“The war between Russia and Ukraine and the global response to the conflict are evolving rapidly, with the trajectories of economic growth and financial-market performance being significantly altered from just a month ago. Although we continue to think that the most likely outcome is for the global economy to continue expanding, we now expect slower growth with higher inflation, and we presume that the odds of recession have now increased.” — Gordon Telfer, Chief Investment Officer, Portfolio Manager (The Scotsman)
Geopolitical tensions flare up
Russia has delivered on its threat to go to war with Ukraine and the invasion has opened up the possibility of a drawn-out period of uncertainty. While there are potential paths to a resolution if Ukraine and NATO agree to Russia’s demands, an agreement seems unlikely at the time of writing. From an economic perspective, Ukraine’s economy has been devastated and Russia is being subjected to harsh sanctions limiting flows of money, goods, and technology. Aside from shock and revulsion from this unprovoked aggression, the main near-term impact on the rest of the world is through lower supplies and higher prices for commodities, which will be most harmful to European countries given their reliance on Russian energy. We project a 0.7% reduction in the Eurozone’s 2022 GDP growth to 3.0% and a 0.3% decrease in U.S. growth to 3.1%. From a long-term perspective, the Russian-Ukraine war brings a range of potential implications including a new Cold War, increased defense spending, nuclear proliferation, and a heightened motivation for countries (particularly in Europe) to accelerate the shift in energy supplies toward renewables.
Global economic recovery slows
Although the pandemic continues to gradually recede and both consumer and business spending is rising, the impact on growth is much less pronounced than it was a year ago. Moreover, a tightening of financial conditions, slowing Chinese growth, reduced U.S. government spending and elevated inflation were already working to undermine the economic expansion prior to the Ukraine conflict beginning. As a result, our forecasts for 2022 have moved somewhat lower from last quarter and remain below the consensus. We forecast global growth is set to decelerate to 3.5% in 2022 from 6.2% in 2021. Developed-world growth should fall to 3.0% from 5.1%, while growth in emerging markets is set to slow to 4.3% from 7.3%. It is worth noting the significant uncertainty around these forecasts given that the damage from sanctions on Russia is particularly unclear. As a result, we believe the risk of U.S. recession in late 2022, early 2023 is significantly higher, at somewhere between a 25% and 50% probability.
Higher inflation for longer
Inflation is running at its highest levels in several decades, now above 7% in the U.S. and Europe while approaching 6% in other nations. The main drivers are surging commodity prices (energy in particular) and supply-chain disruptions, but smaller factors include still accommodative central banks, wage growth and a housing boom in much of the world. Inflation is likely to rise even further in the short run, due to the war in Eastern Europe. Offsetting some of these inflationary forces, over the next year, might be any easing in supply-chain pressures and the economy-dampening impact of central-bank rate increases. Taken together, we anticipate high and above-consensus inflation for 2022, but with a decelerating trend during the second half of the year. We continue to believe that inflation ultimately will, over a longer-term horizon, eventually fully revert to normal, with aging demographics and slower population growth even bringing inflation down below historical norms.
Currency landscape altered by Russia-Ukraine conflict
The currency landscape has been altered by the freezing of Russian foreign-exchange reserves following the country’s invasion of Ukraine. The short-term impact of the conflict has been a stronger U.S. dollar as investors seek the safety, security and liquidity associated with U.S. assets. But the longer-term consequences of the war, which include higher commodity prices and a reluctance among countries to accumulate reserve assets, may create headwinds for the greenback. In this environment, we expect that commodity currencies could become the clear winners and the U.S. dollar may weaken.
Central banks respond to inflation pressures
The war in Ukraine may ultimately reduce the amount of monetary tightening that would have otherwise taken place, but this year is still expected to be one when most developed world central banks move ahead with rate increases to temper inflation. We look for four 25-basis-point rate increases from the U.S. Federal Reserve (Fed), the Bank of England this year and none by the European Central Bank given the economic outlook for the region. Based on our historical analysis, we estimate that four rate increases theoretically reduces a country’s economic growth by 0.5% over the following 18 months – far from a recessionary impact. However, the speed at which central banks flipped to tightening mode presents at least some risk to economic growth and capital market returns.
Recent jump in yields moderated near-term valuation risk, but the long-term direction for yields likely remains up
Rising rates and higher inflation pushed bond yields sharply higher at the start of the year. The U.S. 10-year yield rose more than 50 basis points to above 2.00% between the end of November and into the end of the quarter. We believe the hit to growth from the Ukraine war will continue to boost demand for safe-haven assets, pulling yields lower near-term. However, our models continue to suggest that the long-term direction for yields is higher, mostly since real, or after-inflation, interest rates are unsustainably low at -2.8%, their lowest level in 60 years. While there have been a variety of global GDP headwinds to real rates ranging from aging global demographics to lower potential growth rates, to an increased preference for saving versus spending, even placing them at 0% would provide substantial upward pressure on nominal bond yields. We recognize there are some war–related risks to economic growth that could temporarily limit the increase in yields, but our expectation for higher nominal yields over the longer term sets up a scenario where sovereign-bond returns are low or even slightly negative for many years.
Stocks enter correction, improving return potential if earnings come through
After a strong 2021, global equity markets tumbled in the first two months of 2022 as major indexes experienced declines of 10% to 20% from their recent peaks. The broad-market S&P 500 Index finished the quarter down over 5%. A major concern for equity investors at the start of the year was the prospect of tighter Fed policy, prompting a significant cut to the valuations of the market’s most expensive companies. While the war in Ukraine is causing stock-market volatility, economic growth and earnings are forecast to continue rising, albeit at a slower pace. The consensus of analysts’ estimates continues to evolve higher (see chart below). Analysts’ expectations for the S&P 500 are for 8% profit growth this year, so there is still a decent cushion against the uncertainty. Moreover, given that measures of investor sentiment are extremely pessimistic, and valuations have come down, any indication that the outlook is improving could result in a significant positive upswing in investors’ attitude toward stocks allowing markets to move higher.
Source: PSC Macro
Scotsman’s Outlook Spring 2022
The distribution of potential return outcomes spans an unusually wide range due to the war, surging commodity prices, leading to high inflation levels and a tightening of financial conditions via global central banks. We recognize that the odds of a negative return scenario for equities have increased meaningfully. Within the spectrum of possibilities, our base case continues to look for an extension of the global economic expansion, a peak in inflation by the end of the year and continued central-bank interest rate hikes. With this backdrop, the significant re-pricing in equities, since Russia’s invasion of Ukraine, has reduced equity valuations and therefore boosted return potential, assuming that solid nominal GDP growth will continue to support gains in corporate profits. From a portfolio allocation standpoint, we would continue to underweight fixed income given our longer-term view that the asset class will deliver low to slightly negative returns as yields rise. We would selectively add to equity exposure given the recent pullback, during the first quarter, and the potential for upside assuming our base case scenario plays out.