inflationary pressures in the U.S. Nevertheless, additional entities have been added to U.S. blacklists recently. One difference between the two systems is their way of dealing with coronavirus. China is still sticking to its zero-Covid strategy, contributing to the slow recovery seen in global supply chains. In the U.S. and in most European countries the loosening of Covid restrictions has already started to affect corporate sentiment. Covid policies, fighting inflationary pressures and the public debt situation will be important topics in the upcoming presidential elections in France in April, the French parliamentary elections in June, and the U.S. midterm elections in November. In the event of a Republican majority in the U.S. midterms, decisions to impose additional or stricter regulation, especially in the financial and technology sector, might also become more difficult. In the EU, climate change-driven initiatives and regulation concerning market dominance, antitrust measures and data privacy are under discussion. For China, there is the expectation that market stress induced by regulatory activities, including those aimed at promoting its “Common Prosperity” development objective, could ease towards the end of the year.

Russia's invasion of Ukraine has prompted extensive government-level sanctions and corporates severing business ties with Russia.

While U.S. growth has long since returned to its pre-crisis trend, many Eurozone countries still have lower GDP than at the end of 2019. Eurozone growth rates should therefore pick up relatively sharply when economic activity returns to normal. However, the escalating conflict in Ukraine could delay the recovery as higher energy prices are weighing heavily on the purchasing power of households, dampening consumption growth. At the same time the European economy is set to benefit from the fiscal stimulus supplied by the Next Generation EU fund, from which the first sizeable disbursements have already been made to promote digitalisation and climate protection projects. In the U.S. by contrast, there is growing uncertainty as to whether the Biden Administration’s planned infrastructure programme will be passed by Congress, which means that appreciable fiscal stimulus could be a non-starter in 2022. As European economies are more affected by the Ukraine crisis, GDP growth in the Eurozone will likely slow down more sharply than in the U.S. compared to last year. Although several emerging market countries may also experience a slowdown, the level of growth is likely to remain decent on a long-term comparison. In China, the still uncompromising zero-Covid measures and the downturn in the real estate sector will probably hold back near-term growth in 2022, although the government and the central bank have already approved stimulus measures. Given still relatively strong global growth and ongoing supply shortages in several sectors, the risks of overheating with hefty price rises in individual sectors have not been eradicated. In fairly tight labour markets, the shortages could continue to intensify and send wages rising faster. In a high-risk scenario, in which fossil fuel trade between Russia and Europe comes to a standstill and energy prices spike, our economists would expect the European economy to fall into a technical recession, e.g. two consecutive quarters of negative GDP growth, due to unavoidable outage of industrial production, a deterioration in consumer and corporate sentiment, and negative knock-on effects for other sectors. Central and Eastern European countries and Germany would be hit hardest in this scenario due to their high dependency on energy supplies from Russia. Should risks abate, the macro environment for benchmark government bonds would probably become difficult again, as robust growth rates make rising interest rates and yields more likely.

Asia’s export-oriented economies were expected to be – and should still be – the main beneficiaries of the expected recovery in global trade. However, the war in Ukraine as well as higher energy prices clearly represent downside risks to these growth expectations. The potential impact on GDP growth and inflation is expected to vary across Asian economies – mainly depending on the export share of GDP and dependence on energy imports of each economy. Less strained supply chains and deeper negative output gaps in response to stricter containment measures for Covid have left the region less vulnerable to inflation pressures than elsewhere. However, since U.S. rates and bond yields have always been important determinants of Asian currency values and interest rates, Asia's central banks will not stand still over the course of the year, but move progressively onto their respective normalisation paths. But unlike at the dawn of past U.S. hiking cycles, central banks in the region – excluding China – seem this time to have more room for manoeuvre, and will not necessarily need to be ahead of or in lockstep with the Fed. The Bank of Korea, for example, has already hiked rates three times since October 2021 and South Korea is likely to be among the first Asian economies to finish its hiking cycle this time. In China, a strict zero-Covid strategy has led to renewed restrictions on movement, and private consumption is weaker than anticipated. The Ukraine conflict creates additional downside risks for China’s growth prospects – mainly as a result of a higher energy import bill. Accordingly, we have revised down our GDP forecast for China’s growth in 2022 from 5.3% to 4.5%. Recently, the Chinese government delivered its work report to the National People’s Congress (NPC), setting the annual growth target at “around 5.5%", which implies that average sequential growth will need to recover to an above-trend 6.5% QoQ seasonally adjusted annual average (SAAR), which would be challenging. Average new home prices in China’s 70 major cities rose slightly in January, but in the near future lower investment and declining sales in the real estate sector cannot be ruled out. While the tense liquidity situation in the property development sector might persist for the time being, we do not expect Beijing to be directly involved in potential settlements of payment defaults. Hence, the market shakeout is likely to take place at a local level, with usually better capitalised state- owned enterprise (SOE) developers taking over projects from their troubled private competitors. We anticipate that the People's Bank of China (PBoC) will implement further liquidity easing for China's banks and additional rate cuts to stimulate consumer demand as well as to strengthen capital investment. However, with some service sectors currently under pressure from Covid and renewed scrutiny of the tech sector, a still cautious short-term approach seems to be warranted.

