Energy Crisis, High Inflation, and Cold War 2.0. Throwback to the 1970s?
March 3, 2022
Global equities faced extreme challenges in February 2022 as the invasion of Ukraine by Russia shocked the world. Prior to this event, stocks were already witnessing early signs of a bear market. Remarkably though, since the day of the invasion, the S&P 500 has gained ground, as fighting remains contained to Ukraine. However, the situation is extremely complicated, and we expect to see more volatility in the short term.
Vladimir Putin has committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. If he succeeds, and it is not clear yet that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. Current estimates are that the Russian economy will experience a 35% drop in economic activity this year.
At the moment, it is very unclear how the war will evolve in the short term and whether it will draw in other countries. Assuming that World War III will be averted, markets could still experience a freak-out moment over the next few weeks, similar to what happened at the beginning of the pandemic. Google searches for nuclear war are spiking. If a freak-out moment is coming and leading to a sharp market correction, it would be a buying opportunity for investors.
Cold War 2.0
No matter what happens next, it is unlikely that the relations between Russia and the West will improve any time soon. As was the case during the original Cold War, both sides will likely come to an understanding that allows the establishment of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings.
For now, we remain constructive on stocks on a 12-month horizon. While it will take a couple of months, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. It is clear, however, that the era of globalization is likely over.
U.S. Economy and Fed Policy
Q1 growth in the U.S. is likely to be closer to 4%. Given the rise in consumer prices in the U.S. and other developed economies, above-trend growth supports a hawkish monetary policy shift. There are good arguments in favor of aggressive tightening by the Fed. Still, our view is that seven rate hikes over the coming 12 months is likely too aggressive.
A peak in headline inflation over the coming months will help restrain longer-term household inflation expectations. The surge in wage growth continues to reflect mostly pandemic-driven labor market distortions that could unwind.
The U.S. February nonfarm payroll report was stellar. The world’s biggest economy added 678,000 jobs, much more than expected. The unemployment rate fell to 3.8%, just above pre-pandemic levels.
Gains continue to be concentrated in the service sector, especially in leisure and hospitality. These also constitute among the lowest-paid workers, who correspondingly are seeing the fastest wage increases. Such a balanced recovery is exactly what the members of the FOMC would like to see, suggesting a rate hike this month is highly likely.
Despite the uncertainty around the Ukraine conflict, we expect the Fed to proceed with a 25 basis point rate hike at its March meeting. The risks and uncertainty surrounding the Ukraine crisis reduce the likelihood of a steeper 50 basis point rate hike. This is because over the near term, the Fed will be watching the evolution of financial conditions to guide the pace of rate hikes. A sharp tightening of financial conditions would likely cause the Fed to ease the pace of hiking. We expect this dynamic to limit the number of rate hikes over the near term.
Beyond this near-term outlook, inflationary dynamics will be relevant when it comes to how much the Fed will tighten. A scenario in which rising energy prices keep inflation higher may cause the Fed to accelerate the pace of rate hikes later this year. On the flip side, if the oil price spike is short-lived and energy prices moderate, then the Fed will probably maintain a gradual pace of tightening. We view this latter scenario as more likely.
Ultimately, while central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates in the coming years.
Energy Crisis
The recent spike in energy prices because of Russia’s invasion of Ukraine could prompt increased production from core OPEC producers to reduce the elevated risk premium and allow refiners to boost inventories.
We expect the oil price to come down again in the second half of 2022, implying eventual deflation from energy prices and a slowdown in the pace of advance in headline CPI over the coming months.
That would represent a very significant easing in headline inflation relative to current levels, and we do not expect that long-term household expectations for inflation would rise much further in such a scenario. The easing in the prices paid component of the ISM manufacturing index also points to an imminent peak in headline inflation and, by extension, household inflation expectations
Russian energy exports to Europe have not yet stopped as a result of the conflict. Next to that, it is still a possibility that the U.S. Congress approves a resumption of the Iran deal, which would allow Iranian oil to be sold. Thus, the Fed is unlikely to tighten aggressively this year.
