The war in Ukraine has continued to take a heavy toll on the country and its people. Meanwhile financial markets have experienced high levels of volatility, while energy prices have surged.
Below, four AXA IM experts outline their thoughts on the impact of the crisis on markets, the global macroeconomic outlook, the path of inflation and emerging markets.
Chris Iggo, Chief Investment Officer, Core Investments
The Ukraine crisis has created a great deal of uncertainty for markets. The most obvious impact has been on energy prices and on growth expectations, and this has come as markets were already dealing with higher inflation and the prospect of monetary tightening.
We have seen interest rates go up, and bond yields rise significantly from their 2021 lows. Credit spreads have widened significantly, and we’ve seen a clear de-rating of many equities as investors seek a higher risk premium.
Should we re-enter the market given these new valuations? The uncertainty makes that a problematic call, but when we look at what may be priced in then we may be close to some interesting levels. In bonds the market has priced in a lot of monetary tightening for the next 12 months, and if correct that does put an upper limit on where yields may eventually go. We see benchmark 10-year Treasury yield at a peak of 2.5%-3% in this cycle as the Federal Reserve (Fed) steadily tightens.
We believe credit markets are still in reasonably good shape. The widening of credit spreads, we feel, suggests that returns from credit – both investment grade and high yield – could potentially be superior to those from government bonds.
We think earnings forecasts for equities have not yet fully taken on board the increased risk of recession from the Ukraine conflict, while the effect of tightening cycles tends to be delayed, so downgrades to earnings-per-share forecasts could still be ahead of us.
Markets have reacted positively to the news of peace talks between Russia and Ukraine, but equity markets still need to contend with higher bond yields, monetary tightening, and some expected downgrades to corporate earnings. We do have more confidence that what is priced-in to the interest rate outlook, is appropriate for the time being, dependent on the path ahead for inflation.
David Page, Head of Macroeconomic Research
The war in Ukraine will have a significant impact on the Ukrainian and Russian economies; we expect sanctions on Russia to be in place for a long time, which is likely to keep energy prices elevated. Russia and Ukraine are key commodity suppliers, so supply chain disruption adds to expectations that global inflation is likely to peak higher and fall back less quickly than previously hoped.
Europe will be the epicentre of the anticipated growth shock, with increased gas prices having a marked impact on real incomes, household spending and business investment. The fiscal response should partly offset this, but we expect a contraction in Eurozone growth in the second quarter (Q2), then a flat-to-positive reading in Q3 – with a potential risk of two consecutive contractions, which would mark a recession. Later this year, the public boost to investment should help – we forecast 2.1% GDP growth for the Eurozone for this year and 1.2% next.
The UK will also be hit by rising gas prices and is already going through a sharp uptick in the cost of living. The resulting real income squeeze could be the worst in the UK since the 1970s. So far, the fiscal response has been more muted than in Europe, while the central bank is currently tightening policy. This could culminate in a marked hit to UK activity. We forecast growth of 3.8% this year and 0.7% next.
Oil prices feed through to gasoline costs, which has a marked impact on US consumer spending. Real incomes are under pressure and we expect US growth to slow, perhaps materially. Our forecast is for sustained growth, but with the risk of a negative quarter given the prospect of a sharp inventory unwind. This will become more obvious during the second half of 2022 and we expect the Fed will slightly soften the pace of tightening as a result.
China faces domestic challenges in terms of a structural shift, as well as a renewed outbreak of COVID-19. It will be a challenge to deliver the government’s 5.5% growth target, and we expect to see significant fiscal and monetary stimulus to drive this. For broader emerging markets (EM), food price inflation is problematic, and EM central banks could have to tighten policy even further.
Overall, we expect a marked increase in global inflation, which will slow global growth to 3.1% this year and 2.8% next. This may mean that developed economy central banks do not need to tighten monetary policy quite as much, with some scope for cuts in 2023.
