Investment Perspective: Less Growth, More Inflation

In just a few weeks’ time, the threat of a Russian invasion of Ukraine has become the reality. The resulting humanitarian toll has led to millions of Ukrainians leaving the country, with a similar number displaced and too many killed or injured. Forecasting the eventual outcome remains highly uncertain, but Russia’s relentless attacks show no signs of abating and the “off-ramp” for President Putin remains elusive. European growth will be most notably affected due to the region’s close economic ties and reliance on Russian gas and oil. There will also be second-order effects as surging commodities prices affect inflation and growth globally. So far this year, oil prices are up 45%, European natural gas prices are up 74%, and global metals prices have risen 33%. As shown in the exhibit below, Russia and Ukraine represent a small percentage of the global economy, but they have an outsized role in European energy and global agriculture. Beyond the risk of war-related supply disruptions, there is the potential for “weaponizing” the supply of key commodities. Russia and Ukraine are major producers of palladium, used in many industrial applications, and neon gas which is used in semiconductor production.

The impact of surging commodity prices will be felt most directly in those economies that are large net importers – such as major European countries and some emerging market economies like China. The U.S. is better positioned as a major producer of energy and agriculture, but it won’t be immune to the indirect effects. We have downgraded our growth outlook for Europe as a result, and risks around U.S. growth have risen. We have also increased our inflation expectations globally, as inflation was reaccelerating even prior to the Ukraine invasion.

In our global policy model, we have reduced our recommended exposure to developed ex-U.S. and emerging market equities, and increased our exposure to inflation-linked bonds, high yield bonds, U.S. equities and cash. Our base case outlook now envisions slower growth due to the fallout from the invasion, and more persistent inflation as countries have to find new commodity supplies. Our risk cases focus on the potential for military escalation by Russia, through unconventional war tactics or the invasion of the Baltics and other NATO countries. Our final risk case addresses the potential of a greater economic shortfall as the economic restructuring necessary to address the “newest world order” is greater than market expectations.

Investment Perspective - March 2022 - Outlook