Executive summary

A more uncertain world: economic and financial decoupling

The recent events in Ukraine serve to highlight the fragility of the global geopolitical and economic order. Russia’s unprovoked attack on Ukraine has, first and foremost, resulted in a humanitarian crisis. Our thoughts are with those impacted.

Russia’s military actions have led to an unprecedented response by governments in the United States, Europe and elsewhere to impose financial and economic sanctions on individuals, companies and the Russian state. These sanctions will isolate Russia from the global economic system. As a major exporter of energy (oil and gas), metals and agriculture, the full or partial removal of Russia from those markets will also have a profound impact on the global economy for many years (Figure 1). Moreover, some countries such as China, who have not supported the imposition of sanctions, are expected to be drawn more closely to Russia in future, and drift further away from the West.

Figure 1. Share of crude oil exports by country 

While the war in Ukraine has acted as a catalyst for accelerating this global decoupling it is a trend that began many years ago. These are potentially tectonic shifts that could shape geopolitical, economic and financial market outcomes for decades. It is likely to usher in a period of greater uncertainty, increased economic and market volatility and more challenging asset allocation decisions.

For investors, the more immediate uncertainty is around how the situation in Ukraine evolves from here. At the time of writing, the conflict had shown no signs of easing, with advances being resisted in many key towns and cities, but with ongoing Russian bombardment. Meanwhile, talks between Russian and Ukrainian officials continued to try to find a ceasefire and settlement agreement.

As such, the range of possible outcomes over the coming weeks and months remains wide. A further escalation in the use of force from Russia could follow. Equally, a more protracted period of military stalemate may ensue, with depleted Russian forces struggling to make further inroads. Or it may be that peace talks can at least deliver a ceasefire to allow for a longer negotiated settlement.

But even under the most optimistic scenario, we do not expect sanctions on Russia to be wound back quickly. Unlike the sanctions regime imposed on Iran, whereby clear goals were identified for sanctions to be lifted or eased, no such goals exist for Russian sanctions. On the other hand, should the conflict escalate, then we expect further sanctions to be enacted, including on oil, and over a longer-term horizon, potentially on gas as well.

As the second largest supplier of crude oil globally (after Saudi Arabia) and the fourth largest supplier of natural and liquified gas (and the largest to Europe), the threat of such sanctions will keep prices elevated. While “self-sanctioning” from Western companies taking delivery of Russian oil and other cargoes, as well as the recent European Commission announcement to reduce European reliance on Russian gas by up to two-thirds within the next 12 months (and completely by 2027) is likely to add more upward pressure on prices (Figure 2).

Figure 2. European and US wholesale natural gas prices

These additional global inflationary pressures come at a time when the strong global recovery from the COVID pandemic had already seen underlying inflation rising quickly, with shortages in global manufactured goods, and already elevated energy prices, contributing to multi-decade highs in both headline and core inflation.

Heading into 2022, we expected another year of well above trend growth across all the major economies. While the magnitude of the shock to global energy and other commodities is still evolving, we have marked down global growth this year by around 0.5 percentage points, to a little below four per cent.

The impact of higher energy prices on household disposable income will be felt globally, but will be even more acute in the UK and euro zone, where natural gas prices will be impacted by uncertainty of Russian supply.

Moreover, income and activity will be affected more heavily in those economies that are net importers of oil and gas (again, among the larger advanced economies that would include the UK and euro zone), while potentially being modestly beneficial to the larger net exporters (Canada and Australia amongst the advanced economies). However, even with the larger impact on the euro zone, we still expect growth of around 2.5 per cent this year. There are risks on both sides of that projection, but they are skewed to the downside given the risk of higher energy prices. Growth projections for the major economies are shown in Figure 3.

Figure 3. Major economy GDP growth projections: slowing, but not stalling

We have revised up our inflation outlook to reflect both the recent shock to energy prices, but also to reflect upside surprises in goods inflation that have persisted for longer than anticipated (Figure 4). In the Eurozone and the UK, inflation is expected to peak around 7 and 8 per cent, respectively, the highest rates in over 30 years. Around half of the year-on-year increase can be attributed to the direct contribution from energy prices.

Figure 4. CPI inflation projections: higher for longer

In our central scenario this contribution is expected to fall, reflecting the decline in futures contracts for oil and gas. However, there is an unusual amount of uncertainty given the war in Ukraine, with the risk of further upside surprises in oil and gas prices. In the United States, the peak in inflation is also expected to be around eight per cent, but the contribution from energy is smaller, at around two percentage points. Inflationary pressures are more broad-based in the US, with both goods and services inflation ex-energy well above their average of recent decades, reflecting the strength of domestic demand, rising wage pressures and ongoing supply challenges.

With robust demand growth expected this year, even in the face of the energy shock, and inflation rates way above target for all the major central banks, we expect policy rates to rise markedly over the course of 2022 (Figure 5).

Figure 5. Market expectation for policy rates: tighter policy required

At the forefront of that move will be the Federal Reserve (Fed), where we now expect policy rates to be around 2-2.5 per cent by the end of the year. That is a much faster pace of rate hikes than previously expected, reflecting some pull-forward from our expectations for 2023. It also reflects an expectation of the Fed now needing to tighten policy by enough to become outright restrictive, thereby slowing growth to below trend in 2023/24. We expect the policy rate to peak around 3.5 per cent, but the range of possible outcomes is wide.

In the euro zone and the UK, a materially worse outlook in the trade-off between growth and inflation makes the monetary policy outlook even harder to assess. In both cases there will be a strong desire to ensure that high inflation rates do not become embedded in future wage and pricing decisions. But at the same time, the impact on national income from the energy shock is expected to be a material drag on growth this year. Overall, we continue to expect further rate increases from the ECB and BoE, but for those rate increases to be slower than the Fed.

While yields have risen materially this year, reflecting the expectation that policy rates will need to rise significantly in order to address the inflation overshoot, we believe this process has further to go. With positive inflation surprises more likely, inflation risk premia need to be higher, while real rates need to also adjust to slow growth.

As such, we prefer to be underweight duration (Figure 6). The higher-yield environment presents a more challenging outlook for equity markets. However, with growth expected to remain above trend this year – albeit slower than in 2021 – and corporate pricing power seemingly robust, we prefer to be modestly overweight equities in developed markets, with a more neutral view for emerging market equities. Recent spread widening in credit markets has provided an opportunity to move from a preferred underweight to neutral.

Figure 6. Asset allocation summary