The war in Ukraine introduced extreme geo-political uncertainties to an outlook growing increasingly cloudy. Until the invasion, the key variables in our outlook for 2022 were the pandemic and inflation. We believed the Endemic Phase of the pandemic would facilitate greater re-opening of global economies. Re-opening would depend on uncoordinated and inconsistent health policies. China’s zero-COVID policy is a prime example. China’s government locks down cities with more than 10 million people because of a single case. We, therefore, expected that further supply chain disruptions would persist as a major source of inflation but believed future disruptions would prove shorter and less impactful. Prior to the Ukraine conflict, we were confident pent-up demand would drive economic activity, but the Fed’s aggressive policy stance toward surging inflation could slow growth.
For the first time since 2020, COVID became secondary in terms of media coverage. The First Quarter witnessed a daily avalanche of information about inflation and Ukraine. Volatility spiked as the stock market suffered a meaningful correction, but it nearly fully recovered by the end of March. In addition, market participants became fixated on an anomaly known as an inverted yield curve.
Short maturity Treasuries tend to be sensitive to monetary policy. When the Fed raises rates, there is a corresponding rise in yields for short-term Treasury notes. Longer maturity Treasuries tend to be sensitive to long-term inflation expectations. Declining yields for longer maturity Treasuries suggest inflation expectations should moderate, possibly as the result of tighter monetary conditions. Historically, whenever short-term yields exceeded long-term yields, the economy entered recession 12 – 18 months later. An inverted yield curve, in other words, is a lead indicator of a “policy-induced” recession.
The inverted yield curve is a classic example of correlation, not causation. Thus, we caution against excessive reliance on a single indicator. Moreover, there is a limited sample set with which to conduct statistical analysis. We are disinclined to abandon our generally constructive outlook for 2022 simply because the yield curve inverted.
However, we acknowledge the global economy was unprepared for additional supply shocks. In addition to the disrupted flow of energy to Western Europe, Russia and Ukraine are large exporters of agricultural products. Sharp spikes in food and energy costs are the equivalent of a consumption tax. Consequently, we expect economic data in the second and third quarters will reflect a “crowding out” of spending on discretionary items. There is already evidence of what economists refer to as “demand destruction”. The duration of the Ukraine conflict will determine the extent to which high food and energy prices curtail other consumption. It is possible that declines in consumption activity could influence future Fed policy actions.
Russia’s invasion resurrected Cold War geo-political frameworks and prompted prognostications of the end of globalization. We would note that global trade peaked during the Great Financial Crisis, and it is possible that COVID and Russia-Ukraine accelerated established trends. It seems clear that the combination of COVID and Russia-Ukraine has incentivized nations and companies to diversify their suppliers and partners. We expect a lengthy period of investment to erect redundancies, to stockpile inventory, and to avoid single points of failure. Over time, the intensity of the geo-political situation should diminish, but we expect the Russia-Ukraine conflict could have long-term and profound economic implications. We caution against drastic, reactive shifts in investment strategy, but we acknowledge an unsettled economic back drop could require adjustments.