Magda Branet, Head of Emerging Markets and Asian Fixed Income
US dollar-denominated EM debt indices have fallen around 10% since the beginning of 2022, partly due to rising risk aversion and widening of spreads, while the sell-off in Treasuries has also had an impact.
As the Ukraine invasion began, Russian and Ukrainian sovereign bonds quickly moved to distressed levels, meaning the market is assigning the same probability of default to both. This is quite astonishing given before the invasion Russia was rated BBB – investment grade – with one of most solid balance sheets in emerging markets, and Ukraine was rated B-.
Russia’s ability to pay is still relatively high – the question of default surrounds its willingness to pay. For instance, it has offered to buy back some of its dollar bonds in rubles, which would be a default event on certain bonds.
However, both countries formed a relatively small part of emerging market bond indices before the war – Russia around 3.5% and Ukraine about 1.5%. Even after Russia has exited all indices, we are still left with an investment universe that is quite diverse, consisting of around 70 countries and about 450 corporates issuing debt in dollars.
The higher commodity prices that we are seeing is actually a tailwind for around half our investment universe, where countries are exporters of commodities and experiencing a positive trade shock, supporting their currencies and fiscal accounts, while importers of commodities are negatively impacted.
The main headwind is the Fed tightening, which historically has not been positive for emerging markets, as it represents a reduction in US dollar liquidity. Countries with high financing needs that need this liquidity will be impacted most. But compared to previous Fed tightening cycles, many emerging market economies today have lower financing needs due to the positive terms of trade shock.
Emerging markets have already tightened monetary policy quite aggressively since 2021, and been pre-emptive in dealing with inflation problems, so today many EM economies have much higher interest rates than the US or Eurozone – the difference reduces the probability of drastic capital outflows and is proving to be supportive for EMs and their currencies.
Going forward we see an interesting level of yield in EM hard currency debt – the high yield component of the universe yielding just below 10%, which is historically very elevated. Aside from a short period in 2020 this is the highest yield we have seen in the asset class in the last 10 years.
Jonathan Baltora, Head of Sovereign, Inflation and FX, Fixed Income
We believe that the current high level of global inflation is the result of COVID-19-related disruptions and the short-term oil price increase, but also three longer-term structural changes: Fiscal spending, deglobalisation and trade wars, and the green revolution.
The era of austerity has gone, and governments are supporting consumers and companies – fiscal spending is already higher, and the war in Ukraine is expected to increase spending on military budgets. This will mean more negative fiscal balances, but more economic growth and potentially more inflation.
Deglobalisation was already a factor after the US/China trade war that started in 2018, but the Ukraine war is likely accelerating this trend, making companies rethink their value chains and supply chains. They are starting to onshore production, realising that they cannot always rely on the cheapest source for their inputs.
And the green revolution, as the world transitions to net zero, is seeing populations upgrade their consumption habits, which we believe will be a source of inflation.
In our view, the current extremely elevated inflation will likely start to decelerate in the latter part of 2022, but measures introduced due to the war will slow that deceleration. For example, the US has said it may release some of its oil reserves to the market, but then it will need to replace stocks, which could have the effect of lowering oil prices in the near term but make them more elevated in 2023.
Even so, when you look at one-year inflation rates priced into the market, 2022 inflation is expected to be very elevated, but the market is expecting inflation to decelerate quite dramatically next year and the following year.
We believe this is where the opportunity lies. For instance, we expect five-year US Treasury Inflation-Protected Securities to have an income of between 4% and 5% from now until the end of the year, which would represent a very attractive carry thanks to elevated inflation levels while at the same time providing a hedge against stickier than expected inflation.
The breakeven curve is very inverted, suggesting that the market still expects inflation to be transitory. An oil price crash would be the biggest risk, but is not our central scenario, and even if oil prices fell back to $90 a barrel, this would not change our view that short duration inflation-linked bonds is our preferred strategy. Until year-on-year inflation starts to slow down, we believe the market for inflation-linked bonds will remain bullish.