Given India’s large exposure to crude oil imports – accounting for 28% of total imports in 2020 –negative impacts on GDP growth are to be expected if oil prices remain at current levels or rise even further. Higher oil prices are bound to have an adverse impact on India’s inflation, fiscal and current account dynamics, which should ideally make Reserve Bank of India (RBI) more proactive regarding monetary policy normalisation. However, given RBI’s dovish bias, the central bank may very well perceive the current oil price increase as a bigger risk to growth, thereby delaying the normalisation process further. According to the recently published FY2022/23 budget plan, the Indian central government aims to support the ongoing economic recovery by increasing its investment framework by 35% compared to the current budget plan. The roughly USD100bn public investment package is to be used for measures such as road and rail network expansion and solar energy projects.

Rising energy prices, labour shortages and disruptions to supply chains and container shipping have sent inflation rates soaring to levels not seen for several decades. Consumer price inflation in the U.S. breached the 7% threshold and the Eurozone has seen levels of 5%. The rhino in the room has been unleashed and may now prove difficult to stop. Economic recovery has caused surges in demand for goods and services. At the same time, the post-Covid world has brought some supply constraints – and supply is very difficult to control for central banks. Sanctions as well as businesses halting their operations in Russia are exacerbating supply chain problems. Furthermore, shortages in platinum, palladium and even neon are hampering the manufacturing of intermediate products. Service inflation is picking up too, and here we see one deep impact of the Covid crisis – labour shortages. The labour force participation rate in the U.S. has not reached pre-crisis levels, and in Europe unemployment has dropped below its pre-pandemic level and 25% of companies are reporting that scarcity of labour is limiting their production. Low unemployment supports the bargaining power of unions. Much will depend on whether employers and employees are more concerned about economic uncertainty or the inflation outlook. And while we expect some inflation drivers to recede (energy price rises should slow over the medium term), longer-term issues such as the shrinking workforce and the growing share of GDP generated by labour-intensive services are likely to remain, and inflation is therefore unlikely to return to pre-pandemic levels in the years to come.

Supply shortages – of materials and labour – are likely to keep inflation levels elevated.

Inflation has multiple impacts on asset classes. For real returns it remains a challenge for nominal bond investments – in particular where a rise in yields is a headwind as well. Companies are trying to pass on their higher costs and those with pricing power should be able to protect their margins, but rising inflation is often accompanied by yield increases – a challenge for earnings multiples. The decarbonisation of the economy has an inflation impact too, at least in the short term via carbon pricing on the one hand and underinvestment in traditional energy sources on the other. In the longer run it could be deflationary, however, when the economies of scale of renewable energies prevail.

In our annual outlook we argued that the prospect of higher inflation posed a challenge for central banks which would be faced with a risk of being more reactive than proactive. With the resurgence of inflation central banks – most prominently the Fed – have in recent months moved away from the narrative that spikes in inflation were transitory. Multi-decade inflation highs made them rethink their monetary stance despite new approaches like average inflation targeting. The conflict in Ukraine presents an additional challenge for central banks, as spikes in inflation driven by supply shocks are largely beyond their control. The Fed is expected to generally continue along its chosen path, though, as the U.S. is less directly affected by the war in Ukraine. The ECB, however, is in a more challenging position as in addition to soaring inflation it also has to deal with an economic slowdown and seek to ensure financial stability. In general it will stick to its sequencing approach, i.e. ending asset purchases first (it has recently announced plans for a faster winding down of its asset purchase programme) and then hiking interest rates. The Fed is likely to raise its Fed funds rate four more times by 25bp each in 2022 while a certain level of data dependency remains. Three further hikes are likely to follow in 2023. Fading economic momentum and lower inflation could stop the rate hike cycle, but higher inflation expectations could also call for even higher rates. In addition, the Fed will likely start to reduce its balance sheet later in the year 2022. Central banks are in uncharted territory here, as they disembark from an ultra-expansionary monetary policy that led them to expand their balance sheets, while government debt has increased as well. The last time U.S. inflation rates were at today’s levels, the U.S. government debt-to-GDP ratio was much lower. Advocates of Modern Monetary Theory might face difficult times now.

