Updated: May 24, 2022
Positioning in the looming stagflation environment
Russia’s invasion of Ukraine is one of the true black swan events of recent years, and the raft of sanctions imposed could certainly affect global economies. As our Global Chief Economist and Head of Macroeconomic strategy Frances Donald noted, there are three aspects we need to consider when assessing the macroeconomic impact of the recent geopolitical conflict:
1. Another stagflation shock makes the prospect of a return to Goldilocks conditions by the year end look less than solid.
2. More dovish commentary is expected from the Bank of Canada, Bank of England, and, most importantly, the European Central Bank.
3. The theme of global desynchronisation should become more important throughout 2022. Europe is most exposed to growth destruction from higher energy prices.
What’s changed and our current assessment
Following the raft of sanctions imposed on Russia, interest rates futures immediately reflected the prospect of a lower-than-expected interest rate hike by the US Federal Reserve (Fed) in March, i.e., a 25-basis point rate rise became the consensus view1 . In response, some European government bonds have rebounded. Earlier this year, before the military conflict started, we had a slightly positive view on Europe for 2022 as it possesses multiple growth drivers. Indeed, the latest PMI readings in Europe fare well. However, given the raft of sanctions imposed, 2 we have started to look at Europe less positively. At the time of writing, the Russia-Ukraine situation remains fluid. As such, here is our current base-case assessment:
1. We believe that geopolitical events and a stagflation outlook will not lead to a global economic recession at this point. However, a rapid deterioration of the conflict and more severe sanctions against Russia may significantly weaken the global economy (subject to the scale of the conflict and its duration).
2. Europe, as Russia’s major trading partner, would be most affected, and capital flows will likely return to the US
3. Lower rate-hike expectations.
4. Commodity-driven inflation is driving the need for inflationary hedges
Potential impact to broad asset classes
US dollar continues to be supported
The prospects for a more sustained stagflation shock, exacerbated by recent events, has seen adjustments in our asset-allocation positioning. As such, we believe that persistent volatility and more frequent bouts of risk aversion will occur in the first half of 2022. While the US is still on an above-trend growth path 3 at this point amid the expected resumption of shale energy demand, we think the US dollar will continue to be supported, attracting capital inflow into US assets.
Equities: geographical and sector
Within developed markets, US equities are favoured over their European counterparts. Versus other regions, we believe the US will be minimally impacted by sanctions against Russia. Within the US, the energy and defence industry should expect to see higher substitute demand. For example, the US will play a more important role given the ban on Russian oil exports, as it can provide shale energy in lieu of energy embargo from Russia. Given weaker economic growth momentum, coupled with ongoing geopolitical uncertainty, we expect equity markets to experience heightened volatility. However, markets with significant exposure to energy and materials (as inflation hedges) and consumer staples (as a defensive play) may find some insulation thanks to higher commodity prices. Within emerging markets, we are relatively more positive towards select Asian equities (commodity exporting markets, such as Indonesia, Thailand, and the Philippines, see chart 1).
Chart 1: MSCI market exposure to materials, energy and staples
Select bonds that can outperform The prospect of aggressive rate hikes is now lower, and the Fed is expected to raise interest rates by only 25 basis points in March (50 basis points had been anticipated by the market). Also, we think that bonds look more favourable, and our overall allocation has been revised to less of an underweight. Assuming current geopolitical events and stagflation do not lead to a severe recession, we believe the US high-yield market has the potential to deliver relatively better performance versus risk assets like equities, as it is better compensated via higher coupons under rising inflation. Also, US high yield has a lower default potential versus other regions, as these bonds have a relative greater exposure to oil and gas sectors. Although signs of financial deleveraging in the face of liquidity withdrawal by the US Fed still needs to be watched carefully. Meanwhile, floating-rate bonds (beneficiaries of a rising rate environment), China renminbi government bonds (a stable exchange rate and higher coupon rates versus other government bonds), and preferred securities (a fixed income-like product with higher coupon rates) are also expected to be more resilient than risk assets. Other income-generating asset classes, such as REITs, will be supported, as rate differentials (REIT yields minus government bond yields) should narrow at a slower pace than before.
We view commodities from two perspectives, both as inflation hedges and diversification tools. We expect commodity prices, such as oil and agriculture products, to remain elevated on the back of supply disruptions and geopolitical events. Commodities with inflation hedge properties, like precious metals (gold and silver), oil, and farm products could perform better.
At the time of writing, the macro-outlook and geopolitical events are still highly fluid. The odds of slower growth and higher inflation are increasing, and we believe investors should seek active management and diversification to reshape their portfolios for an evolving investment landscape.