Ukraine crisis warrants near-term caution as markets grapple with heightened uncertainty
On the March PGIM CIOs Call hosted by PGIM Quantitative Solutions, chief investment officers and senior investment professionals from PGIM’s international businesses, PGIM Fixed Income, and PGIM Quantitative Solutions discussed the impact of the Russian invasion of Ukraine on global economic growth, inflation and the financial markets.
The March CIO call participants discussed the path forward for the global economy and the outlook for financial markets amid rising uncertainty from the Russian invasion of Ukraine. Uncertainty about growth prospects was already elevated at the beginning of the year given the expected slowdown from strong growth in 2021, the COVID shock on supply and demand, and the monetary and fiscal policy unwind. The events in Ukraine and the fallout on energy and other commodity prices has ratcheted uncertainty up even higher.
While there is still significant uncertainty regarding how the situation in Ukraine will unfold, the call participants focused on three scenarios. The best-case scenario is one in which hostilities could ramp up in the short term, but a deal could be struck sooner than later. A middling situation would be one in which there is a protracted war, but the conflict doesn’t spill over to the rest of the world. The pessimistic scenario is that the war in Ukraine morphs into a much bigger conflict that could trigger a significant flight to quality, creating a market environment similar to what investors experienced in 2020. The odds of the worst-case scenario materializing are low, while the more probable first two scenarios would see markets stabilize eventually and financial flows return.
The Russia/Ukraine crisis began amid a backdrop of solid growth prospects and a strong outlook for the global economy. However, the invasion has sharply heightened uncertainty about the economic outlook. Rising oil prices and punitive sanctions imposed by the US and its allies may create a supply shock, contributing to higher inflation and trimming GDP growth, particularly in Europe. Meanwhile, the Omicron variant of COVID is fading, and many governments are removing restrictions on activity, which should provide a tailwind to 2022 growth (absent a new, deadly variant). US GDP growth was expected to slow this year but still remain above trend. While growth is expected to pull back modestly in the first quarter of 2022 due to a reversal in inventory rebuilding, domestic demand remains robust, with retail sales and industrial production solid so far.
The impact of the Russian invasion on energy prices could trim 2022 GDP growth expectations, but the US is likely to be relatively more insulated, and the impact is likely not as significant as in Europe. Eurozone growth in the first and second quarters of 2022 likely will be impacted by rising energy prices, sanctions, and other disruptions to economic activity. Japanese GDP rose 5.4% annualized in the fourth quarter of 2021, a strong rebound from the -2.7% decline in Q3. Strong global demand and the nearly $500-billion fiscal stimulus package announced late last year is expected to contribute to solid economic growth in 2022. Meanwhile, growth expectations for emerging markets remain solid at around 5% for 2022 although they could be revised lower in coming months as the impact of the war in Ukraine becomes apparent. While the oil and commodity price shocks are a negative for commodity importers, especially in Asia and emerging markets in eastern and central Europe, many of the exporters, such as those in Latin America, are likely to benefit.
Before the invasion of Ukraine, the consensus was that prices globally would climb 5.3% by Q2 2022, from 4.7% in Q4 2021 before easing to around 4% by the end of 2022. The call participants noted that we need to recognize that Russia, Ukraine, and Belarus are huge exporters of critical commodities, such as oil, food, fertilizers, and minerals, and that we must weigh the impact of reduced supply of these commodities on inflation. The rise in oil and other commodity prices, along with fresh supply-chain shocks, could push inflation higher than previously expected.
Central Bankers Must Thread the Needle
On the policy front, the Federal Reserve (the Fed) and other major central banks are facing particularly uncertain conditions as they attempt to calibrate their monetary policy real-time, while assessing changes in both demand and supply. The problem the Fed has been facing over the past two years is the presence of both demand- and supply-side shocks.
Aggregate demand has surged beyond what policymakers expected, while there have been intense supply-side pressures as supplies dried up in many industries due to supply-chain disruption and difficulty meeting the surge in demand. Aggregate demand is expected to slow naturally as COVID-related demand eases and fiscal stimulus rolls off. Further, there is a possibility that rising oil and commodity prices reduce demand as household budgets are stretched and households reduce their savings rates. Supply-chains bottlenecks had been expected to ease, but the Ukraine-Russia conflict could further disrupt supply chains in some sectors. With the outlook for demand and supply conditions being particularly uncertain, policy decisions, which will hit the economy with a lag, become very difficult. There is now a greater chance of a policy mistake.