The expectation of interest rate hikes and the move from quantitative easing to quantitative tightening have triggered a rise in yields, which is forecast to continue. Spreads have, however, also widened and a style rotation from long-duration, i.e. growth, stocks into value has become apparent – interrupted by the recent decline in yields. The shift in monetary policy may bring twilight to some long-lasting investment narratives as the hunt for yield becomes slightly less intense.

2022 has been a challenging year for fixed income so far. The shifting sands we forecast within the fixed income asset class have led to increased volatility and yields initially trending higher in the U.S. and Europe. Ultimately, however, yields are likely to be driven by the normalisation of monetary policy going forward, especially as central banks begin a cycle of rate hikes and balance sheet reductions. While yields on shorter maturities will be influenced by expectations of near-term changes in policy rates, longer-term government bonds will respond to changes in the expected terminal policy rates and the pace of quantitative tightening, i.e. the expected balance sheet reductions. An important assumption for all asset classes is that real yields are likely to remain negative over a twelve-month horizon.

Less accommodative monetary policy will have an impact on the interest rate structure. We expect the yield curve to flatten, with yields on short-term government bonds rising more sharply than their longer-term counterparts. The outlook for peripheral spreads in the Eurozone is somewhat mixed. Growth and expansionary fiscal policy including the Next Generation EU (NGEU) recovery fund should remain supportive for the next twelve months. On the other hand, the prospect of rising policy rates and reduced monetary policy support due to the expiry of net asset purchase programmes could lead to widening spreads between the core and the periphery. Central bank asset purchase reinvestments and the ECB's commitment to averting fragmentation should prevent a significant widening of those spreads, but we do not expect a return to last year's lows in spreads. Fundamentally, the balance sheet cash of USD investment grade (IG) remains elevated, which should limit borrowing needs. However, a strong number of rising stars would bring in additional supply to the market, technically weakening the case for this segment. For EUR IG, the invaluable support provided by the ECB via its corporate sector purchase programme (CSPP) is virtually certain to come to an end this year. But the decline in negative-yielding debt in the segment is likely to bring more inflows from institutional investors and we see spreads narrowing over the next twelve months. The high yield (HY) segment in both the USD and EUR markets is fundamentally in a very strong position at present. Default rates for 2021 in both markets were at record lows with USD HY at 0.5% and EUR HY at 0.7%. Although these are expected to rise to close to 1% in both regions, the fact that they are coming off such a low base means that they should not be viewed negatively. Nevertheless, in line with our expectations, the hawkish tilt by both the central banks pushed interest rate volatility higher and, consequently, spreads wider. As this seems to have been overdone, we expect the spreads to tighten from the current levels. We believe the outlook for emerging market (EM) bonds is attractive in the medium term, while the near-term outlook is clouded by high inflation rates and uncertainties due to geopolitical tensions. Emerging market sovereign bonds should benefit from solid GDP growth – high commodity prices and a recovery in tourism should also be supportive. Although geopolitical issues are likely to be a continuing theme for the sector, the lack of a dominant individual country weight should keep these idiosyncratic risks in check and push overall spreads lower.

In the light of recent developments, we have lowered our forecasts for equity markets broadly. We still see decent upside for most stock markets, though. While we note that in the short term stock market performance hinges largely on the development of the Ukraine conflict as well as the impact of sanctions and potential Russian retaliation, we remain cautiously constructive on this asset class in the longer term for two reasons:

• 01

  Our yield forecasts imply real yields will stay in negative territory for the foreseeable future, i.e. the TINA theme should remain valid. Nevertheless, we think that multiples have likely peaked for the cycle.

