As if “living with Covid” were not sufficiently challenging, the war in Ukraine and its human costs have added another geopolitical layer of complexity to the healing process for the global economy following the Covid recession. Markets, however, still look set to weather these storms reasonably well.
Hefty increases in energy prices, stubbornly persistent and now even prolonged supply chain disruptions and labour shortages had already sent inflation rates around the globe soaring to levels not seen for many decades. Entering 2022, hopes of an eventual fall in the number of Omicron cases in the U.S. and in many European countries offered scope for pent-up consumer demand to be satisfied, while full order books promised considerable upside for the industrial sector too.
However, with the sanctions now imposed on Russia by the international community and existing shortages being exacerbated by the conflict, economic output growth may now be lower and the forecasts in this report reflect this. We now expect U.S. growth to outstrip that of the Eurozone in both 2022 and 2023 because of the Eurozone's geographical proximity to the conflict zone and Europe's structural disadvantage as the world’s largest net importer of energy.
In the developed economies, already elevated inflation rates may now be driven even higher given the conflict-induced oil and gas price shock.
Household consumption may be dampened by higher energy prices, which could delay economic recovery. And although the general economic environment should remain favourable, the spectre of a temporary bout of stagflation in developed markets cannot be ruled out in the short term.
Asia should in theory benefit from a pick-up in global trade as increasing re-openings may well lead to a sustained period of robust demand. After all, much of Asia is still relatively locked down and thus economic activity is far below pre-Covid levels. That said, the current headwinds for growth (i.e. demand) in Europe may postpone the positive trade impulse that many expected before the current Ukraine crisis.
With economies beginning to get to grips with recent supply side shocks including the coronavirus pandemic, disrupted U.S./China trade relations and higher energy prices, U.S. and European corporates had been reporting prior to the invasion that demand was generally very robust and well above production capacity. Many firms are still planning to increase output and hire staff, which may put upward pressure on wages, with these higher costs then being passed to customers. A sustained deterioration in the outlook of corporates has not yet been observed, but at least some downside adjustments are likely going forward.
Finally, decarbonisation of the economies is still a secular inflation driver, via carbon pricing and underinvestment in traditional energy sources.
Central banks are now facing a dilemma as price pressures are unlikely to abate anytime soon and the economies need ample liquidity provision in light of deteriorating financial conditions and rising risks to growth. Monetary policy will be tricky and is likely to be increasingly data-driven and dependent on how the conflict evolves. But one corner now appears to have been turned: government bond yields have moved up markedly in recent weeks and can be expected to trend higher over time due to inflationary pressures that are here to stay and responses by the main central banks.
Credit looks in a reasonable state to weather this particular storm. With strong balance sheet cash positions and record-low default rates the case appears to remain fundamentally positive for developed market (DM) credit. The case for emerging market (EM) credit remains intact. Bouts of technical selling pressure are to be expected, though, whenever risk sentiment sours due to the conflict situation or other factors like inflation spikes and/or central bank action.
We still remain cautiously constructive on equities. Despite rising interest rates, low or often negative real rates (given higher levels of inflation) continue to support the “there is no alternative” (TINA) argument and the earnings outlook is still positive, but the uncertainty surrounding our outlook has risen substantially and high levels of stock market volatility are likely to persist. “Risky rotations” on the stock markets will also likely stay with us for quite some time. And while, as noted, many real rates are expected to stay slightly negative on a 12-month horizon, they are likely to be volatile and “data-as well as Fed-dependent”.
Volatility is still high against the backdrop of the war in Ukraine and fundamentally sound investments may have already suffered more than implied by their intrinsic value due to broad- based risk reductions. Investment opportunities should however arise over time.
The commodities bull market continues to rage with oil prices already supported by low inventories. Oil and gas prices are also expected to remain elevated on account of the potential disruption of supplies from Russia and the sanctions-related imponderables.
Negative real yields and gold’s function as a crisis hedge keep it relevant. We remain constructive on real estate with the stage set for residential and industrial property to provide relatively attractive returns.
Looking at foreign exchange markets, they are now increasingly responsive to geopolitics, while monetary factors may gain more relevance again over time.
Strategic asset allocation remains the foundation of our investment approach. In these unprecedented times where high levels of uncertainty are attached to any and every forecast the importance of risk management and diversification cannot be overstated. As we argued in our annual outlook, we believe that geopolitical issues are set to remain a defining feature of capital markets. Risk premia are here to stay and must be factored into investment strategies.
In a nutshell, investors should strive for an appropriate strategic asset allocation, not allowing themselves to be swayed by the storms that may disrupt markets but resolutely retaining their longer-term focus.
Christian Nolting
Global CIO
