Andrew Pease

GLOBAL HEAD OF INVESTMENT STRATEGY

The crisis in Ukraine creates near-term risks for markets, but also casts a shadow over the longer-term outlook. The immediate threat comes from high energy prices, rising food prices and disrupted supply chains. The longer-term issues are a new cold war between Russia and the West, increased military spending and a further blow to globalization. The war is a defining moment for Europe, which now needs to unwind decades of Russian energy dependence, accelerate its sustainable energy transition and rebuild military capability.

Markets had plenty to worry about before the invasion, including the onset of U.S. Federal Reserve (Fed) tightening, the impact of COVID-19 lockdowns on supply chains and inflation and the outlook for China with problems in the real estate sector, its zero-tolerance COVID-19 policy and heavy-handed regulation of technology firms.

Our theme for 2022 prior to the invasion was The Great Moderation. We expected global growth to moderate from the post-lockdown surge in 2021 but remain above trend. The consequences of the invasion are lower global growth, with Europe taking the largest hit, and higher inflation. Even so, global growth this year should still be above trend, provided hostilities ease and global energy prices stabilize. Above-trend growth should support equities over bonds and cash, but the conflict has created significant uncertainty, which means more market volatility.

The main cycle risks from Russia/Ukraine come from:

• Energy prices and their impact on global growth and inflation
• Food prices, given Russia and Ukraine’s importance in global wheat and corn exports
• Supply chain disruption, particularly for motor vehicle parts and semiconductor production

The energy price channel¹ is the most important, and oil prices sustained above US$130 per barrel (bbl) could trigger a much larger global downturn and risk of a recession.

The minimal economic-damage scenario assumes that hostilities ease by mid-year, Russian energy supply is maintained, oil prices stabilize at around US$100/bbl and European natural gas prices return to below €100 per megawatt hour (mwh). A lot of things must go right in this scenario, but the initial price spikes when the invasion occurred have been largely reversed.

The energy price channel matters more for Europe due to the dependence on Russian gas exports. Europe obtains more than 40% of its natural gas and 20% of its oil from Russia. Natural gas prices averaged around €20/mwh over the past decade. They spiked to €250 after the invasion. Natural gas supplies from Russia have not yet been disrupted, although this is still a risk, and the price has fallen back toward €100. Europe’s ability to quickly switch to other sources of supply is limited. It’s fortunate the energy crisis is unfolding in March, near the start of the northern spring, rather than October when heading into winter. A short-lived shock to energy prices should see European economies recover in the second half of the year. COVID-19 has become less deadly, post-pandemic reopening is underway and fiscal policy is supportive because of the European Recovery Fund. The Russia/Ukraine conflict means fiscal policy is likely to become slightly more supportive. Germany has committed to boost defense spending to more than 2% of gross domestic product (GDP), and both French President Emmanuel Macron and Italian Prime Minister Mario Draghi have called for less restrictive fiscal rules in Europe.

The global economy was on track for strongly above-trend growth in 2022. Before the invasion, the industry-consensus view was that the U.S. would grow by around 3.5% this year, Europe 4.0%, and the UK 4.5%. The war is unlikely to reduce U.S. growth by more than 0.5 percentage points, while the impact on European growth is likely to be 1.5-2.0 percentage points. We can put the UK mid-way between the U.S. and Europe. This takes 2022 GDP growth projections to 3.0% for the U.S., 2.5% for Europe and 3.5% for the UK

Other risks: supply chain disruptions, food prices

The harder-to-judge risks come from Russia and Ukraine’s integration into global supply chains and their importance in commodity markets.

Russia is a major global supplier of palladium, which is used in the manufacture of motor vehicle catalytic converters. Ukraine provides around 50% of the world’s neon gas, which is used in the production of semiconductors, which are also essential in motor vehicle production. Surging motor vehicle prices, due to parts shortages, were one of the important drivers of rising global inflation during 2021. The war could delay the recovery in global automobile production and prevent prices from declining. Ample inventories of palladium and neon, however, should cushion the impact on motor vehicle and semiconductor production.

