Just as we were looking to a return to some semblance of postpandemic normalcy, the Ukraine conflict and resulting geopolitical stress have further complicated the macro landscape for 2022.
As we’ve mentioned previously, the extended disruption to global supply chains and surge in commodity prices have amplified the dilemma facing major central banks: On the one hand, this will push headline inflation (and inflation expectations) even higher; on the other hand, it will amplify the squeeze on real incomes, economic activity, and core inflation further ahead. Tightening in this environment risks exacerbating the downside risks to economic growth. In our view, there’s very little monetary policy in isolation can do to address cost-push inflation.
The best-performing markets year to date are energy (41.3%)1, agriculture (25.0%)1, and industrial metals (21.5%)1, reflecting the worsening global shortage after removing the supply from a critical producer such as Russia. By extension, equity markets leveraged to rising commodity prices, such as Indonesia, Canada, Australia, and Brazil, have outperformed. Precious metals, the U.S. dollar (USD), Chinese government bonds, and U.S. Treasury bills have also performed well relative to the weakness seen in other assets, reflecting their safe haven status.
At the other end of the spectrum, growth-oriented stocks and sectors that have a higher equity duration—Chinese equities; stock markets in the Europe, Middle East, and Africa regions—and Asia high-yield debt have underperformed, reflecting these markets’ sensitivity to tighter global financial conditions and their respective trade, financial, and geopolitical linkages to the Ukraine crisis.
Cross-asset volatility remains elevated: Our composite measure of risk aversion indicates a difficult quarter ahead for risk assets, yet many central banks are pushing ahead with monetary policy normalization. Apart from the questionable efficacy of tightening into a negative global supply shock, this dynamic has important implications for global liquidity.
Global liquidity growth has slowed markedly—from a record 21.5% in March 2021 to 5.4% by mid-March 2022, the slowest rate since April 2020.2 A declining global liquidity impulse is most relevant to emerging- market (EM) growth and earnings, but it also has broader relevance to risk assets.
We’re still of the view that policymakers’ concerns over high inflation will ultimately give way to worries about slower growth. For this reason, we anticipate a dovish pivot from the U.S. Federal Reserve (Fed), likely in Q3, and believe the U.S. central bank’s tightening cycle will fall short of the market’s pricing in terms of its pace, magnitude, and duration.
Crucially, we think it’s extremely likely that the next global stimulus phase will represent a significant departure from the playbook that investors have been conditioned to seeing since the global financial crisis. While the public policy response to every crisis in the past 15 years has been steeped in neoliberalism—broadly characterized by globalization, offshoring and free trade, limited role for the state in the economy, a structurally lower consumption share of GDP, and the hyperfinancialization of the global economy—the social and political appetite to repeat these policy prescriptions is incredibly limited at this juncture. Indeed, we’re already seeing revolutionary shifts in the opposite direction.
Europe has awakened to the great power competition and, in a historic shift, Germany has announced plans to ramp up its defense spending and end its reliance on Russian energy in light of the crisis in Ukraine. Significant increases to defense spending are being adopted by governments across the world. Meanwhile, Western solidarity around sanctions has been ramped up to previously unthinkable levels—key Russian banks have been barred from the global SWIFT system and major economies have introduced restrictive measures that will prevent the Central Bank of Russia from accessing its foreign reserves. Many Western banks and businesses are engaging in self-sanctioning, opting to avoid unsanctioned Russian entities out of fear that the official sanctions list might broaden at a later time.
These are profound changes, developments that have significantly accelerated the pace at which we’re progressing toward an even more fragmented global economy. In fairness, this movement was already in place before the pandemic but has been catalyzed by Russia’s invasion of Ukraine. Military conflicts change everything. As the politics change, economics will too, and financial markets—as history informs us—will follow.
From a longer-term perspective, we continue to expect to gravitate toward a medium- to longer-term macro landscape in which governments will play even bigger roles in economies. Naturally, the extent of government involvement will vary greatly from economy to economy, and central banks are likely to come under increasing pressure to monetize government spending.
Against that backdrop, key macro themes going forward will, in our view, include significant geopolitical upheaval, private sector deleveraging, reshoring and reindustrialization in developed markets/industrialization in EM, lower and flatter yield curves, increasingly negative real interest rates, competitive currency devaluations, more government regulation, and increasing protectionism/localization.
The strategic investment implications from this macro thesis remain a portfolio biased toward up-in-quality assets, U.S. equities and fixed income over other developed markets, and EM with less room or willingness to monetize deficits (e.g., the eurozone and China). Similarly, the thesis would favor the USD over high beta fiat currency. Sectorwise, critical industries benefiting from industrialization and rising living standards in both the United States and rest of the world should outperform; these include utilities, materials, and consumer staples.
Finally, exposure to alternative assets (e.g., gold, residential real estate investment trusts, and crypto assets) as a form of protection from fiat devaluation may also make sense.
