Positioning in the looming stagflation environment

Russia’s invasion of Ukraine is one of the true black swan events of recent years, and the raft of sanctions imposed could certainly affect global economies. As our Global Chief Economist and Head of Macroeconomic Strategy Frances Donald noted, there are three aspects we need to consider when assessing the macroeconomic impact of the recent geopolitical conflict:

1. Another stagflation shock makes the prospect of a return to Goldilocks conditions by year end look less than solid
2. More dovish commentary is expected from the Bank of Canada, Bank of England, and, most notably, the European Central Bank
3. The theme of global desynchronization should become more important throughout 2022—Europe is most exposed to growth destruction from higher energy prices

What’s changed and our current assessment

Following the raft of sanctions imposed on Russia, interest-rate futures immediately reflected the prospect of a lower-than-expected interest-rate hike by the U.S. Federal Reserve (Fed) in March, that is, a 25-basis point (bps) rate rise became the consensus view.¹ In response, some European government bonds have rebounded.

Earlier this year, before the military conflict started, we had a slightly positive view on Europe for 2022 as it possesses multiple growth drivers. Indeed, the latest readings of the region’s Purchasing Managers’ Indexes appear reasonable; however, given the raft of sanctions imposed,² we have started to look at Europe less positively. 

At the time of writing, the Russia-Ukraine situation remains fluid. As such, here's our current base-case assessment:

1. We believe that geopolitical events and a stagflationary outlook won’t lead to a global economic recession at this point; however, a rapid deterioration of the conflict and the introduction of more severe sanctions against Russia may significantly weaken the global economy (subject to the scale of the conflict and its duration) 
2. Europe, as Russia’s major trading partner, would be most affected, and capital flows will likely return to the United States
3. Lower rate-hike expectations
4. Commodity-driven inflation is driving the need for inflationary hedges

Potential impact to broad asset classes

The U.S. dollar continues to be supported

The prospects of a more sustained stagflationary shock, exacerbated by recent events, have led to adjustments in our asset allocation positioning. As such, we believe that persistent volatility and more frequent bouts of risk aversion will occur in the first half of 2022. The United States is still on an above-trend growth path³ at this point amid the expected resumption of shale energy demand—we think the U.S. dollar will continue to be supported, attracting capital inflow into U.S. assets.

Equities: geographical and sector 

Within developed markets, we favor U.S. equities over their European counterparts. Versus other regions, we believe the United States will be minimally affected by sanctions imposed against Russia. Within the United States, the energy and defense industry should expect to see higher substitute demand. For example, the United States will likely play a more important role given the country’s ban—along with the United Kingdom—on Russian oil exports, as it can provide shale energy. 

Given weaker economic growth momentum, coupled with ongoing geopolitical uncertainty, we expect equity markets to experience heightened volatility; however, markets with significant exposure to energy and materials (as inflation hedges) and consumer staples (as a defensive play) may find some insulation thanks to higher commodity prices.

Within emerging markets, we’re relatively more positive toward select Asian equities (commodity-exporting markets such as Indonesia, Thailand, and the Philippines).  

Select bonds that can outperform

In our view, the prospect of aggressive rate hikes is now lower, and the Fed is expected to raise interest rates by only 25bps in March (50bps had been anticipated by the market). We also think that bonds now look more favorable and our overall allocation has been revised to less of an underweight.

Assuming current geopolitical events and stagflation do not lead to a severe recession, we believe the U.S. high-yield market has the potential to deliver relatively better performance versus risk assets such as equities because the asset class provides better compensation in the form of higher coupons. Also, U.S. high yield has a lower default potential versus other regions, as these bonds have a relatively greater exposure to oil and gas sectors. Although signs of financial deleveraging in the face of liquidity withdrawal by the Fed will need to be monitored carefully.

Meanwhile, floating-rate bonds (beneficiaries of a rising rate environment), China renminbi government bonds (a stable exchange rate and higher coupon rates versus other government bonds), and preferred securities (a fixed-income-like product that offers higher coupon rates) are also expected to be more resilient than other risk assets.

Other income-generating asset classes, such as real estate investment trusts (REITs), will be supported, as rate differentials (REIT yields minus government bond yields) should narrow at a slower pace than before. 

Commodities

We view commodities in two ways: as inflation hedges and diversification tools. We expect commodity prices such as oil and agriculture products to remain elevated on the back of supply disruptions and geopolitical events. Commodities with inflation-hedge properties such as precious metals (gold and silver), oil, and farm products could perform better.  

Conclusion

At this time of writing, the macro outlook and geopolitical events remain highly fluid. The odds of slower growth and higher inflation are rising, and we believe investors should seek active management and diversification to reshape their portfolios in an evolving investment landscape.

1 Bloomberg, as of March 7, 2022. Federal funds futures indicated a 96.9% chance of a 25bps hike at the March Fed meeting. On the announcement of European Union sanctions, Germany’s 10-year government bond price rose from 97.776 on February 25, 2022, to 100.799 on March 1, 2022. Meanwhile, 10-year bond yields fell from 0.2261% to -0.0799% over the same period. 2 Bloomberg, as of March 7, 2022. Eurozone IHS Markit's Composite Purchasing Managers' Index climbed to a five-month high of 55.5 in February 2022. On March 8, 2022, the United States banned Russian oil exports. The European Union announced a series of sanctions against Russia. These included a ban on all transactions with the Central Bank of Russia, which limits its ability to access foreign reserves. In addition, seven Russian banks were removed from the SWIFT international payments system and eurozone-based companies banned from exporting technology to Russian weapons manufacturers, pharmaceutical companies, military communications units, and shipyards. Last, eurozone-based companies are banned from doing business with the designated state-owned companies specializing in military production. 3 Bloomberg, as of March 7, 2022. The U.S. economy expanded by 5.7% year over year in 2021, a higher-than-trend growth of 2.0% to 3.0%.