Rising food prices, however, could be a significant risk. Russia and Ukraine supply around a quarter of the world’s wheat exports. Prices have surged 50% since the start of 2022. Much of this supply goes to emerging markets in the Middle East and Africa. Food prices are an issue for inflation but are also a risk for political stability in many emerging economies.

Supply-side-driven inflation shocks are challenging for central banks. They want to sound concerned about the longer-term inflation implications of commodity price rises in order to anchor longer-term inflation expectations, but they also need to proceed cautiously with interest-rate increases because of the potential impact on growth.

Fixed income markets expect the Fed will lift rates a further six times in 2022. The U.S. economy is the closest to full capacity and least affected by Russia/Ukraine. We agree the Fed will keep hiking policy rates back toward a neutral setting of around 2.25%. The two indicators we have been watching for Fed action continue to provide conflicting signals. The Atlanta Fed’s wage growth tracker highlights the labor market pressures from the post-lockdown reopening. The five-year/five-year breakeven inflation rate, which measures investor expectations for the five-year average inflation rate in five years’ time, is still well contained. Surging wages point to more rate hikes this year, but well contained longer-term inflation expectations mean the Fed might not need to go too far into restrictive territory.

The eurozone economy is further from full capacity than the U.S. and faces a bigger economic hit from Russia/Ukraine. This means the European Central Bank will focus on growth risks more than inflation. Markets expect two rate hikes this year, but it’s likely that rates will remain unchanged or only rise once as higher energy prices slow economic growth.

Labor market conditions are tighter in the UK than Europe (in part due to Brexit) and energy prices are threatening to keep headline inflation above 6% by the end of the year. Household disposable incomes are set to be depressed in April by the 1.25% increase in the national insurance levy and 54% increase in the energy price cap on household gas and electricity bills. The market expects the Bank of England to tighten a further five times this year, but pressure on households could limit this to two or three moves.

1. Less globalization. The backlash against globalization started with the financial crisis in 2008. It gained pace with former U.S. President Donald Trump’s trade wars and was delivered a further blow by the COVID-19 pandemic. The risks to global supply chains caused by the invasion will trigger a further decline in global trade as a share of GDP. Less globalization means less global competition, fewer productivity gains, more inflationary pressure and lower global growth.
2. More geopolitical risk. The invasion has highlighted global political fault lines. Russia’s no limits partnership with China puts the focus on the U.S./China relationship. The severity of the economic sanctions on Russia likely will deter China from pursuing its claims over Taiwan anytime soon, but ongoing tensions will be a continuing watchpoint.
3. An accelerated clean-energy transition. The one positive from the Ukrainian tragedy may be an extra impetus to the move away from fossil-fuel dependence. The European Union plans to be independent from Russian fossil fuels well before 2030, with energy-saving measures and more of a role for wind and solar. China, in turn, can use discounted Russian natural gas to lower its coal dependency.

Our cycle, value, and sentiment (CVS) investment decision-making process still scores U.S. equities as expensive. The UK and emerging markets are at fair value and Europe is only marginally expensive after the recent market declines. The hard-to-value Japanese market also scores as slightly expensive.

The Russia/Ukraine war has increased the risks and uncertainty around the cycle outlook. On balance, we still expect the cycle to be supportive for global equities and remain a headwind for government bonds. In our 2022 Global Market Outlook report, we commented that above-trend growth and higher long-term interest rates would favor cyclical and value stocks over technology and growth stocks. The rest of the world, particularly Europe, is overweight cyclical value stocks while the U.S. has a higher weight to technology stocks. The war has complicated this outlook due to downgrades to the European outlook and higher commodity prices. Even so, cyclical/value stocks have outperformed so far this year. The case for further outperformance is now weaker, but there could be more gains should hostilities ease and the European growth outlook improve in the second half of the year.