Given the uncertainties, the Fed is likely to be somewhat cautious going forward. With inflation high, it still needs to tighten policy. At the same time, the Fed hopes to avoid pushing the economy into a recession as it battles inflation, which is, to a large extent, fueled by a supply shock. Consensus expectations on the number of Fed rate hikes this year have been falling recently, and the Fed funds rate may end 2022 near 1%. However, given the significant uncertainty, there are alternative scenarios under which the Fed could tighten significantly and finish the year with rates around 2%.
Overall, call participants highlighted the need to remain cautious given the uncertain environment. While the odds of a recession in the next 12 months are low, the risk of recession is elevated compared to what it was a few months ago as the markets try to gauge the impact of the geopolitical crisis in Europe. While the yield curve is expected to flatten, the risk of recession is low since the long end of the yield curve is anchored by macroeconomic and geopolitical variables and prospects for the US economy still appear solid, although with significant uncertainty
While there are diverse predictions as to where the Fed funds rate will be at the end of 2022, the 2% mark is likely to be a magnet for the ten-year Treasury yield, as it looks more likely that the Fed will successfully deliver a soft landing given the strong starting point for the US economy. Stocks and other risk assets are expected to remain under the cloud of uncertainty in the near term as the war continues to unfold. While fundamentals prior to the invasion of Ukraine were solid and valuations had improved, the uncertainty engendered by the conflict in Europe points to the need for caution in the near term.
WEBINAR SUMMARY - THE WORLD ON THE BRINK: UKRAINE, RUSSIA, AND THE GLOBAL ECONOMY
The events unfolding in Ukraine have shocked and saddened the world. The human suffering is incalculable, and the financial and economic consequences of the war are already substantial and likely to grow. PGIM brought together a host of experts to discuss the ongoing conflict and its ramifications, and the following are brief highlights of the discussion, which can be watched in its entirety here.
- The role of sanctions: Perhaps the most significant of the many sanctions imposed on Russia and its leaders is the decision by Western countries to freeze Russian central bank reserves. The goal is to decouple the Russian economy from the global economy in the hopes it will collapse and pressure President Putin to end the onslaught. Until then, it’s likely sanctions will be further imposed. Closer to home, states are issuing executive orders largely focused on having state pension plans divest of Russian investments.
- The energy impact: There is also growing global sentiment for further energy-related sanctions against Russia, and one potential outcome of the crisis is the likelihood that the push for a greener economy will accelerate. The political will in Europe is strong to diversify away from a dependence on Russian oil, and Russia’s actions in Ukraine have further opened Europe’s eyes to the significant risk that dependence presents to the continent. The transition won’t happen overnight, however; the investment required to get there will be massive, and the world will need to realistically recognize that the answer isn’t to shut off all investments in fossil fuels.
- The fate of inflation: The Fed and other central banks are in a difficult spot. Even prior to the invasion, central banks were coming off the longest period of low, zero, or even negative rates in history, making normalization tough enough to begin with. After decades of disinflation there has now been a sharp acceleration in inflation, on the heels of huge fiscal response in light of a crippling pandemic. Navigating it all in the current environment will be a challenge, and it’s likely the Fed will be more cautious in raising rates, though a 25-basis-point hike this month seems certain as of now.
- Is there contagion risk?: While Russia’s is a relatively small economy, it is intertwined with key areas globally, notably oil, grains, fertilizer, and many other commodities. There will be fallout around the world - the US was already grappling with high inflation, which is likely to continue - and standing up to Putin won’t be pain free for the West. That said, the impact on the Russian economy will be many times worse, and it’s likely this leverage will become important in resolving the crisis.
- Second-order effects: The near-term impact of the invasion has already been devastating, but there may be long-term favorable developments. After a long period in which Russia was able to expand its influence with little pushback from the West, a more united free world is a positive. From a geopolitical point of view, Germany embracing the notion of hard power is an important development. The invasion has also likely paved the way for a more strategic Europe, one with strong transatlantic relations. Finally, the future of Putin himself will be heavily defined and perhaps determined by his actions in Ukraine.