War and inflation rattle the markets

The economic consequences of war, persistent inflation and renewed worries about supply chain problems due to the coronavirus outbreak in China, all fuel uncertainty about the global economic outlook. Monetary policy tightening is about to start, and bond yields have soared since the start of the year. Stock market volatility has increased, but stocks are holding up well despite the global headwinds. Can this fairly benign market development continue?

A recap of how we ended up here

Economic and market developments have been driven by central banks ever since the Global Financial Crisis of 2007-2009 broke out. Ultra-loose monetary policies of zero or even negative steering rates, huge asset purchase programs and long-term financing to banks has supported risk-taking in the markets and boosted asset valuations ever since.

When the global coronavirus pandemic struck the world economy in early 2020, central banks around the developed world brought steering rates back to zero level and re-activated or stepped up the asset purchase programs which had been suspended or scaled down earlier.

The inflation problem surfaced during 2021, as supply chain bottlenecks related to the pandemic were holding back production and aggregate demand was heavily supported by both loose monetary and fiscal policies in the developed world.

In the fall of 2021 economic growth started to lose steam after the rapid pick up from the depths of the pandemic. At the same time energy prices soared due to temporary factors and rising political tensions between Russia and the western powers. Inflation surged at levels not seen in decades, both in the US and in Europe, by the end of the year. This was the time when stagflation fears emerged. Stagflation is a phenomenon not seen since the 1970s, high inflation combined with low or even negative growth and soaring unemployment.

The central banks on both sides of the Atlantic insisted stubbornly that inflation was a transitory problem, which would recede on its own towards the target rate of 2%. Finally late last year the Fed made a U-turn and announced that inflation can’t be described as transitory and that monetary policy tightening is about to start. The ECB followed suit early this year.

Soaring inflation and more hawkish central bank communication raised sovereign bond yields on both sides of the Atlantic during the first months of this year. In the stock markets, volatility increased and broad stock indices retreated. Many growth stocks took large hits as the discount rates of future profits shot up.

And all of this was before Russia invaded Ukraine in late February. The initial shock of the war rattled markets and sent stocks lower globally. European stocks were particularly affected, as investors reacted to aggression in the middle of Europe and fears of escalation of the war were elevated. A couple of weeks after the war broke out, equity prices rebounded, and are currently at higher levels than they were before the war started.

The worst of the coronavirus pandemic seemed to be over in the developed world when new omicron outbreaks emerged in China. The large Shanghai area is the worst affected and the authorities have responded to the outbreak by declaring strict lockdowns. Shanghai is the largest seaport of the world, and the lockdowns will hamper growth in China and will cause renewed supply chain problems globally.

What’s ahead for the economy in 2022?

High inflation is here to stay, as energy and food price shocks will linger. Inflation will peak in the coming months mainly due to the base effect. That is, as inflation took off last year, the reference price level in year-on-year inflation calculation goes up. Somewhat moderating inflation figures do not mean, that inflation is under control. At best, it will take at least a couple of years to drive inflation back to anywhere near the central banks’ inflation target.  

In the US, inflation reached 8.5% in March, which is the fastest pace of inflation in 40 years. Core inflation, which excludes volatile items such as energy and food, rose to 6.5%. High core inflation reveals that inflation is broad based in the US economy. Wage inflation is one driving force, average hourly earnings rose by 5.6% in March.

In the Euro Area, inflation rose to 7.4% in March, which is the highest figure during the whole monetary union era. War in Ukraine and economic sanctions have pushed oil and gas prices to new heights and energy prices are 45% higher than a year ago. Core inflation was 3.0% in March, which implies that, unlike in the US, a major part of inflation in the Euro area still stems from cost-push shocks.

One thing which is certain is that the European economies will be much harder hit than the US due to the war. This can already be seen in both business and consumer confidence figures. Europe has much tighter trade relations with Russia, and the several rounds of economic sanctions already imposed against Russia will hurt European economies. The dependency of Europe on Russian energy supplies is a particularly strong factor, which will impact both the inflation and growth outlooks.

Economic activity will slow down considerably due to the war in Europe. GDP forecasts will be lowered further as all the direct and indirect consequences of the war materialise. The International Monetary Fund published its spring forecast for the global economy this week. The Euro Area GDP growth projection for the current year was cut to 2.8%. We will most likely see several downward revisions to European growth outlook during the current year.

Further economic sanctions may have sizeable effect on European economies. Leading German economic research institutes published a joint assessment on the economic impact of the possible Russian gas embargo just last week. According to their estimate, German GDP would fall short of the current projections by 6.5 percentage points during 2022-23 if Russian gas supplies were terminated. This careful analysis shows that the potential output losses can be significant.    

In the US the cyclical position of the economy is much stronger than in Europe. US growth projections have been lowered mainly due to the weaker growth outlook in Europe. The IMF’s new growth projection for the current year shows a still robust growth of 3.7%. Growth is unlikely to be this strong, but worries about a recession in the US economy seem overstated. The US labor market is strong, in March unemployment declined to 3.6%, almost half a million new job were created and hourly wages were up 5.6% from previous year. In addition, the US is the biggest oil producer in the world. Energy price increases will obviously have distributional effects, but the overall impact to the economy is much milder than in Europe.

