Coming into the year, we were thinking that 2022 would likely be a year of normalization. Then Russia invaded Ukraine in late February. The conflict clouded the economic outlook, particularly in Europe, and severely disrupted the normalization that had been taking shape across global growth, inflation, supply chains, and consumer demand.
The upshot is that we now find ourselves at the crossroads of a long-term structural shift in global levels of inflation, coupled with elevated short-term volatility driven by geopolitical events and a rapidly tightening liquidity environment. In our view, this set of circumstances has spawned three large macro dislocations that capital markets have yet to price in accurately.
1 Monetary and fiscal policies across Europe
The first such mispricing is a broad investor underappreciation of “inflecting” policy dynamics across major developed market (DM) central banks. Over the past 12 years, these central banks bought a cumulative total of around USD$20 trillion in assets (as of April 30, 2022), which acted to suppress market volatility and term premiums. This buying spree is now ending and, in fact, going into reverse. This year could be the first year in more than a decade when global central banks in aggregate become net sellers of sovereign bonds.
Notably, the European Central Bank (ECB) recently shifted to a decidedly more hawkish monetary policy stance, with policymakers now more determined to confront and hopefully subdue mounting inflation – and this despite fears that the ongoing war in Ukraine could drag Europe into recession, given the region’s reliance on energy imports from Russia. In effect, rather than depressing market volatility as in the past, the ECB and other central banks could actually become a source of volatility into 2023.
A related implication of the Russia/Ukraine crisis will likely be larger and more enduring fiscal deficits across Europe, where many nations will seek to finance accelerated timetables to rearmament (read: increased defense spending) and greater energy independence (read: higher household energy costs). That could fundamentally change the euro area, including how we think about German bunds, potentially leading to a long-term move back to pre-eurozone-crisis levels.
Increased lending, rising interest rates, and wider credit spreads should provide tailwinds for European cyclical industries, specifically financials. Additionally, we expect surplus capital investment to drive interest rates even higher, which would affect holders of European duration.
2 Persistently low capex by commodity producers
Across commodity-producing companies globally, investment spending has continued to be quite low relative to history, which has important implications for the lead times required to bring new production capacity online when global demand for commodities is high.
The market has been intently focused on supply chain bottlenecks being a primary cause of today’s inflation, but we believe that even after those issues have been resolved, adequate supplies of raw materials may still not be available. Following years of overinvestment into rising commodity prices, capital expenditures (capex) by commodity producers have been minimal for several years now and may not increase meaningfully anytime soon. For example, despite surging oil prices, we have still not seen a substantial response from suppliers, which may continue to more than offset demand shortfalls. Similar trends are occurring across metals and mining producers, whose annual capex spending is at or around 50-year lows
This discipline on the part of many commodity producers is anchored in their not-too-distant memories of weaker-than-anticipated prices and negative cash flows, leading to an emphasis on return over volume, long-term regulatory and energy transition-related uncertainty, and a generally tight economy limiting their ability to add capacity. Without an uptick in investment spending in these areas, this phenomenon will likely translate to higher commodity prices on balance, keeping inflation stubbornly above central bank targets.
3 Emerging markets: Late-stage tightening cycles and more
Despite recent bouts of market volatility, we are becoming more constructive on emerging markets (EMs), specifically countries that stand to benefit from rising commodity prices, capital outflows from China, and the closure of Russian commodities markets.
While investors have historically tended to bucket EM fixed income into a single broad category, we believe a more nuanced approach is called for to exploit the variations that exist across the constituents of EM indices. For example, unconstrained EM allocations may help to better identify pockets of opportunity within various regions and countries. Significant differences in EM central bank policies, import/export dynamics, and currency behaviors have arisen recently, all of which should lead to larger relative dispersions among individual countries’ fixed-income market returns (rather than all of them trading as a bloc.).
Moreover, several EM central banks are toward the latter stages of their interest-rate hiking cycles. These EM countries were early to raise rates in an effort to stem inflation, while developed market (DM) central banks kept their rates low to ease financial conditions and prolong the so-called easy money cycle. Much of the initial pain associated with more hawkish EM rate-tightening cycles has already been absorbed by these countries, unlike their DM counterparts. With policy rates much higher than the developed world there is room for these central banks to start cutting rates if disinflation should take hold.
Quick investment takeaway
Against this still-uncertain global backdrop, we see potentially more attractive return opportunities in European value assets and select emerging markets than in the United States through the remainder of the year. More broadly, we believe unconstrained and opportunistic investment strategies may be well suited to navigating this market environment.
This material is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise. John Hancock Investment Management and its representatives and affiliates may receive compensation derived from the sale of and/or from any investment made in its products and services.
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Currency transactions are affected by fluctuations in exchange rates, which may adversely affect the U.S. dollar value of a fund’s investments. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions.
The subadvisors’ affiliates, employees, and clients may hold or trade the securities mentioned, if any, in this commentary. The information is based on sources believed to be reliable, but does not necessarily reflect the views or opinions of John Hancock Investment Management.