As a fragile world economy continued to emerge from the pandemic, 2022 began with the stage set for recovery. Economic momentum appeared to be well underpinned by pent-up demand and fiscal support, while the Omicron Covid-19 variant, which had dominated headlines and briefly roiled equity investors at the end of 2021, was found to be less severe than previous iterations, with many governments resisting further restrictions as the virus appeared to be on the pathway to becoming endemic.
However, the backdrop changed dramatically in the early hours of 24 February when, after months of denying such an intention, Russian President Vladimir Putin launched an invasion of Ukraine, claiming that NATO’s eastward expansion posed a threat to his country and stating that he was seeking to ‘de-Nazify’ Russia’s western neighbour. Although Putin’s path to war had become apparent since November, when Western intelligence sounded the alarm about a military build-up along Russia’s western border with Ukraine, the invasion – the first time a great power has invaded an independent European sovereign state since World War II – delivered a big shock to financial markets.
The events in Ukraine above all constitute a human tragedy, but have inevitably had immediate ramifications for economies. The attack triggered the imposition of sanctions on Russia by Western allies on an unprecedented scale, including restrictions on the activity of the country’s central bank and the removal of selected Russian banks from the SWIFT international payments system; Russian stocks and the rouble plummeted as a result. Fuel and energy prices, meanwhile, rose sharply, reflecting Russia’s position as the largest natural-gas exporter in the world, and the second-largest oil producer and exporter after Saudi Arabia.
The fallout from the conflict, particularly from a commodity and supply-chain perspective, was certainly a key factor driving risk sentiment during the period, with many equity indices falling sharply in the immediate aftermath of the invasion. However, a more hawkish tone from the US Federal Reserve (Fed), signalling a quickening of the cycle of interest-rate hikes amid concerns about elevated and persistent inflationary pressures, was also a significant catalyst for a major equity-market sell-off that had gathered pace during January. Many of the beneficiaries of the hitherto ‘easy money’ environment, such as the large US technology names, registered particularly sharp declines, although many of these stocks moderated their losses by participating in a broader rally which developed towards the end of the period as indices bounced from an oversold position. Nevertheless, the S&P 500 index of US stocks suffered its first quarter of losses since the opening quarter of 2020 and the start of the coronavirus pandemic.1
Bond markets experienced a torrid quarter, as the increasingly hawkish words and actions from major central banks caused yields to rise. Although the invasion of Ukraine initially caused a flight to safety, a rally in government bonds was held back by the additional inflationary impetus of the conflict, and 10-year US Treasury yields (which rise as bond prices fall) were up over 80 basis points during the quarter.2 Riskier corporate bonds, meanwhile, also suffered big losses, widening the spread (yield premium) over government bonds.
10-year government bond yields (%)
Source: Factset, April 2022
In fixed income, UK gilts lost significant ground, with the FTSE Actuaries UK Conventional Gilts All Stocks Index returning -7.2% over the quarter, while overseas government bonds, as represented by the JP Morgan Global Government Bond Index (excluding the UK) produced a return of -3.3% in sterling terms. Corporate bonds also weakened, with the ICE BofA Sterling Non-Gilt Index returning -6.2% over the quarter.3
In equity markets, Asia Pacific ex Japan stocks produced a positive return of +1.4% for UK investors over the quarter, while UK equities were also just in positive territory with a return of +0.5%. Returns from all other major regions were negative, however, with North American stocks delivering -2.1% in sterling terms, and emerging-market equities returning -2.5% over the three-month period. Japanese equities, meanwhile, delivered a negative return of -3.5%, while Europe ex UK equities declined by -7.1% in sterling terms.4
Against the increasingly uncertain backdrop, gold made strong gains over the quarter, returning +6.3% in US-dollar terms and +9.6% in sterling terms.5
Even before surging energy prices as a result of the Ukraine invasion had been taken into account, US consumer price inflation hit a new 40-year high in February of 7.9% year on year.6 Citing these inflationary pressures, as well as the tightness of the labour market, Fed Chair Jay Powell announced a quarter-point increase in the federal funds rate following the March FOMC (Federal Open Market Committee) meeting – the first hike since 2018 – and indicated that there would be six further increases this year.
US consumer price index
% change, year on year
Source: FactSet, April 2022.
Powell acknowledged that the Ukraine crisis and related events were likely to weigh on economic activity, and the Fed revised down the median estimate for US economic growth in 2022 to 2.8% from the 4% projected in December.7 Powell was keen to stress that he believed the economy, which expanded by 6.9% on an annualised basis in the fourth quarter of 2021,8 could handle tightening, and downplayed the prospect of a recession. However, at the end of March, an inversion of the yield curve (when two-year Treasury yields rise above those of 10-year Treasuries),9 which has typically been a sign of an impending recession, heightened fears that the Fed’s attempts to tame inflation would bring about a sharp slowdown in economic activity.
