As 2022 began, investors generally believed that inflation was the market’s biggest challenge. Events of the past few weeks, however, make it clear that economic variables aren’t the only issues investors have to consider. Russia’s invasion of Ukraine is a game-changer, with wide-ranging implications for the world and markets. It’s too early to know those implications for sure, but financial markets are already under pressure, and we expect the global economy to feel the impact in the coming months.
Geopolitics…Punctuated by Ukraine Invasion
Geopolitical tensions tend to simmer in the background, and investors are often correct to ignore them when making investment decisions. Russia’s late-February invasion of Ukraine, however, served as a dramatic reminder that tension sometimes transforms into something much more significant. The eruption of open warfare in Eastern Europe triggered global outrage, a massive humanitarian crisis and market turbulence.
While we believe that the direct spillovers to most individual economies are limited at this stage, there will inevitably be a global economic impact. The crisis comes at an awkward time for the world’s economy. With inflation already too high in many countries, the likelihood that the conflict will push energy prices up—and inflation with them—is an unwelcome development.
Rising energy prices increase the risk that inflation expectations become unanchored, even in places that have little direct exposure to commodity exports from Eastern Europe. Higher commodity prices leave consumers with less money to spend on other items, slowing growth. Not only that, but the invasion has also hit financial markets, tightening financial conditions, which will very likely impair growth in the coming quarters. Higher inflation and lower growth are a bad mix for the economy.
In addition, investors who have become accustomed to ignoring geopolitical risk may take recent events as a reminder that many other geopolitical hotspots continue to dot the world’s landscape in 2022. Each could incite periodic bouts of volatility, which could lead to higher risk premiums and pose further challenges for markets.
Elections Hold Potential Shifts in Leadership and Power Balances
Even beyond potential geopolitical conflict, 2022 brings a slate of global elections, many of which could have substantial policy ramifications nationally, and even regionally. While an exhaustive list is impractical in an abbreviated format, several contests seem noteworthy at this juncture.
In April, French president Emmanuel Macron seeks another term in France’s two-round presidential election that hinges on wide-ranging issues from the cost of living to labor regulation and the environment. April will also see Hungarian voters head to the polls to choose between nationalist Prime Minister Viktor Orbán and conservative Péter Márki-Zay.
In the Philippines, May will see the election of a successor to President Rodrigo Duterte, as the Pacific nation seeks to recover from the COVID-19 pandemic. Incumbent Brazilian president Jair Bolsonaro faces a challenging reelection battle against former president Luiz Inácio Lula da Silva to be decided in early October. And in November, US voters will decide the new makeup of congress, with the result certain to have a major impact on the country’s legislative agenda.
Higher Inflation Makes the Policy Task More Complex
Inflation, which spiked for many economies during the pandemic, has remained stubbornly high. Even before Russia’s invasion of Ukraine, expectations of tighter monetary policy pushed government bond yields higher and equity markets lower. We expect inflation to fade eventually, but it will take months, keeping markets on edge.
The combination of faster inflation and slower growth complicates the task for central banks. For decades, low inflation has allowed policymakers to look through periods of geopolitical tension and the associated rise in commodity prices, focusing instead on managing the headwind to economic growth. But with inflation already well above target, that may not be possible this time around.
We expect the US Federal Reserve to start rate hikes in March (after the date of this publication) and begin reducing its balance sheet shortly thereafter. Inflation is simply too high for the Russian invasion to derail the process, given the limited direct impact of the Russian invasion on the US economy. The European Central Bank (ECB), on the other hand, is earlier in its policy normalization cycle than the Fed is, so rate hikes are unlikely in the near term. That said, the ECB is reducing the pace of its asset purchases, making rate hikes possible later this year. We don’t think the European economy is likely to be strong enough for rate hikes, particularly given its geographic proximity and stronger economic links to Russia and Ukraine, and we expect that the evolving economic outlook is likely to prevent the ECB from tightening policy materially.
Monetary policy tightening is likely to drive global yield curves flatter, as is typical during hiking cycles. Financial conditions should continue to tighten more broadly as well, and the likelihood of reduced fiscal stimulus adds to the case for slower economic growth. Higher yields and the prospect of a prolonged policy tightening cycle is likely to push risk premiums up across asset classes.
Is the Global Pandemic Fading from the Economic Picture?
While the news from Eastern Europe is bad, we think it’s worth highlighting a positive development that may provide some offset to the negative developments in financial markets. For two years, COVID-19 has dominated the headlines in terms of public health, economic impacts and market reactions—from the initial outbreak to the delta and omicron variants. In recent weeks, omicron has faded rapidly, with virus infections falling off sharply.
It’s too soon to declare the pandemic over, as the possibility of a new variant remains. However, given the previous widespread nature of the virus, as well as advances in both vaccinations and treatments, it does seem likely that COVID-19’s role as a primary determinant of economic activity is near its end. Early signs are that economic growth picked up as the virus faded—that may not be enough to offset the negative impact of developments with Russia, but it may cushion the blow to a degree.