What about the yield curve inversion, doesn’t it forecast recessions quite well in the US? The US yield curve has flattened considerably during this year as the 2-year treasury yield has risen 2 percentage points along with expectations of a rapid steering rate rise. At the beginning of April this 2/10-year relation slipped to negative territory after a strong jobs report from March. Currently the 10-year treasury yield is only about 0.2 percentage points higher than the 2-year yield. When the yield curve inverts, it basically tells us that bond market actors expect that growth will slow down and that eventually the central bank will lower the steering rate. In history, yield curve inversion has often preceded economic recessions. But false alarms do happen. I would not put much weight on the predictive power of the yield curve this time. The Fed’s massive bond purchases have distorted market pricing in the treasury market for a long time.    

The year of great divergence in monetary policy

The Fed started the normalisation of monetary policy by raising the steering rate by 25 basis points in March. The Fed has also indicated that it will start the run-off process of its huge $9 trillion balance sheet with a pace of $95 billion per month.

Market expectations of the rate hike cycle in the US have recently shifted towards larger rate increases during the current year due to soaring inflation. Futures market see the steering rate at close to 3% at the end of 2022. This would be the fastest rate hike cycle since 1994. Will the Fed be that aggressive? Remembering that the Fed will also start shrinking the balance sheet, financing conditions are tightening substantially. And it is very hard to assess what will be the combined impact of these two tightening measures.

The Fed is facing a challenging calibration exercise where it should find a balance between interest rate hikes and the balance sheet run-off. I do think that the markets are ahead of themselves, and the rate hike cycle will not be quite as aggressive as market pricing currently indicates.  So, instead of having the steering rate around 3% at the year end, I would expect it to settle just above 2%.

The Governing Council of the ECB has been clearly divided about whether it should tighten monetary policy and try to curb soaring inflation or just calmly look through high inflation and wait for the price pressures to ease. The war in Ukraine shifted the balance again towards softer approach on inflation. I believe that the ECB will lower the Euro Area GDP forecast for the current year substantially in the June Governing Council meeting. A weaker growth projection will give more power to those members who argue that growth must be supported, and that monetary policy normalisation must be postponed.

How will the stock markets perform amid all these uncertainties?

So, what about the stock markets? After a volatile start of the year, broad stock indices are 10% lower than the all-time high at the turn of the year both in the US and Europe. Volatility in the stock markets is likely to continue both in the US and in Europe. But for different reasons.

In the US it is the inflation problem and the rate hike cycle, which cause uncertainty around stock market developments. And this time the Fed might be deaf to stock market volatility, as getting inflation under control is also the main worry of the Biden administration. Weaker equity markets would contribute to bringing aggregate demand down through the wealth effect to consumption and through weaker business confidence. And it might even increase labor market participation, as the value of retirement plans would fall.

In Europe, it is the economic downturn caused by the war which will be the main worry in the stock market. Energy and food price shocks together with economic sanctions and uncertainty will hamper household consumption and firms’ investments.

An often-heard explanation to the resilience of the stock markets amid many uncertainties is the lack of alternatives. This ‘there-is-no-alternative’ (TINA) narrative builds on the state of the fixed income markets. Running yields in the bond markets have been very low for long. In the US, the 10-year treasury yield has climbed from 1.5% to just below 3% during the current year. This has pushed the expected real interest rate close to zero after being two years at the -1% level. So, small steps towards normal times in bond market investing.

‘The-fear-of-missing-out’ is another explanation, which keeps many investors fully invested in the stock market. Even though one would believe in the yield curve inversion as a predictor of a recession, it has usually taken a year and a half before the recession starts. And the stock market has performed fairly strongly after the inversion on many occasions.    

Alternative investments is an asset class, where investor demand has been, and continues to be, high. The traditional TINA narrative of stock versus bonds forgets that private assets have grown to be a credible alternative to listed securities. The private equity market in particular has continued to provide overperformance over broad stock indices, despite excellent performance in the listed market.

The private equity industry continues to grow rapidly, as investors continue increasing their allocations, due to its low volatility and solid performance. Despite vast amounts of money pouring into the asset class, the deployment pace has remained fairly constant as the deal flow universe of the unlisted market is so much larger than that of the listed market. It will be interesting to see whether the allocation to the US will further increase at the cost of Europe, given the ongoing war in Ukraine.

To sum up, challenging times ahead for listed equities on both sides of the Atlantic due to inflation, the pandemic and the war in Ukraine. However, a swift reversal of the flow of funds from equities to bond markets seems unlikely in the short term. And the growth of the private equity industry is a positive phenomenon for the capital markets and for the society as a whole. Deeper capital markets with many financing options for growing companies will lead to more economic growth, better welfare for people and a more vibrant corporate sector. So, despite the many headwinds, listed stocks as an asset class may still hold up fairly well this year in the developed world.

The US economy is strong, and the Fed is a key actor in navigating the economy through a high inflation era. Even though the Fed may this time listen more closely to Main Street than to Wall Street, the macroeconomic and market outcomes are at least partially in the hands of domestic economic policymakers. In Europe, the economic situation is weaker to start with, and the macroeconomic environment is heavily impacted by the war and by the uncertainty around the economic consequences of the war. Hence, I do believe, that in relative terms the US stock market will perform better than European stock markets this year.

April 26, 2022
Anssi Rantala
Senior Advisor / Chief Ecenomist