• 02

  We feel comfortable with our single-digit earnings per share (EPS) growth assumptions for 2022, as companies have so far demonstrated the ability to sustain high earnings margins by passing on cost inflation to customers. We note that despite the market turmoil, bottom-up analysts have raised earnings expectations broadly for the full year 2022 this year, as direct earnings exposure to Russia and Ukraine is limited and concentrated in European companies.

We stick to our neutral rating across equity regions. After being hit relatively harder by the swift increase in real yields, U.S. stocks have held up comparatively well in the wake of the invasion of Ukraine due to the limited business exposure of U.S. companies and a reversal of the previous move in real yields. We see single-digit upside from current levels, supported by a rebound in economic indicators once supply chain bottlenecks ease and the economy reopens after the Omicron wave. Although S&P 500 EPS growth normalised compared to previous quarters, Q4 index quarterly EPS were still more than 20% above trend level. Reassurance about the ability of U.S. heavyweight companies to generate stellar earnings in uncertain times should help the S&P 500 to regain traction.

European equity markets are likely to stay under pressure for longer, given Europe’s close proximity to the conflict, its higher level of energy dependence and its vulnerability to sanctions and potential retaliation by Russia. However, with financial conditions to remain accommodative and fiscal spending to be ramped up, we still see upside for European stock markets. However, we expect market volatility to remain elevated given the uncertainties around the war in Ukraine. Eastern European emerging markets are suffering from both their high dependency on Russian energy and their proximity to the conflict. Hence valuations are likely to remain under pressure with a potential for further deratings. Asia Pacific stocks have proved relatively stable, seeing only minor increases in risk premiums. Latin America has emerged as the best performing region due to its weak linkage to Russia and the high weight of its commodity sector. While contagion effects might also drag on emerging markets, comparatively high interest rates offer a margin of safety for combating diminishing economic growth.

Oil: In early March, the U.S. announced a ban on oil, natural gas and other energy imports from Russia. The UK will phase out imports of Russian oil and oil products by the end of 2022. It is currently unclear to what extent other countries will follow suit. However, both the EU and the UK do not want to stop natural gas supplies from Russia for the time being. The release of oil from the strategic government reserves could not stop commercial inventory drawdowns. On the supply side, OPEC+ continued to underproduce relative to its targets, and we remain sceptical about OPEC+ reaching its announced baseline production levels. A deal with Iran could, however, bring more capacity to the market, and producers in the U.S. are likely to start cashing in on price strength with the rig count gradually ticking up. This should result in supply potentially outpacing demand in the coming quarters. However, OECD commercial inventories are at their tightest levels in more than seven years and roughly 8.5% below the previous five-year seasonal average. The fact that rebuilding these inventories to pre-Covid levels will be a lengthy process should cushion the price impact of a surplus market.

Level of dependence on Russian oil and gas is determining respective government policies on sanctions.

The situation in Ukraine is likely to remain in focus for the foreseeable future. Western demand for oil from outside Russia should provide a sustained tailwind for prices. We therefore expect a WTI price of USD 110/b by the end of March 2023. Prices of industrial metals such as copper, nickel and aluminum have also increased significantly due to the conflict in Ukraine. Industrial metals should also support the transition to green energy sources. Gold: Both expectations of rising inflation expectations triggered by the sharp increase in the price of energy commodities and the status ascribed to gold as a "safe haven" are currently causing prices to test new highs. The precious metal is riding its hedging characteristic for the time being given high inflation and geopolitical tensions. Were it not for the war in Ukraine, gold may well have come under pressure due to the expected Fed rate hikes. With central banks possibly acting more cautiously and inflation expectations rising at the same time, real interest rates in many industrialised countries are likely to remain deeply negative for quite some time. Inflation and geopolitical risks will keep attracting investors to gold. This should support the gold price, which we forecast at USD 2,100/oz at end-March 2023.

