How have global capital markets reacted to the war in Ukraine? Chief Investment Officer Dan Chornous reviews the key factors driving volatility in fixed income and equity markets, including tightening financial conditions, persistent inflation and the risk of recession.
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What are the economic and market implications of the Russia/Ukraine conflict?
This is an exceptionally fluid situation. And unfortunately, as we’re dealing with this at kind of a gut level and seeing the unprovoked attack and devastation on our screens, we also have to consider the impact of it on global capital markets and the economy. And there will be an impact in the near term and in the long term.
In the near term, inflation, which most of us expected to peak in the fall of this year and come back to more—towards sustainable levels by middle of 2023, will probably rise a little higher in the interim and perhaps peak later in 2022, but nonetheless, still peak this year. That’s on the back of, not only rising energy prices, but also the fact that Ukraine is a major exporter of many other commodities, including foodstuffs.
This makes it much more difficult for the Federal Reserve Board and other central banks to manage interest rate hikes that were in place for 2022 and beyond. And they want to dial it up enough to make sure that inflation does peak before expectations change but not so much that the economy in the United States and elsewhere would fall into a recession. There’s a lot more jeopardy in that now with the external forces of the invasion, rising commodity prices, and kind of a busted confidence that comes with the invasion.
So these are near-term impacts, but there are also some longer-term impacts that we need to think about. As you know, globalization was already under review, at least to the degree to which we had arrived at a globally interconnected world prior to the pandemic.
Climate policy will now also have to be reconsidered as we reflect on our need for, not only bringing climate change in hand, but also making sure that we have secure access to energy.
And finally, during a period of fiscal tightening, governments everywhere need to think about defense spending and protecting their citizens, which to some degree, looks like the beginning of a new Cold War.
So there are new pathways to bad outcomes for the whole global economy and for capital markets as a result of the invasion. That doesn’t mean that we will necessarily take those pathways, but we need to be aware that they now exist.
Have your economic forecasts changed with recent geopolitical events and persistent inflation?
2022 and 2023, even before the war in Eastern Europe, were looking to be a year of slowing, fortunately for inflation, but also for growth. We need to shave those forecasts a little more now. In the case of inflation, it’ll hang up higher, perhaps peak later in 2022, but we still do look for a peak, and eventually a fall back towards the 2.5-to-3% level in 2023.
Growth is also problematic. We’ve adjusted our forecast down by 0.5% in most countries; 0.75% in the emerging world. But still, growth of 3% or so is expected across most countries. And considering the pre-pandemic world, that’s not bad. It comes on the back, though, of slowing fiscal relief, rising interest rates, and I think that the chances of a recession have been raised measurably since our last forecast.
I think it’s important to note, though, that even for the freshest forecasts that we’re seeing from the most damaged areas, that being Europe, nobody’s looking for a recession yet. It needs to be monitored. But to kind of put a scale on it, if we thought the threat of recession in the coming 12 months was kind of 15 to 25% prior to the invasion, we would raise that to something like 20 to 40% out over the next 12 months and monitoring that minute to minute.
What is your outlook for inflation?
Even prior to the invasion of Ukraine, inflation was problematic and a focus for central bankers everywhere. And the roots of inflation in this cycle were very different than inflations that we’ve seen even in my lifetime. It was supply chain disruption that came on the back of the pandemic, and it was also changes in demand patterns as we put economies through the stress of that pandemic, including lockdown. So, some of that was going to calm itself. We felt that inflation would peak somewhere in the 6-to-7% range in the fall of this year, and naturally start to decline. And we forced that decline even faster by a path of rate hikes by the Fed and other central banks.
Unfortunately, the war in Ukraine, Russia’s invasion of Ukraine, puts additional upward pressure on inflation. The energy prices have spiked; other commodities are higher; foodstuffs will increase. And dependent on how that war progresses, we expect that inflation may now peak at above 8%. And it’ll peak later in 2022 than we originally thought, but still peak within the current year and come off quite sharply in 2023 as the increases that we’ve seen over the last 12 months are not replicated at the same rate, at the very least.
So we would look for inflation to be a problem, peaking this year, and then coming off. But certainly, it complicates the path for the Fed and other central banks as they hope to deliver a soft landing for the economy.
What is your outlook for fixed income?
Fixed income markets have been quite volatile in the last 12 months as we approach the end of the pandemic, and the beginning of a tightening of Fed policy. In fact, financial conditions have been tightening for quite some time. And we’re about to kick off the first of rate hikes, possibly as soon as you see this video.
We had looked for four rate hikes by the Federal Reserve Board and similar levels of interest rate tightening by other central banks as we try to bring down inflation, certainly within this year, and do that before inflationary expectations become untethered. It’s the right thing to do right now.
Unfortunately, that’s been complicated by the war in Eastern Europe. Rising energy prices, rising commodity prices will put additional upward pressure on inflation, and, I think dangerously, might persuade more people that it’s pernicious; it’s not coming down anyway.
Four rate hikes should remove around 0.5% growth, enough to deliver growth of around 3%, lower inflation, and that soft landing that central banks typically target, as we move into this stage of a mature economic cycle.
Now the consensus now has seven rate hikes. Clearly, that’s not enough, given the math I just explained, to push the economy into a recession. But every additional rate hike raises the specter of recession that much more. We’re confident that four will be enough, and that remains our forecast.
Now in that environment, we think that yields should peak at close to 2.25%, using the U.S. 10-year T-bond yield as the benchmark. But when we made these forecasts, the yield was closer to 1.75%, but already up from 1.2% since last summer. As I speak, yields are closer to 2.2% right now. There has been a very large adjustment at the 10-year point on the yield curve. We think that’s pretty much enough. And at current levels, returns on T-bonds and other similar bonds will be pretty close to their coupons.
What is your outlook for equity markets?
In a normal market forecast, you’d have a base case, and a bad case, and a good case. And typically, they would take the form of a normal bell-shaped curve. Your highest conviction would be at the centre.
I think that the path for inflation, the tightening of central bank policy, and now the war in Eastern Europe, has flattened out that distribution. It’s much more difficult to put a whole bunch of conviction between one of those three outcomes.
So let’s talk about the worst case. War drags on. Earnings, which are currently around $205 for the S&P, and expected to go $220 over the next year, don’t come through. The economy slides into a recession. Earnings fall 25%. That can take the S&P down as much as 3,000. Now, it’ll bear the brunt of decline from here, I think, because it was the most highly valued market leading into this. But that’s still a doubling of the losses that we’ve seen so far. Painful.
What about the good case? Well, we affect a soft landing. Some type of a negotiated settlement calms the situation, at least for a time, in Eastern Europe. And we get $220 in earnings. In fact, in our own forecast, we can see earnings not rising at 8%, which is currently forecast, but in low double-digit ranges—10, 12, even 14%. Put a 20 multiple on that and the market trades between 4,500 and 5,000. So there’s almost an equal balance between the downside and the upside right now, dependent on the outcome for the economy.
In our scenario, we still favour the positive. We don’t think that the economy will fall into a recession, and we think there’s a good enough cushion against that happening. We’ve run with a mild overweight in equities, even recognizing the storm clouds that are gathering.
We continue with a mild underweight in fixed income. Even as rates have risen towards our targets, the total return expected of something like 2, 2.25% on sovereign bonds just isn’t that attractive relative to the numbers that we see generated by stocks—mid single digits, maybe a little higher over the coming 12 months.
We’ll be monitoring the situation closely, as we always do, but perhaps even more closely right now, given the fluidity of events.