As the horrific war in Ukraine continues, economies around the world are starting to digest the impact of energy and soft commodities price shocks that are occurring as a result, and high inflation and damaged growth will define the macro outlook for several quarters. 

China assets, inflation-linked bonds, and equities backed by strong corporate balance sheets and pricing power will help build resilience into portfolios.

Transmission channels

Rising food and energy prices are the two key channels through which downside risks will be transmitted to the real economy from the war in Ukraine, reflecting the costs of a real and growing human tragedy. 

European economies are particularly exposed, given their heavy reliance on Russian oil and gas. We estimate that the region is at risk of a 2.4 percentage point decline in growth if energy supplies from Russia were to become severely disrupted. 

Meanwhile, we would expect a 100 per cent rise in oil prices to translate into a 200-basis point increase in global inflation. During the last comparable event, the 1973 oil embargo, oil prices rose up to 300 per cent within a 12-month period. The risk of disruption to oil and gas supplies is increased by the prospect of fresh sanctions on Russian energy exports. 

Additionally, the war in Ukraine will disrupt the supply of food and soft commodities, including wheat, leading to further inflationary pressures and cost of living increases, especially for commodity-deficient emerging markets.

Monetary policy complications

These stresses complicate the policy environment for developed market central banks, which had signalled intentions to raise interest rates and focus on fighting inflation. While the European Central Bank is more exposed to an adverse growth shock than the Federal Reserve, both may be forced to slow down plans to tighten. China’s central bank had adopted an accommodative policy stance before the Ukraine crisis, and is likely to continue to provide stimulus to the economy.  

Building resilience

On a regional basis, China’s economy has shown signs of stabilisation. Its central bank is in stimulus mode and has followed a policy of focusing on domestic resilience, which may insulate it from the worst of rising input prices. Given this positive starting position, China sovereign debt offers an attractive way to diversify portfolios. 

Meanwhile, global equity markets are under pressure and reflect the prospect of stagnant real earnings growth, as well as uncertainty around tail risks and indirect exposures to Russia. In these conditions, we prefer high-quality companies with solid balance sheets, combined with pricing power and the ability to retain talent, which will be crucial factors in weathering the stagflation storm. Some emerging markets, such as Brazil, could see some outperformance in equities where there is an opportunity to take advantage of higher commodity export prices.

In fixed income, our two areas of focus are inflation protection and duration exposure. For the former, inflation-linked bonds offer an attractive safeguard in the current stagflation environment. Real yields will be pushed ever lower as recession risks exert more influence over monetary policymakers and the pace of tightening is slowed. 

Assets such as Asian investment grade credit look particularly attractive in this scenario, in which some exposure to duration should be helpful. Asia, as a region, is away from the epicentre of the crisis and will benefit from policy accommodation in China. 

Funding stresses

Funding conditions had been on a tightening path leading up to the escalation in Ukraine, but the situation has worsened in the past two weeks. Liquidity indicators, such as the euro cross currency basis and FRA-OIS spreads, are signalling increased stress but are not yet at levels associated with the start of the Covid crisis or the 2008 financial crisis. 

While the funding squeeze is a concern, we would expect the major central banks to ease liquidity conditions through their foreign exchange swap lines if the scramble for dollars leads to a panic. 

Russia’s central bank, having been cut off from a large chunk of its reserves, is in a more difficult situation. It will not be able intervene in foreign exchange markets and support its currency, raising the prospect of a severe domestic banking crisis if access to USD is shut off entirely. 

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