We are optimistic that central banks can approximate a soft landing even if the growth/inflation trade-off worsens somewhat. Despite some reduction in market expectations, we think markets remain priced for substantial tightening and that central banks are unlikely to surprise on the hawkish side. However, if inflation proves stickier or higher than we expect — perhaps because supply-chain bottlenecks don’t ease as anticipated — then central banks may be forced to tighten more aggressively and risk assets may falter.
One potential driver of more persistent inflation is a drawn-out conflict in Ukraine that inflicts greater-than-expected disruptions in energy, metals, and wheat markets. If Putin’s ultimate goal is to occupy all of Ukraine, then we fear the conflict will be a bloody stalemate of urban warfare with even greater economic costs in the form of reduced business and consumer confidence, higher inflation, and lower growth for the rest of the world.
On the upside, if Russia chooses to retreat or only occupy parts of eastern and southern Ukraine, risk assets may rally strongly. Any news that suggests the potential to avoid interruptions in trade with Russia would also help markets, as would an increase in European fiscal support. Turning to China, the country’s opaque system is difficult to analyze, but an upside policy surprise is worth watching for. Finally, in terms of the pandemic, we appear to be on the cusp of a more normal summer in the northern hemisphere and a recovery in the service sector, though we must acknowledge the risk of yet another variant.
Stay the course with equities — Given geopolitical uncertainty, we expect a risk premium in global equity and credit markets — particularly in Europe and EM. However, given the repricing we’ve already seen, the likelihood of less hawkishness from developed market central banks, and extremely bearish sentiment, we expect equities to outperform bonds over a 12-month horizon. We prefer Japanese and US equities.
Inflation risks remain higher for longer — Shortages and supply-chain disruptions stemming from the Russian invasion of Ukraine could drive commodities prices higher. Allocators may want to consider adding broad exposure to commodities, the asset class that has historically been most sensitive to higher inflation. We think TIPS are likely to outperform US Treasuries. Higher yields and inflation should support value stocks, but weaker growth would favor growth stocks.
Stay short in fixed income — We continue to favor shortening duration in fixed income given our expectation of higher longer-term yields and wider spreads.
Consider defensive assets — US equities, unhedged Japanese equities, and gold are likely to be favored should growth weaken amid geopolitical uncertainty. High-quality government bonds may regain some of their diversification role during bouts of turmoil. We think the focus should be on quality in equities: domestically oriented companies, service companies, and companies that have growth potential and are profitable may be more insulated from geopolitics. More military spending by Europe is highly likely and may warrant a closer look at defense stocks (though ESG considerations could limit allocations).
Active management may play a role — In an environment of increased volatility, higher return dispersion, and worse liquidity, active managers have the opportunity to distinguish between winners and losers and take advantage of price dislocations that may not be justified by fundamentals at the country and company level.