Geopolitical developments are anathema to macro strategists. They’re difficult to predict and time, can be violently disruptive to market pricing—although usually for short periods—and they tend to distract market participants from focusing on core longer-term themes. When they occur, seasoned macro strategists typically highlight the benefits of looking past the headlines and focusing on where we are in the business cycle, the direction of interest rates, and the strength of the consumer.
And yet, as we’ve spent the past several weeks reflecting on the implications of a Russia-Ukraine conflict, we cannot dismiss its impact on our global macro views. Although many assets have already rebounded from their initial sell-off, we’d caution that there are reasons to consider how the situation will affect our medium-term outlook.
A stagflationary economic shock
Indeed, the conflict and its repercussions amount to a stagflationary economic shock, which is hitting the global economy at a moment in which it was already suffering from painful inflation and signs of a growth slowdown to come. While the magnitude of the shock isn’t yet known—and will be a function of the evolution of events—the trajectory of this particular geopolitical event is sufficient for us to:
- Add conviction to our existing call that the first half of 2022, particularly the second quarter, could be mired in stagflationary dynamics (lower growth, higher inflation), persistent volatility, and more frequent bouts of risk aversion
- Lower our conviction that the second half of 2022 will be an easy return to a Goldilocks scenario (stable growth and lower inflation)
As these are still early days, I’d stress that these are changes in our convictions around our base case, not a change in our outlook overall.
Commodity inflation is critical
To start, the main channel through which this conflict will affect global growth and inflation forecasts is through commodities. As Sue Trinh recently explained, the Russia-Ukraine conflict needs to be monitored very closely, particularly given Russia’s critical role in commodity markets:
“Russia is the world’s leading exporter of natural gas (17.1% of global production) and the second-largest exporter of crude oil (12.1%). For context, Saudi Arabia accounts for 12.5% of the crude market.
Russia and Ukraine are also significant agricultural producers: Their combined wheat, barley, and maize exports represent 21% of the global total, and together they supply 60% of the world’s sunflower oils. Russia and Belarus also account for approximately 20% of total fertilizer exports, which is vital for global food production.
Meanwhile, Russia is one of the world’s largest producers of critical metals. It’s the biggest exporter of palladium (20.7% of total volume) and ranks second after Chile in terms of refined copper (7.1%). The country also holds the third position for nickel (11.2%) and aluminum (9.0%).”
Our three-part framework for assessing the situation
Understanding this, we’ve constructed a simple framework through which we incorporate this evolving conflict in our outlook.
1 Another stagflationary shock. Our regular readers may be familiar with our view that the first half of 2022 (especially late Q1 and Q2) is likely to see stagflationary dynamics (higher inflation than comfortable, lower growth than comfortable). The higher-inflation-than-comfortable component of isn’t controversial, and the ongoing run-up in energy (and food) prices, exacerbated by the Russia-Ukraine conflict, is readily observed.
But the second-order impact of sharply rising energy and food prices is a growth shock, as energy demand has notoriously limited elasticity; that is, even if gas prices or heating costs soar, we still need to get to work and to stay warm, and consumers either have to use savings or cut back in other areas of spending. This is on top of negative real wage growth and weak consumer confidence data in most major economies. U.S. personal income data also out this week showed income rose 0.0% month over month, and spending only rose off the back of declines in the savings rate. That’s not a healthy consumer backdrop for experiencing another price shock. We expect to be thinking much more about the global consumer’s exposure to energy in the weeks ahead.
We’ve already been operating with the expectation that high costs would cramp growth, but the Russia-Ukraine conflict compounds the issue and is consistent with ongoing yield curve flatteners. It also potentially throws a wrench into our expectation that inflation would begin cooling after February and would sharply decline to 2% in most major economies by year end. We’re still comfortable with the path of that decline, but its speed may be affected by these tensions.
Combined with supply chain disruptions that may limit inventory rebuilds that we hoped would fuel growth in the second half of 2022, our call for a return to Goldilocks by year end is looking less than solid.
2 A potential slowdown in central bank tightening. Central bankers were out in droves this week and few could avoid addressing the Russia-Ukraine conflict. Most highlighted the uncertainty this has injected into the outlook and downplayed the likelihood of a 50 basis point (bps) hike in March. Meanwhile, markets have gone from pricing in a 50bps hike as a near certainty two weeks ago to now having a one-in-five chance. That’s consistent with our central bank outlook, which has made the point that the odds of a 50bps hike were overpriced. Indeed, we continue to believe the U.S. Federal Reserve (Fed) can hike three times this year in total, along with quantitative tightening, whereas the market is still pricing in six to seven hikes in the next 12 months.
The Fed is once again in a situation in which inflation is coming from global and supply-side developments; interest-rate hikes will do little to cool energy-driven inflation precipitated by geopolitical developments. But both the pressure coming from some moderate increases in services inflation and the political challenges associated with 7%+ year-over-year prints probably mean they’re still on the path to normalization.
The biggest reason we expect the Fed to pivot more dovishly this year is because we expect the narrative to turn away from high inflation toward low growth. And if we’re correct that the Russia-Ukraine conflict will compound the growth shock, then we have even more conviction in our call that the market is overpriced—both in that it still has a 20% chance of a 50bps hike priced into March but also because of how much tightening it believes the Fed will engage in over 2022. Should the Fed pivot, it will be able to resteepen the curve, which is desperately needed, and support an extension of the cycle.
The Russia-Ukraine conflict isn’t solely about the U.S. central bank, of course. We expect more dovish commentary from the Bank of Canada, the Bank of England, and, most important, the European Central Bank as it assesses the stagflationary dynamics at play.
3 Relative impacts/trades. We expect the theme of global desynchronization to become more important over the course of 2022. While the stagflationary shock emanating from the Russia-Ukraine conflict is global in nature, its effects will be felt unevenly around the world. In terms of major macro economies, Europe is most exposed to the growth destruction from higher energy prices, given its natural gas exposure and existing weaknesses. Indeed, recession odds for Europe will climb in the coming year (although recession isn’t our base case). We believe the United States is in a better position to absorb some energy and food price inflation, although the country, in absolute terms, is worse off.
As Sue Trinh covered, emerging markets are, on balance, weakened, but those economies that can absorb higher food and energy prices (e.g., Singapore and Malaysia) or those with least exposure to liquidity shocks (e.g., Indonesia and the Philippines) could be relative outperformers. It’s also likely that global export momentum slows somewhat, and so those economies less reliant on foreign demand may enjoy a mild relative advantage.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional
Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Manulife Investment Management Timberland and Agriculture Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.