Within two years, the global economy has been confronted with two negative developments or shocks. First, the pandemic (SARS-CoV-2), second, a geopolitical shock (Ukraine), which in turn triggered a commodity price shock. The effects are stagflationary.
Recovery and inflation before the invasion
The impact of the pandemic was ultimately stagflationary. Without the pandemic, GDP would have been higher and inflation lower. The surprisingly persistent high inflation (OECD: 7.1% pa in January) also caused a mini-interest rate shock at the beginning of the year (increasing rate hike expectations). As the omicron variant subsided, in February, cyclical economic indicators pointed to a renewed acceleration of economic growth (after the slowdown between December and January) and confirmed the base scenario “continuation of the recovery scenario”. The global purchasing managers’ index (manufacturing and services) rose to 53.4 in February from 51.1 in January. In addition, the price components of the Purchasing Managers’ Index pointed to continued high inflationary pressure (output prices at 60.0 after 59.6). At the same time, unemployment rates in the US (February: 3.8%) and the euro zone (January: 6.8%) pointed to a tight labor market. This in turn points to increasing wage growth. Last but not least, in the USA., the further increase in the participation rate (62.3%, pre-pandemic: 63.4%) points to a slow improvement on the supply side of the labor market.
Higher investment activity and budget deficits
Russia’s invasion of Ukraine represents a drastic event on several levels. Perhaps the value of democracy and the rule of law will now become more apparent. While the West is not intervening militarily, the use of sanctions and the supply of weapons to Ukraine signifies a new Cold War. The West’s relations with Russia are persistently troubled. Likewise, because of the sanctions, there is increasing motivation among those states that do not count themselves as part of the West to emancipate themselves from dependence on the US dollar and other reserve currencies. The likelihood of an Asian currency bloc around the renminbi has increased. In addition to China’s geostrategic strengthening, the supranational organizations NATO and the EU also appear strengthened. This implies, among other things, that promised NATO defense spending will indeed be met, that possible NATO enlargement has become more likely, and that the exit of another EU country and the breakup of the eurozone have become less likely. More bailouts would be put in place if needed. Similarly, the motivation to invest more in energy security and defense (including outside NATO) has increased. Government and private investment ratios are likely to be higher in the trend of the coming years than in the baseline scenario, but so are likely budget deficits.
Slump in the Russian economy
The sanctions imposed by the West are hitting the Russian economy hard. This is because they are forcing it to become even more self-sufficient. Some Russian banks have been excluded from the SWIFT interbank messaging system. Likewise, the foreign assets of more and more Russian citizens (oligarchs) are frozen. A large portion of the Russian Central Bank’s foreign currency reserves have also been frozen. In addition, foreign companies are pausing or terminating relations with Russia. This means a slump in trade and GDP (working assumption: -9% this year), as well as a disruption of supply chains. It also threatens to put the brakes on credit. S&P has downgraded the credit rating to CCC-. The ruble’s exchange rate against the US dollar has plummeted (63% since the beginning of the year). Pressure on the Russian government has certainly increased, as it can no longer provide stability and prosperity.
Commodity Price Shock
The invasion of Ukraine, similar to the pandemic, means a stagflationary shock and is a major new source of uncertainty. The share of global GDP of Russia and Ukraine is only 3%. The sanctions imposed by the West massively affect those exports that are not commodities, as well as access to global financial markets. Nevertheless, pronounced price increases in commodities have taken place. The index for industrial metals has risen by 24% since the beginning of the year, that for energy by 48% and that for agricultural goods by 26% (source: Bloomberg Commodity Price Indices). Russia is a leading producer of oil, gas, metals and grain. The latter is also true for Ukraine. The driving factor is an increased risk premium for possible production / export reductions, i.e., fears of commodity sanctions by the West and export restrictions by Russia. In addition, a self-restraint of Western companies (banks, insurance companies, transport companies, trading companies) due to legal and reputational risks is apparent. The further development of commodity prices will be determined above all by the nature of the sanctions imposed by the West and possible counter-sanctions by Russia. Both depend, among other things, on the course of the war in Ukraine.
High inflation and subdued recovery
Strong commodity price increases will keep inflation rates at a high level in the coming months (globally at around 6% pa). In the baseline scenario, global inflation could be around 1 percentage point higher this year (Q422: 5% pa) than in the pre-Ukraine scenario. The EMU is more affected (+1.5 percentage points to 4% pa). Risks are tilted to the upside. High inflation rates dampen purchasing power and reduce consumer sentiment. Global real GDP growth is estimated to be around 1 percentage point lower compared with the pre-Ukraine scenario (Q422: 3% pa). The EMU is more affected (-2 percentage points to 2.5% pa). Risks are tilted to the downside. Especially in the case of supply disruptions, the risks for a recession would increase.
Dilemma for Central Banks
Central banks are faced with a dilemma. Inflation rates are surprisingly high, driven by commodity prices. In some countries (USA), pass-through effects from pandemic-driven costs to other price components are already evident. Companies will try to pass on higher raw material costs. Employees will demand higher wages. Because unemployment rates are already low and the baseline scenario is continuation of recovery,” pass-through to other price components has become more likely. At the same time, economic growth will be affected by the commodity price shock, recession risks have increased and uncertainty on the financial market has risen.
First moderate raises of policy rate until year end expected
Central banks have little influence on the development of inflation this year. The aim is to keep secondary run effects low and inflation expectations as stable as possible. The neutral interest rate level should be reached as quickly as possible. The Ukraine crisis is dampening but not preventing the exit from the ultra-expansive monetary policy stance. The likelihood of surprisingly hawkish moves has decreased (+50 bp hike by the Fed; policy rate hikes to restrictive levels). Working Assumptions:Fed raises policy rate to 1.5% by end of 2022, start of Quantitative Tightening (reduction of central bank balance sheet) in summer, ECB also raises policy rate by end of December (to -0.25%). Last Wednesday, the Canadian central bank raised the key interest rate by 0.25 percentage points to
0.5%, as expected. Fed Chairman Powell announced a rate hike on March 16. ECB President Lagarde is likely to sound cautiously next Thursday. However, an increase in inflation projections is likely to maintain the possibility for key rate hikes.
Ambitious growth target in China
Support for the global economy is coming from China. The government has set its GDP growth target for this year at 5.5%. This is ambitious, as other forecasts are around 5%. For this reason, more economic support measures on the fiscal and monetary policy side have become more likely.
Additional uncertainty leads to higher risk premiums on the financial market
The additional uncertainty is increasing risk aversion on the markets. In line with this, volatility indices and risk premiums for equities, bonds and exchange rates have risen. This puts pressure on valuation measures such as the price/earnings ratio. In general, as long as the recovery scenario holds, the outlook for risk assets remains positive.
Prognoses are no reliable indicator for future performance.