Listening for the Tectonic Shifts
Salient developments will shape financial markets over the next year, but listen for sounds of more structural shifts in the economic and political order as well.
In a spring full of disorienting headlines, the three most salient developments have been the continuing commodity price spikes from Russia sanctions, the COVID lockdowns that threaten Chinese growth, and the hawkish turn by some of the world’s largest central banks. These will shape financial markets most over the next year, but listen for sounds of more structural shifts in the economic and political order as well. Sooner or later, these will shape markets, too.
For now, we continue to give slightly better odds to our Stagflation Shock scenario, which has rising prices taming growth later this year. But we acknowledge that recovery momentum remains strong, which could deliver growth and inflation that linger Higher for Longer. Our Fine Balance scenario, in which prices moderate on their own as supply chains normalize, now looks like a longshot.
The U.S. economy remains robust with workers enjoying strong wage growth and ample savings buffers. Spending still looks healthy and the latest PMI surveys record strong activity. It’s still hard to imagine a U.S. recession anytime soon, but consumer spending will surely cool as food, fuel, and housing costs all move higher.
We are also keeping a close watch on long-term inflation expectations. These have been anchored so far but could deliver a longer period of higher prices without hurting growth. Commodity shortages and slow normalization of supply chains predate the Ukraine war and may signal something more enduring.
In Europe, the labor market is still strong and spending looks healthy, but the shocks from Ukraine are obvious. Lining up alternative energy suppliers may come over a few years, but the transition will add to the continent’s costs. Governments are helping cushion the blow with tax cuts and subsidies. Strong reopening momentum and a relatively accommodative European Central Bank could deliver above-trend growth, but a sudden embargo on Russian energy threatens recession.
Here, too, there are deeper shifts afoot as the continent digs in on its commitment to Kyiv and isolation of Moscow. This will mean finding new trading partners to replace Russia and more defense spending. This comes on top of large spending promises to accelerate the green transition and a fresh attempt to rethink the iconic spending limits within the Maastricht Treaty.
In Asia, the most worrying news has been China’s fresh outbreak of COVID that has triggered lockdowns covering nearly one-third of the population and scuppered the recovery in domestic consumption. The impact on production appears limited so far, but global supply chains may soon feel additional disruptions. Meanwhile, the Bank of Japan persists with its policy of yield curve control to bolster economic growth, even as the yen plumbs new depths amid rising global rates.
The much bigger shift looks underway in Asia, as Russian sanctions divide its major economies. The Chinese government continues to offer tacit support for Moscow, and other regional economies may expand their Russian trade in spite of U.S. warnings. These tensions likely won’t affect the durability of this economic cycle but may well alter long-term investment flows that give shape to the next.
If it feels like the ground beneath your feet is shifting, it is.
By: Christopher Smart