Following a boom year in 2021, the overall real estate outlook for 2022 remains positive. With the anticipated continuation of the global economic recovery and real global property yields above their long-term averages, property prices could prove resilient even within the current environment of tightening monetary policy and geopolitical uncertainty. However, the Russia- Ukraine war is currently an incalculable risk. Extensive sanctions and further increases in energy prices could stall the European economy in particular, and depress the real estate market. Of all the sectors, the outlook for offices is the most unclear. Accordingly, office price growth in the U.S. was the most sluggish of the sectors covered below in 2021 (c.14% YoY). Vacancy rates remained high at almost 17% by the end of 2021, 5pp above pre-crisis-levels. Looking ahead, employment growth and an abating pandemic could buoy the market. However, with more people likely to work from home in future, pre-crisis vacancy rates seem a long way away, especially in some European countries where remote working has historically been less common (e.g. Spain, Germany, Italy). In view of tight labour markets, tenants may favour high-quality spaces in order to attract and retain employees. Sentiment around retail space varies across the globe. In 2021, the average retail property price in the U.S. increased 21.5% YoY due to low supply and robust absorptions. European retail property performance is likely to be more fragmented and less dynamic. Urban prime high street stores could benefit from a recovery in tourism, while the structural shift towards remote working and e-commerce are likely to weigh on city-centre retailing. In the U.S. and in Europe industrial was the best performing property sector in 2021. This outperformance could very well continue despite rising supply in 2022. U.S. prices were up by 29% YoY in 2021, boosted by e-commerce and industrial activity growth. Demand comfortably outpaced supply, leading to a record low vacancy rate of 3.2% at the end of last year. Rents rose 11% YoY to their highest on record. As absorption rates are expected to remain elevated, rising construction costs could translate into another year of double-digit rent growth in 2021. Similarly, European industrial rents are expected to continue growing at a steady pace alongside further yield compression. With expected returns of slightly above 10%, prime industrial properties could lead the European ranks in 2022. However, their margin of outperformance is set to decline compared to 2021. U.S. residential properties appreciated by 23.6% YoY with the net effective rent rising 13.4% in 2021. The vacancy rate in the sector declined by 2.2pp to 2.5%, its lowest on record. Yet affordability among households remains solid, as the NAR's Affordability Index finished at around 148 points last year. Despite rising mortgage rates, strong employment and wage dynamics as well as structural factors around household formation and housing shortages might boost returns in 2022 to above 10%. Similarly, as well as structural housing shortages in Europe and institutional investor-driven demand could drive up prices and dampen already low yields.

Overall real estate outlook for 2022 remains positive, although the impact of the war in Ukraine represents an incalculable risk.

Until mid-February, both the U.S. dollar (USD) and the euro (EUR) had benefited one after the other from increasing expectations of more restrictive monetary policy by the respective central banks. Overall, however, this ensured that the currency pair traded in a very narrow range. This all changed with the invasion of Ukraine which put the supposed currency “safe havens” in focus. First and foremost, was the U.S. dollar, since the U.S. economy is likely to be affected to a much lesser extent by the conflict in Ukraine. The Swiss franc (CHF) and the Chinese renminbi (CNY) were also in demand on the foreign exchange markets. Commodity currencies benefited from the rally in prices.

The USD is likely to remain supported in the short term due to safe-haven demand. While we now expect the ECB to hike less than initially thought as it tries to maintain favourable financing conditions in the region, the risk premia that have been baked into the EUR recently should reverse at least partially over the coming twelve months. In addition, the safe-haven flows into the USD are likely to moderate. Thus, we think that the EUR will strengthen especially in the second half of the year; however, it may not be able to reach our pre-conflict forecast of 1.20. We now expect the EUR to trade vs. USD at 1.15 by end-March 2023. Our forecasts for USD/JPY and GBP/USD remain largely unchanged from those we made for the end of 2022. Monetary policy in China is expected to be loosened, in contrast to the U.S. We therefore see the balance tilted slightly in favour of the USD, pushing the USD/CNY to 6.45 by the end of March 2023.

Strong commodity prices are likely to continue supporting the Australian dollar (AUD), New Zealand dollar (NZD), Canadian dollar (CAD) and Norwegian krone (NOK) – however, higher commodity prices could dampen the global economy in the medium term, allowing tailwinds to turn into headwinds. As in 2021, many EM currencies are still being supported by high commodity prices and central bank rate hikes (e.g. Brazilian Real (BRL), South African Rand (ZAR), and Mexican dollar (MXN)). Latin American currencies in particular have even appreciated significantly against the USD dollar since the beginning of the year. In early March, the renminbi rose to its highest level against the USD dollar in almost four years. China’s current account remains impressively strong, its consumer price inflation impressively low, and PBoC monetary policy remains supportive. In general, the availability of carry will offer continued support for emerging market currencies.

The invasion of Ukraine has shifted the focus of market participants to safe-haven currencies such as the U.S. dollar and the Swiss franc, with the Chinese renminbi also in demand.