1. Inflation – or Stagflation?
How real are the risks? The world is facing a surge of inflation due to high commodity prices and the lingering impact of the pandemic. Lockdown restrictions in 2020-21 drove up demand for – and prices of – goods. The resumption of travel and leisure activities related to the easing of pandemic restrictions has boosted service prices. Unemployment in the US and Europe has fallen below pre-pandemic levels, but wages have failed to keep pace with prices, resulting in falling real incomes. At the same time, central banks are signalling their intention to aggressively raise the cost of borrowing. The business environment is becoming tougher as high costs squeeze profit margins, with recent data showing services and housing negatively affected. We think that recession can be avoided in the US and Europe, but growth may stall at some point this year, leading to higher unemployment and business failures. While commodity exporters are riding the wave of strong revenues, global stagflation creates a challenging environment for most policy makers, particularly in emerging economies with limited resources.
2. Energy & Food Prices
Commodities divide us into “Haves” and “Have Nots.” Energy prices have soared in the past couple of years, with oil prices up three-fold and natural gas prices quadrupling. At the same time, according to the UN’s World Food Price Index, food prices have risen by more than 70% due to adverse weather events such as droughts and floods, along with high fertiliser costs, exacerbated in recent months by disruptions to Ukrainian grain exports. Energy prices initially rose as a result of the post-pandemic recovery in economic activity and have spiked higher this year on the Russia-Ukraine war. Emerging economies have consequently been split into two camps: commodity exporters – the “Haves” – and the “Have Nots,” who are disadvantaged by higher commodity prices. Steep food prices are potentially the most damaging, since food is a high proportion of household budgets in many emerging-market countries. For example, food accounts for 37% of consumer spending in Egypt and more than 50% in Kenya. Countries in Africa and the Middle East are particularly dependent on wheat imports from Ukraine and Russia.
3. Financial Markets & Interest Rates
A throwback to the 1970s looms large. The possibility of inflation pressures persisting for longer than anticipated has fundamentally changed how investors look at asset markets today. The “Fed put” (actions to limit a severe market decline) really doesn’t exist as long as inflation is so far above target. The Federal Reserve may fear a financial-market panic, but it doesn’t worry about steady downward pressure on equities. The challenge for investors now is to come to grips with much higher levels of asset price volatility than during the last 30 years of the “great moderation.” Elements of the 1970s could return: the stop-and-go policies that reflected the tension between inflation and employment goals; the risk that desirable long-term structural policies will contribute to short-term inflation pressures; and slower productivity growth as structural shocks are absorbed. There are no clear winners here. Instead, we may be entering a world of reduced capital and trade flows, and concerns about the reliability of USD assets – which may not be friendly to the USD over the medium to long term.
It ain’t over till it’s over. Trade tensions have been simmering since the 2008 global financial crisis, with developed countries such as the United States, Japan and France increasing talk of near-shoring and onshoring production. Global trade integration remains high, though. Emerging-market economies contribute significantly to the gross exports of developed OECD economies – their value-added contribution rose from 3.5% in 1995 to 8.5% in 2018. This is an indicator of the importance of global value chains (GVCs), which encompass the end-to-end process of bringing a product to market. Expansion and trade participation in GVCs rose to 46% in 2008. The global financial crisis saw a drop, but this was quickly reversed by 2010 and participation peaked at 44% in 2020.
Global trade reached a record USD28.5 trillion in 2021 – up 13% compared to pre-pandemic levels. Again, this was despite ongoing rhetoric about the need to increase self-sufficiency and reduce dependence on GVCs. The International Monetary Fund forecasts that global trade will continue to grow in 2022, but at a slower pace (+6% year over year) than in 2021 (+10% year over year).
Keep your friends close – and your supply chains closer? The Russia-Ukraine conflict has profound implications for the global community. It has brought a rapid shift in threat perceptions and a re-strengthening of key alliances that had been fraying for years – most notably across the Atlantic and within the EU. More broadly, the conflict has built a circle of “like-minded countries” and reinforced some of the key tenets underpinning international relations and the global order. The war also runs the risk of accelerating the world’s bifurcation into distinct camps with diverging governance models and value systems, and competing economic and strategic objectives. Pre-existing fears around supply-chain risks are being heightened in the wake of trade wars with China and the pandemic. The list of products deemed key to national security has expanded from semiconductors and medicines to staple foods, pushing a re-think of today’s complex and fragmented supply chains. While globalisation and one of its main embodiments – supply chains – have long been viewed as a benign and positive historical evolution of best economic practices, both are now highly politicised.
6. Energy Diversification
Europe tries to look beyond the horizon. Western nations are in overdrive as they try to rapidly diversify their energy imports away from Russia amid the war in Ukraine and its impact on global energy prices. This process is most pronounced in Europe, where Russia has been the primary provider of oil and gas for decades. The European Commission has proposed that by the end of 2022, EU countries stop all Russian oil imports and reduce gas flows by two-thirds. Efforts to reduce energy dependence on Russia will not only have a long-lasting impact on global energy markets but will also create significant growth headwinds to Europe. This could force nations to increase investment in renewables and speed up the move towards net zero emissions, but Europe will need new sources of oil and gas in the near term – and most likely at higher prices. Russia could continue to weaponise its oil and gas flows during this transition, leading to periodic shocks to household budgets and even energy shortages in some countries next winter.
7. Digital Assets
In a word, volatile. Digital assets have experienced a period of instability in response to the start of the FOMC’s tightening cycle and the Russia-Ukraine war. Recent declines in US tech stocks are a reminder of crypto’s high correlation to the Nasdaq. These assets are still in the early stages of development, and the sudden collapse of the Terra stablecoin reaffirms this. Most stablecoins – crypto assets pegged to the US dollar and used to create a link between fiat currencies and crypto – are backed one-for-one by collateral, but Terra was linked to a smart contract platform and used an algorithm to maintain the peg. The collapse of Terra, together with its smart contract platform, wiped out USD50bn of market cap.
Risk assets are, however, likely to recover in the second half of the year as markets move past the peak of Fed pricing. Government oversight of stablecoins is coming, and we expect crypto investments to go more mainstream, with regulation helping rather than hurting investor portfolios. The long-awaited Ethereum (ETH) "merge" is poised to be a turning point for the second-largest crypto asset, giving ETH the advantages of its smaller competitors along with the existing benefit of scale.
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