Economy and financial markets

The likelihood of a “stagflation scenario” has increased, indicating a more difficult environment for financial markets.

11/04/2022
Stock-markets
Read full reportQuarterly Report 1Q2022 - English - FINAL
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Authors

Giovanni Leonardo
Investment Wealth Management
Norbert Brestel
Head of Investment Solutions Switzerland

Growth worries now joined by inflation fears

Coming on top of fears of inflation, the Russian invasion of Ukraine has significantly weakened global growth prospects, and the already high rate of inflation is expected to accelerate even further. The likelihood of a “stagflation scenario” – high inflation with low growth – has increased, indicating a more difficult environment for financial markets. In our investment strategies, we have successively improved protection against inflation since the beginning of the year and remain defensive in government bonds. We have taken account of the increased geopolitical risks by reducing our equity exposure to neutral.

Some of us will remember that 1989 marked the fall of the Berlin Wall, the end of the Cold War and the beginning of globalisation. Although somewhat critical at the beginning, we have become accustomed to the fruits of globalization over the years and peace in Europe is seen as the natural state of affairs. So natural that we forget why the European Union came into being and why it is important. Since 24 February, we have seen Russia’s invasion of Ukraine undo all the achievements of recent decades. This invasion is an unimaginable humanitarian tragedy in the heart of Europe and, with thousands of deaths and more than three million refugees, marks a serious setback in its development since the fall of the Berlin Wall. Whether we are taking a leap back in time to the Cold War era, we do not yet know, but there is certainly no way back to the situation before the invasion.

The current economic outlook is very different from our expectations a few months ago when the world seemed to be heading for another year of above-average growth. Economically, the invasion of Ukraine could significantly dampen global growth and even push some countries into recession. Nevertheless, we expect global economic growth to remain positive. In contrast, the already high inflation is likely to rise further, as Russia and Ukraine are major suppliers of energy and food worldwide. The combination of high inflation and low or negative growth is called “stagflation” – and tends to be a difficult environment for financial markets. In this scenario, corporate profits come under pressure as costs rise faster than revenues. Bond markets also struggle under such conditions, as investors demand higher yields to compensate for inflation. It is still possible that such a scenario can be avoided or mitigated thanks to diplomatic efforts, but the risks are increasing.

Central banks are once again in an impossible position, and due to the immense mountain of debt, the Covid crisis and the war that has now broken out in Ukraine, tightening the monetary policy reins too much could prove fatal. Markets have already priced in many rate hikes for the US and are expecting less in Europe. Over the past decade, central banks have shown us that they are capable of preventing crises from turning into a depression by skilfully using the tools at their disposal.

In our investment strategies, we have invested in commodities, gold and inflation-protected fixed income since the beginning of the year in order to benefit from their inflation protection features. In the case of government bonds, we are defensively positioned and keeping duration short in order not to be caught on the wrong foot by any interest rate hikes. We have taken account of the increased geopolitical risks by reducing our equity exposure to neutral. Equity selection has been more focused on dividend and quality strategies.

Giovanni Leonardo 

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Read full reportQuarterly Report 1Q2022 - English - FINAL
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Authors

Giovanni Leonardo
Investment Wealth Management
Norbert Brestel
Head of Investment Solutions Switzerland

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