Russia/Ukraine has added to the challenges facing emerging markets (EM). China’s economy was already under pressure from the real estate downturn and weak credit growth. This has been made worse by the shutdown of major cities due to the zero-tolerance COVID-19 policy, and has been further exacerbated by surging energy and commodity prices. The MSCI China index has taken a beating on worries that the regulatory crackdown on technology firms may not have ended. Broader EM faces the difficulties of Fed tightening, a stronger U.S. dollar (USD), rising food prices and more expensive energy. EM could stage a turnaround if, as seems likely, China undertakes significant stimulus and commodity prices pull back on easing hostilities in Ukraine. For now, however, a neutral stance is warranted.

The U.S. dollar has made gains this year on Fed hawkishness and its safe-haven appeal during times of global conflict. Currencies such as the euro and the yen now appear significantly under-valued on a longer-term basis. The uncertainties around the outlook are large, but there is a case for USD weakness in the second half of the year if Russia retreats from Ukraine and the Fed becomes less hawkish as inflation pressures lessen. Dollar weakness should support the performance of non-U.S. markets and will help offset some of the headwinds facing emerging markets.

Sentiment for equity markets is firmly oversold but not yet at the level of panic reached in late 2018 and early 2020. The cycle uncertainty means we are looking for clearer signs of market panic before recommending a risk-on stance.

• Despite Russia’s invasion of Ukraine, we have a small preference for non-U.S. developed equities to U.S. equities. Provided hostilities subside, above-trend global growth should favor relatively cheaper non-U.S. markets.
• Emerging market (EM) equities face headwinds from the China slowdown, high energy and food prices as well as central-bank tightening across other EM economies to contain inflation pressures. EM equities could recover if there is significant China stimulus early in the year, the Fed slows its pace of tightening, energy prices subside, and the U.S. dollar weakens. For now, a neutral stance is warranted.
• High yield and investment grade credit spreads widened following the Russian invasion of Ukraine. The investment grade spread is back to its longer-term average, but the high yield spread is still low by historical standards. High yield spreads will be at risk if the Russia/Ukraine conflict escalates but could perform well if hostilities subside and the cycle outlook improves. Given the uncertainties, we have a neutral outlook on credit markets.
• Government bond valuations are mixed after the recent selloff, with U.S. now fairly valued and Japanese, German and UK bonds still expensive. Yields will face upward pressure from continuing inflation increases and central-bank hawkishness. A positive for government bonds is that markets have fully priced potential tightening by most central banks, and this should limit the extent of any further selloff.
• Real assets: Global Listed Infrastructure (GLI) has been one of the better-performing asset classes so far this year, benefiting from energy exposure, while real-estate investment trusts (REITS) have posted negative returns. Both should benefit if Russia/Ukraine hostilities subside, the pandemic recovery resumes and inflation concerns continue, although GLI should give back some of the gains from energy infrastructure. Commodities have been the best-performing asset class, with energy and agricultural prices surging on the Russia/Ukraine conflict. Some of these gains will be reversed if hostilities subside, but strong global demand and supply bottlenecks should support prices. The prices for many commodities futures are now below the current price (known as backwardation) after many years when the reverse was the case. Backwardation provides an interest-rate like return for investors in commodities funds. One risk for commodity markets is that Chinese economic stimulus is too small to prevent a further slowdown. On balance, the case for commodities exposure is still positive.
• The U.S. dollar has made gains this year on Fed hawkishness and safe-haven appeal during the Russia/Ukraine conflict. It should weaken if hostilities subside and lower inflation outcomes later in the year lead to less Fed tightening than markets currently expect. The main beneficiaries are likely to be the euro, which has become more undervalued, and the Japanese yen, which has weakened on commodity price inflation and China growth concerns. We also believe British sterling and the economically sensitive commodity currencies—the Australian dollar, New Zealand dollar and Canadian dollar —can make further gains.

Annual 2021 update

Q4 2021 update

Q3 2021 update

Q2 2021 update