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Article written on 20/04/2022 and updated on 12/05/2022.

The Russian invasion of Ukraine has sent shockwaves around the world. First and foremost at a humanitarian level. The human toll is already extremely high, with thousands of lives lost and countless civilians suffering. On the economic front, the prospects for global growth are deteriorating. The scale of the downward revision cannot be reliably estimated as it depends on the duration of the conflict, the economic consequences of international sanctions against Russia, possible retaliatory measures by Russia and, above all, what happens to commodity prices.

Risk of stagflation for the European economy

The spectre of stagflation is back on the agenda, particularly in Europe. Soaring price growth, especially for energy and food, is squeezing real household income and the margins of many companies, with negative consequences on business activity.

Germany is particularly impacted as illustrated by the recent sharp fall in the IFO German business climate index in March.

The surge in prices has been surprisingly vigorous, undermining the scenarios of a moderate and temporary rise. In developed countries, inflation is expected to peak in the first half of the year. The subsequent decline is likely to be gradual and inflation could remain at a structurally higher level than in recent decades, which have been marked by significant disinflation. The desire shown by many governments to relocate certain strategic activities, the increased role of fiscal policy, the unprecedented expansionary monetary policies and the cost of the energy transition, could even support more price rises.

Further interest rate hikes likely

The expected slowdown in global economic growth is not likely to significantly alter the plans for interest rate hikes among the main central banks in the developed countries, particularly the Federal Reserve.

In the United States, the markets are now expecting interest rates to reach around 2.5% by the end of 2022. Inflation expectations reflected in the bond markets (5-year inflation expectations in 5 years’ time are around 2.5%, the highest level since 2014) and consumer confidence surveys have risen sharply. The risk of ‘derailing’ these long-term expectations would have to be considered very seriously by the Federal Reserve.

However, inflation is not the exclusive preserve of exogenous elements (such as rising commodity prices and supply problems): after 11 consecutive months of job creation exceeding 400,000 positions, the US labour market appears tight and this will drive upward pressure on wages.

In the eurozone, markets are expecting about two 25 basis point rate hikes by the end of the year. Ms Lagarde has raised the possibility of a first hike in the weeks or months following the cessation of the asset purchase programmes. A consensus seems to be emerging around the possibility of a first rate hike in the third quarter of this year.

Equity market under pressure

The global equity market has declined around 10% since the beginning of the year (updated to 12/05/2022). Current valuation levels do not offer any major opportunities. Moreover, earnings expectations still appear to be optimistic given the prevailing economic risks. Equity risk premiums have contracted, suggesting a lower relative attractiveness of equities compared to sovereign bonds, particularly in the US.

While short-term opportunities are limited, in the longer term, in a more inflationary context that is still characterised by real rates firmly set in negative territory, equities clearly remain the preferred asset class for investors.

Damien Petit, Head of Private Banking Investments

 

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