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By Ashok Bhatia, CFA
We could see new inflationary pressures and modestly lower growth, with impacts on central bank policy and risk asset volatility.
The security and geopolitical ramifications of Russia’s invasion of Ukraine will take months and quarters to play out. In the near term, we see three key fixed-income investment implications from the overnight events.
First, the peak of central bank tightening expectations has likely passed. So far in 2022, the central banks and markets have been acutely focused on inflation and the policy response, which has resulted in expectations for significant tightening over the next 12 months. We expect growth concerns to now enter the central bank calculus. Whether from commodity prices, tighter financial conditions, or general risk appetite, we believe the modestly rising uncertainty about growth will allow the central banks to be slower on hikes. Near term, we expect the markets to move toward four hikes from the Federal Reserve in 2022 and an unchanged ECB, which has been our base case for the year.
Second, our base case moving forward is that major economies will continue to experience positive growth, given underlying domestic growth trends, continued fiscal stimulus, and a lack of major private sector imbalances. However, we don’t discount the possibility that markets will price toward a more negative growth outcome, or stagflationary outcome, in the near term. And regional growth differences will likely increase, with more pressure on European growth rates. German industrial production, in particular, may be affected given its linkage with the east.
What does this all mean for credit markets? Volatility will remain, but spread-widening toward “recessionary” pricing will likely represent a significant investment opportunity. Spreads in U.S. investment-grade at 150 bps and U.S. high yield at approximately 450 bps or higher should be attractive entry points.
Third, the biggest sectoral impacts will likely be in commodity markets. While energy remains the headline risk, it’s important to note that Russia is a key supplier of industrial metals such as palladium, platinum, and aluminum. The impacts from higher prices and/or lower supply will reverberate not just through mining companies but into a range of sectors that depend upon these supplies. And, obviously, impacts on crude and natural gas will be in focus, and likely create elevated inflation rates for longer.
Volatility will remain high for a while, and the long-term impacts will take time to sort out. But net-net, the growth outlook is likely modestly lower, with implications for lower central bank hiking and continued volatility in risk assets.
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