Pandemic and war creating a ‘non-normal’ market environment

Trying to gauge the state of the current global macro cycle has been a subject of much debate, resulting in different views and thus different market expectations for the year ahead.

Whether we have had the usual business/macro cycle following the global financial crisis of 2008/9 is questionable – especially given the low (even negative) interest rates, a market continually dependent on stimulus and easy monetary policy, and the subsequent prolonged period of lower economic growth or so-called secular stagnation.

It would appear that the general take has been biased towards a mid-late cycle view. The reality, however, is that the pre-pandemic business/economic cycle has in fact been turned on its head given the sudden advent of the pandemic that almost simultaneously triggered an unprecedented lockdown of economies around the world.

And now, compounding the difficulty of forecasts, is the Russian invasion of the Ukraine, accompanied by penal sanctions on Russia and the dire knock-on effects of these developments.

Scarring

The pandemic has had a major impact on economies and its ramifications and scarring will continue to for years to come. Furthermore, let us not be remiss about its socio-economic, health and psychological impact.

The extent of fiscal largesse and ultra-easy monetary policy support during this time remains equally extraordinary.

The reopening of economies post lockdowns has led to a spike in total demand, the response to which has been a severely constricted supply response coupled with acute and continued supply-chain bottlenecks.

This has caused commodity prices to surge – with oil in particular further inflamed by the war and its attendant sanctions on Russia. While the impact of a collapsing Russian economy on the global economy is fairly small, the outsized role played via the supply of certain key commodities is significant, as is the effect on the inflation outlook.

Stagflation

This is further aggravated by the fact that it is occurring at a time when economic growth in the US and elsewhere is already slowing amid high and rising inflation with the likelihood of policy tightening – clearly factors for a stagflationary outcome.

(Stagflation is marked by persistent high inflation combined with high unemployment and stagnant demand).

Ultimately, high prices on the supply side tend to sow the seeds of their own demise over the medium to longer term in the absence of sufficient demand.

The continued supply-chain bottlenecks have also led to upward wage pressure given serious labour market shortages.

The perseverance of high inflation can in part be ascribed to the supply-versus-demand mismatch, with reopening (mainly on the goods side) compounded by base effects.

Persistent price pressures may cause inflation forces to broaden, potentially leading to second-round effects such as rising inflation expectations and faster wage growth (especially a wage-price spiral), which are of concern to policymakers.

Growth slowdown

There is a risk of slower economic growth as a result of shrinking global liquidity on the back of waning fiscal support and monetary policy tightening.

And now, the risk of lower growth – even recession – is a real threat given the war and its potential economic and geopolitical consequences.

The risk of a growth shock has thus increased and it is unclear to what extent this has been anticipated and priced into markets.

Debt levels remain high and are negatively impacted by rising bond yields, especially for investors or holders of debt and in terms of the cost of borrowing. Negative yielding debt has been shrinking on the back of rising bond yields, notably government or sovereign debt.

Rising interest rates (especially if real rates increase) add to issues that markets must contend with, in addition to the continued uncertainty of the pandemic.

Return of the hawk

This backdrop, coupled with inflation that continues to surprise on the upside, has set most central banks on a hawkish path, especially those in developed markets. It would appear that they no longer want to risk policy on the ‘transitory’ narrative and are afraid of being behind the curve – besides their credibility being on the line.

The bottom line is that an unforeseen pandemic – and now war conditions with punitive sanctions and retaliations impacting commodity supply – have plagued and disrupted life as we know it, throwing the previous prevailing economic trajectory off course and causing a ‘non-normal’ economic environment.

Covid-19 produced massive macro distortions. How these and geopolitical developments will unwind over the year and longer term remain unclear.

Macro policy is turning less supportive for asset prices and has implications for growth.

Companies face potentially peaking margins and earnings.

The Russian invasion of Ukraine will lead to a rethinking of national security (observe increases in some security/military budgets lately) and geopolitical strategy and alliances in a post-war world that will determine and reshape the course of the global economy.

And so, market pundits are assessing various scenarios …

In one scenario, it would appear that fiscal and monetary conditions are on course to be less supportive. We are transitioning from a period of low (even negative) rates and high liquidity to one facing higher rates and tighter liquidity and supply conditions globally. The extent and rapidity of monetary policy tightening, especially by major central banks, will be important for financial markets.

Yet, in another scenario, a growth shock may cause policymakers to slow – or even turn – the tightening cycle. A stagflationary economic environment, as mentioned above, has become a higher probability.

Regardless, maintaining the prevailing dovish monetary stance risks having to fight inflation more forcefully later if it is not in check.

Moving too aggressively runs the risk of slowing or scuppering economic growth; it will be a tall order for policymakers to walk the tightrope of not hurting economic growth while combatting inflation, and in a way that does not upset markets; especially given the atypical cycle.

And so it is clear that huge pandemic and war distortions make it challenging to assess the current state of the cycle, let alone make predictions.

We may find that economic and market developments take their own ‘non-normal’ course. The current cycle should accordingly be assessed in terms of its own dynamics, possibilities and probabilities in an environment that remains ever fluid. The outlook is further clouded by uncertainty around Covid-19 developments and the war.

All in all, expect continued volatility, especially if markets deem unfolding events in a negative light.

Fabian de Beer is chief risk officer at Mergence Investment Managers.