Bank of England (BoE) Governor Andrew Bailey warned that people in the UK were facing a “historic shock” to their incomes, stating that the energy-price rise this year would be larger than during any single year in the 1970s. The UK’s fiscal watchdog, the Office for Budget Responsibility, has downgraded the UK’s growth outlook this year to 3.8% from its previous 6% forecast in October,10 after real household income dropped to its lowest level since records began in 1957.
Although the economy bounced back in January following the Omicron Covid outbreak at the end of 2021, with GDP 0.8% above its pre-pandemic level according to the Office for National Statistics, consumer and business confidence have subsequently fallen sharply,11 with the effects of soaring living costs pointing towards a period of ‘stagflation’ (a period of slow growth combined with high inflation).
While a third consecutive interest-rate rise in March saw borrowing costs return to their pre-Covid level, the BoE has taken a decidedly less hawkish tone than the Fed, acknowledging the challenging backdrop and stating only that “some further modest tightening in monetary policy” may be required over the coming months.12
It was a similar story in Europe, where the effects of the Ukraine crisis are being felt particularly keenly owing to the continent’s proximity to Russia and reliance on its gas and oil. At the very end of the quarter, Germany took a formal step towards rationing gas supplies, in anticipation of a potential halt in Russian gas deliveries as a dispute over payments escalated. In a speech on 30 March, European Central Bank (ECB) President Christine Lagarde said that Europe was entering a “difficult phase” as the war pushed up prices, stymied growth and drained consumer and business confidence.13
The dilemma the ECB is now facing is how to control higher inflation, while also ensuring it does not exacerbate the hit to real incomes from the crisis. Earlier in March, hawkish voices appeared to gain the upper hand at the ECB’s policy meeting, at which it left key policy settings unchanged for the near term but decided on a faster tapering of its bond-buying programme. In fact, the central bank indicated that it could stop adding to its bond portfolio altogether later in the year, opening the door to the possibility of rate rises if inflation stays high.
The ECB published three sets of growth forecasts, with downside scenarios modelling the likely impact of cuts to Russian energy supplies to Europe, increased geopolitical tensions and financial-market disruption. In its worst scenario, the eurozone’s 2022 growth would be only 2.3%, compared to 3.7% in the baseline scenario.14
In contrast to the other leading central banks, the Bank of Japan (BoJ) signalled it would remain committed to economic stimulus and continue its efforts to keep Japanese government bond yields low. Towards the end of the quarter the yen dropped to a seven-year low against the US dollar as the Fed and other central banks proceeded with interest-rate rises. BoJ governor Haruhiko Kuroda suggested that a weak yen was “generally positive” for its economy, with its fall beneficial for Japanese exporters.15
US dollar/Japanese yen rate
Source: FactSet, April 2022.
However, after years of deflation, even Japan has not been unscathed by the inflationary surge which has followed the post-Covid recovery and been exacerbated by the Ukraine conflict. Some of Japan’s biggest employers recently agreed to their highest annual salary increases in seven years in the wake of higher energy and food costs.16 Rising prices have the potential to curb GDP growth, which rebounded during the final quarter of 2021 following a relaxation of Covid restrictions.
Momentum in China’s economy slowed in the final quarter of 2021, with growth decelerating to an annualised rate of just 4%.17 This made the country’s 2022 growth target of “around 5.5%”, set at the March National People’s Congress chaired by Premier Li Keqiang,18 appear rather ambitious, particularly in view of significant headwinds facing the economy. These include China’s continued pursuit of a zero-covid strategy, which led to a growing number of lockdowns as the quarter progressed and the Omicron variant took hold in the country, exacerbating supply-chain issues affecting the technology sector in particular. In addition, China has been facing a prolonged slump in the property market, as well as weakened confidence following a government crackdown on technology companies.
The ‘whatever it takes’ promise from Vice-Premier Liu He to ease monetary and credit policies has provided a sentiment boost, but China will also need to carefully manage its ‘limitless’ partnership with Russia. A neutral and mediatory role on China’s part could help in containing the global energy price shock and stabilising its relationship with key trading partners the US and European Union.
Out of intense complexities, intense simplicities emerge.Winston Churchill, UK prime minister 1940-1945 and 1951-1955
2 Source: FactSet, 1 April 2022.
3 Bond market returns sourced from FactSet, 1 April 2022.
4 Equity market returns sourced from FactSet, 1 April 2022 (All sterling total returns, FTSE World Index).
5 Gold bullion returns sourced from FactSet, 1 April 2022.
All data is sourced from FactSet unless otherwise stated. All references to dollars are US dollars unless otherwise stated.
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