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Coming into the year, we were thinking that 2022 would likely be a year of “normalization.” Then Russia invaded Ukraine in late February. The conflict clouded the economic outlook, particularly in Europe, and severely disrupted the normalization that had been taking shape across global growth, inflation, supply chains, and consumer demand.
The upshot is that we now find ourselves at the crossroads of a long-term structural shift in global levels of inflation, coupled with elevated short-term volatility driven by geopolitical events and a rapidly tightening liquidity environment. In our view, this set of circumstances has spawned three large macro dislocations that capital markets have yet to price in.
The first such mispricing is a broad investor underappreciation of “inflecting” policy dynamics across major developed market central banks. Over the past 12 years, these central banks bought a cumulative total of around USD 20 trillion in assets (as of 30 April 2022), which acted to suppress market volatility and term premiums. This “buying spree” is now ending and, in fact, going into reverse. 2022 could be the first year in more than a decade when global central banks in aggregate become net sellers of sovereign bonds.
Notably, the European Central Bank (ECB) recently shifted to a decidedly more hawkish monetary policy stance, with policymakers now more determined to confront and hopefully subdue mounting inflation — and this despite fears that the ongoing war in Ukraine could drag Europe into recession, given the region’s reliance on energy imports from Russia. In effect, rather than depressing market volatility as in the past, the ECB and other central banks could actually become a source of volatility through 2022 and beyond.
A related implication of the Russia/Ukraine crisis will likely be larger and more enduring fiscal deficits across Europe, where many nations will seek to finance accelerated timetables to rearmament (read: increased defense spending) and greater energy independence (read: higher household energy costs). That could fundamentally change the euro area, including how we think about German bunds, potentially leading to a long-term move back to pre-eurozone-crisis levels.
Increased lending, rising interest rates, and wider credit spreads should provide tailwinds for European cyclical industries, specifically financials. Additionally, we expect surplus capital investment to drive interest rates even higher, which would impact holders of European duration.
Across commodity-producing companies globally, investment spending has continued to be quite low relative to history, which has important implications for the “lead times” required to bring new production capacity online when global demand for commodities is high.
The market has been intently focused on supply-chain bottlenecks being a primary cause of today’s inflation, but we believe that even after those issues have been resolved, adequate supplies of raw materials may still not be available. Following years of overinvestment into rising commodity prices, capital expenditures (capex) by commodity producers have been minimal for several years now and may not increase meaningfully anytime soon. For example, despite surging oil prices, we have still not seen a substantial response from suppliers, which may continue to more than offset demand shortfalls. Similar trends are occurring across metals and mining producers, whose annual capex spending is at or around 50-year lows (Figure 1).
This discipline on the part of many commodity producers is anchored in their not-too-distant memories of weaker-than-anticipated prices and negative cash flows, leading to an emphasis on return over volume, long-term regulatory and energy transition-related uncertainty, and a generally tight economy limiting their ability to add capacity. Without an uptick in investment spending in these areas, this phenomenon will likely translate to higher commodity prices on balance, as well as greatly enhanced profitability for raw materials producers in the coming years.
Despite recent bouts of market volatility, we are becoming more constructive on emerging markets (EMs), specifically countries that stand to benefit from rising commodity prices, capital outflows from China, and the closure of Russian commodities markets.
While investors have historically tended to bucket EM equities into a single broad category, we believe a more nuanced approach is called for to exploit the variations that exist across the constituents of EM indices. For example, unconstrained EM allocations may help to better identify pockets of opportunity within various regions and countries. Significant differences in EM central bank policies, import/export dynamics, and currency behaviors have arisen recently, all of which should lead to larger relative dispersions among individual countries’ equity market returns (rather than all of them trading as a “bloc.”) For instance, while emerging EMEA and Asia-Pacific both posted negative returns in the first quarter of 2022, Latin America generated double-digit positive returns amid easing political tensions in the region and sharply rising prices for energy, grains, and metals, which benefited Latin American economies that rely heavily on commodity exports.
Moreover, several EM central banks are toward the latter stages of their interest-rate hiking cycles. These EM countries were early to raise rates in an effort to stem inflation, while DM central banks kept their rates low to ease financial conditions and prolong the “easy money” cycle (Figure 2). Much of the initial pain associated with more hawkish EM rate-tightening cycles has already been absorbed by these countries, unlike their DM counterparts.
Against this still-uncertain global backdrop, we see potentially more attractive return opportunities in European value assets and select emerging markets than in the US through the remainder of 2022. More broadly, we believe unconstrained and opportunistic investment strategies may be well suited to navigating this market environment.