CI Asset Management said in its note on New Year’s Predictions, The world is grappling with yet another disruption of the normal course of business. No sooner had we moved on from the misery of a pandemic than we woke up to news of war in Europe on the fault lines of an historical ideological clash between the global east and west, exacerbating price inflation that had already been ticking higher since the latter part of last year because of supply chain constraints.
The note added that the war between Russia and Ukraine is an unfortunate development, particularly for those directly affected by the violence, and has had far-reaching effects on people’s cost of living across the globe in both rich countries and in more vulnerable emerging economies. Largely because of the abundance of natural resources in both countries directly involved in the armed conflict, annualized inflation has risen to 9.8% globally compared to 5.7% at the end of last year and a five-year average rate of 4.6%.
It explained that Policymakers in the world’s largest economy, where stubbornly low unemployment and strong wage growth have rubbed up against the global dearth in the supply of goods, have taken notice. The US Federal Reserve, the world’s most watched central bank, has hiked rates seven times so far this year in what appears to be an attempt to induce a marked slowdown in demand through monetary tightening, as inflation rose to between 8 and 9% and unemployment remained at only 3.5% compared to a ten-year average of 5.3%.
It pointed out that tightening by the Federal Reserve has naturally led to a rise in bond yields as debt investors adjust return expectations in real terms. Long (ten-year) yields in the US have risen by around 200 basis points in 2022 and the median yield on emerging bonds has followed suit.
This has both hurt returns for existing bond investors and made financing more costly for most government issuers. It has also spilled over into equity markets, which are down 17% in the year-to-date (as measured by the MSCI ACWI index) and at their low for the year were down by as much as 27%.
Despite the erosion in real disposable income, the global economy remains arguably strong. Growth in world output is expected to be close to 3.2% in 2022, down from 6.0% in 2021, which had benefited from a weak base year, but the International Monetary Fund (IMF) expects that to slow to 2.7% in 2023 and cites downside risks to that scenario amid growing geopolitical uncertainty and related cost of funding pressures.
It mentioned that One does not typically wish growth away, but a moderate economic slowdown may not necessarily be a bad thing for investor sentiment in a global economy that has become so intertwined with the flow of capital. As investors seek higher yields on the perceived safer shores of the US, other markets suffer. Emerging markets tend to suffer most, particularly those economies running deficits that require foreign funding. Partly because of the de-risking by investors away from emerging markets, currencies in developing countries have depreciated by some 14% in aggregate this year.
Increasingly, successive inflation prints in countries whose currencies have fallen this year against the US dollar have become self-fulfilling, in that their currencies first depreciate because of inflation, leading to more imported inflation due to the translation effect on the dollarized price of goods, which diminishes the real yield in these countries’ capital markets. And so on, until the tide turns.
It added there are faint signs that the tide, “peak fear”, may be turning. US inflation has slowed somewhat from its high this year of just over 9% to 7.1% as of November. Equity markets, historically inversely related to bond yields, have been quick to react to this, rising by 14% from their low this year (still 17% lower for the year, as described earlier).
Underpinning this is a softening in commodity prices, which had shot up dizzyingly in the immediate aftermath of the onset of the war and which have since fallen considerably from their highest point this year (still more than 25% higher than ten-year averages), as some logistical constraints improved and partial demand destruction kicked in. This, while the US dollar appears stretched on a real effective exchange rate (REER).