Europe is going to be far more affected by what’s going on in Ukraine than the U.S. The U.S. has a couple of things going for it. Net worth in the U.S. is high right now because of stimulus checks. If you plot oil prices relative to net worth, they’re the lowest they have ever been. So Americans have the ability to incur higher costs. As a result, it’s possible that an increase in oil prices would not necessarily impact the American economy as it has in the past.
Back to the 1970s?
The 1970s were a volatile period marked by high inflation, an energy crisis, rising unemployment, and volatile equity markets. The question is whether we are facing the same scenario today. There are clearly some similarities to the early 1970s.
There are also major differences and a number of factors are simply unknown. If we would experience a major energy shock this year with the oil price rising to $150-200 then a recession becomes more likely. However, the global economy is relatively much less dependent on oil than it was back then. On top of that, many countries are already in the middle of a green energy transition and that will only speed up.
The main difference will be that governments and central banks have more experience and willingness to stimulate the economy caused by external shocks.
Another difference is that the equity market is generally not as expensive as it was in the early 1970s. Debt levels are higher but as long as bond yields are lower than inflation (i.e. a negative real rate), that is actually not a problem.
World supply chains are also much more intertwined, especially for China and the West. So, there is a much larger incentive to maintain stability.
Central banks also have more tools available than in the 1970s. Don’t forget that the US dollar was still tied to gold up to August 1971. And when President Nixon abandoned the dollar convertibility, it caused the collapse of the so-called Bretton-Woods system, which caused a lot of volatility in currencies wreaking havoc on markets.
Equity Markets
For equity markets, the short-term will remain uncertain and a fear-driven sell-off is a possibility. However, that would create buying opportunities. Looking back in history, wars have often been good for corporate profitability, especially in America.
On a 6-12 month time horizon, our expectation that monetary policy will tighten at a less aggressive pace than investors expect suggests that the earnings risk to global stocks is not substantial, underscoring that a meaningful contraction in equity multiples would likely be required for stocks to register negative 12-month returns from current levels. In the US, business surveys suggest that sales growth is slowing but is still at healthy levels.
U.S. Dollar
As defensive currencies, the US dollar, Swiss Franc, and the Japanese yen could strengthen in the near term as the conflict in Ukraine escalates.
Looking beyond the next few months, the dollar will likely weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies. For example, relative to the euro, the dollar is 22% overvalued. The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped. Speculators are long the dollar, which increases the risk of a reversal.
Precious Metals and Commodities
Most commodity prices have shot up since the start of the war. Some of that might be a short-term risk premium but we think the structural trend for all commodities is up.
First, because both Russia and Ukraine are commodity producers and that supply will be disrupted for some time. But also because every country now suddenly realizes it is a national security risk to be dependent on other countries for essential supplies of commodities. Whether it is grain or something specific like Neon gas, which is needed for making semiconductor chips. And currently, 90% of the world’s high-quality neon gas is produced in Ukraine. There are alternatives but it will require a lot more investment in the commodity complex going forward.
Overall we strongly believe a commodity allocation should be part of a well-diversified long-term portfolio.
Portfolio Actions
In summary, the near-term outlook for risk assets has deteriorated, despite the sell-off we already experienced. However, on a 12-month horizon we continue to expect stocks to outperform bonds as the global economic recovery maintains momentum.
While more downside is not unthinkable, it is also impossible to predict what is going to happen next. Cash may seem attractive given the volatility, but the combination of value-eroding inflation and re-entry timing concerns make large cash allocations problematic.
In this environment, we favor staying invested in a diversified global portfolio, which should include an allocation to commodities and precious metals. As the U.S. is less likely to be impacted by energy price spikes, U.S. markets are still the place to be. The same goes for U.S. fixed income, especially the short-duration credit yield space.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.
The ISM Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.