The recent Russian invasion of Ukraine coincides with a period of high commodity prices, excessive monetary and fiscal stimulus and supply-chain disruptions, which have fed through to the highest consumer-price inflation in almost 40 years. Just as the US Federal Reserve is expected to make its first rate hike in mid-March, and the European Central Bank (ECB) seeks to wind down quantitative easing and follow with a rate hike of its own later in the year, the spectre of stagflation now confronts the monetary policy establishment.
Higher inflation prospects would naturally prompt central banks to tighten policy, but at the same time – particularly for the European economy – the Ukraine invasion and prospect of energy-supply disruptions will have a dampening effect on business and consumer confidence. Economic data over the coming months will need to be watched closely to determine whether geopolitics is affecting economic sentiment.
As things stand, we fully expect the Fed’s Federal Open Market Committee (FOMC) to press on with its first and subsequent rate hikes in the first half of 2022, but remain to be convinced that the Fed will execute on the full seven rate hikes implied by money markets – particularly given the sharp flattening of the yield curve that has occurred in recent months. For the ECB, withdrawing liquidity from markets is likely to have an outsized impact on corporate credit spreads given its substantial buying activity in credit during the global pandemic. Therefore, the ECB could find itself with the uneasy prospect of having to sell corporate bonds back to the market just as Russia-Ukraine uncertainty is beginning to feed into European corporate credit malaise.
We would expect the threat of further sanctions and heightened tensions to keep energy prices high, but unless there is a material interruption to the energy supply the economic hit (thereby causing stagflation) could be less. This, in turn, will allow the central banks to start their tightening cycle, but may reduce the terminal rate.
Richard Bullock, senior investment analyst, Newton Investment Management
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