Voluntary moves by the private sector were added to the official measures. We have witnessed the mass withdrawal of various companies from Russia out of disapproval of Putin and the Kremlin leadership, whose war is costing untold human lives and suffering. This escalation of the economic warfare pushed oil above $ 130 a barrel, before a further decline thanks to additional supply commitments from the UAE and other countries. Meanwhile, hopes that an advance on a currently stalled battlefield could lead to a ceasefire has also encouraged a temporary mid-week rebound in risky assets. Unfortunately, we are inclined to believe that there will be little progress in the negotiations at this stage. Consequently, it would appear that the Russian war machine may advance relentlessly in the coming weeks, despite valiant efforts to counter it.
We might hope that a popular uprising in Moscow could induce Putin to reconsider, or could lead to his dismissal, but in reality this scenario seems very unlikely. Historically speaking, the Russian people have a tendency to be condescending and accepting the actions of their leaders, despite the difficulties that may be inflicted on them. Against this backdrop, commodity prices will remain high for an extended period. In the wake of recent moves, this could mean that a further substantial increase in inflation is yet to come, and we expect indce in the US, EU and UK to hit 9% respectively. 7% and 10% in the coming months.
These movements will detract from disposable income and cause growth to decline by around 2% in the UK and the Eurozone and by 1% in the US, based on our estimates. However, a recession remains unlikely unless oil prices rise much more than we have seen so far due to further escalation. Over the medium term, we believe interest rates and yields will need to rise significantly. Indeed, the more inflation rises and the longer it remains high, the more we will see inflation expectations un-anchored and secondary effects will occur. As a result, this is likely to mean that the monetary tightening path will largely take place as we have assumed, but that the peak in the rate cycle is likely to be higher than previously expected. US interest rates hitting 1.5% this year may not do much to tighten conditions and curb price pressures. As a result, we believe Fed Funds could rise to 3% by the end of 2023 and continue to move even higher in the first half of 2024.
However, in the short term, rate hikes could be fully priced and given the very uncertain and volatile geopolitical context, it seems less convincing to maintain a strongly directional vision for the moment. For this reason, we took profit on a recent trade in short rates, which was initiated when rates rose immediately following the Russian invasion and subsequent sanctions. In the euro area, the ECB sent a more hawkish message than many expected: downplaying the risks to growth, Lagarde articulated plans to end asset purchases in the third quarter and raise rates soon thereafter. In part, the Eurotower may feel that its mandate is price stability and therefore have no choice but to move in a more hawkish direction. However, it was precisely the hawkish stance that saw Eurozone yields underperform during the week, as well as new pressure in the periphery which impacted spreads. It is possible that hopes of a “Re-Power EU” fiscal package, as Macron will argue vis-a-vis other EU leaders, will help offset the impact of a tighter monetary stance. In our opinion, however, the proposed figure of EUR 200 billion seems too modest.
Furthermore, Union policy suggests that any agreement on this could take a few weeks to take effect. As a result, we think further pressure on periphery spreads is likely in the coming days, with markets largely unconvinced that investments from PEPP maturities can act as some sort of backstop for spreads. Risk assets in general have traded weakly over the past week. The new credit issues required a substantial spreading of existing contracts, putting investment grade spreads under pressure. The shares continued to trade with some nervousness, and asset allocators also got nervous to see bonds and equities slide in tandem. However, some sovereign credits showed signs of stabilization after a very soft end last week. In general, it doesn’t take a lot of volume to have a disproportionate impact on prices.
Meanwhile, it has been confirmed that Russian debt will be pushed off the indices later this month. Prices have largely been devalued to zero and it would appear that Russia is destined to remain in the financial wasteland for a long time, unless a regime change in Moscow takes the country on an alternative path. Volatility in the currency markets remains more modest. We continue to favor the dollar on a relative basis and found it interesting to see the euro slide in the wake of an ECB meeting that turned out to be more hawkish than many had anticipated. Meanwhile, we also favor commodity-exporting currencies, such as the Australian dollar and South African rand, over energy importers such as India or Turkey.
We believe it is likely that the conflict in Ukraine will reach a stalemate in the next month or so. It will be difficult for Russia to impose control over the cities, but the Ukrainian population will not be able to repel the invaders. We will find ourselves in a “new Cold War” context. This will continue to keep risk premia high over the medium term, but when the threat to geopolitical stability eases somewhat, the focus of financial markets will turn back to the economy and financial fundamentals.
Our view is that growth will remain positive thanks to the end of the pandemic, fiscal easing and higher wages resulting from tight labor markets. Uncontrolled inflation is likely to be the main concern and it is already interesting to note the transformation of what we called Bidinflation into Putinflation, with the White House trying to deflect the blame for uncontrolled price pressures. Some inflationary pressures will correct themselves as underlying effects (such as second-hand car price distortions) are excluded from the calculations. However, higher interest rates will be needed to bring the elevated price pressures under control before inflation expectations are undermined too much. Looking at the UK example, we are on the road to double-digit inflation at a time when interest rates are only 0.5%.
The Bank of England will have to continue raising rates even as this weighs on growth and the housing market. At some point, you will realize that it is better to have a short, shallow recession now than a much deeper one later. However, such a trade-off will perhaps be more concerning in a year or two. In 2022, financial conditions will remain stimulating, and rates will end the year well below the level of inflation, likely ending up not hindering demand much. The road ahead appears to be increasingly bumpy for financial markets and volatility may remain high. Yet, if we are careful and choose direction carefully, we should continue to find opportunities on both the long and short sides in the markets.
Meanwhile, it would be remiss of a Chelsea fan not to comment that the war against Putin and his friends should not turn into a war to destroy a football team, despite the desire to dismantle “the Roman Empire”. However, we have enjoyed being European champions twice in the last 10 years. Spurs fans know they can never tell … so up the Chels!