The erosion of purchasing power

War, inflation and the lingering impact of a global disease, made the first quarter of 2022 a historically rough one for investors.  Concerns over the economic implications of the Russian invasion of Ukraine and the potential need for a faster pace of interest rate hikes to combat higher inflation, weighed on both equities and bonds.  Russia is a major energy and commodity producer and the escalation of tensions pushed energy and commodity prices to extreme levels, exacerbating the surge in inflation, supply chain disruption and the risk to global growth.

From an economic perspective, inflation is likely to remain a major area of concern in the second quarter of 2022.  The war in Ukraine has been dominating the headlines for more than a month now and, from an economic perspective, that has greatly increase uncertainty regarding inflation and growth prospects.  When and with what consequences this war will end is pure speculation at this stage, but capital markets should gradually continue to build a certain immunity to the headline risks in the coming weeks. The medium- to long-term consequences, on the other hand, could be enormous.  

It is possible that we are at the beginning of a new bloc formation or a new Cold War.  The war in Ukraine has made Western countries painfully aware of their dependence on authoritarian states.  This is likely to drive deglobalisation, with procurement security taking precedence over the cheapest possible sourcing strategy.  This in turn could further fuel higher structural inflation.

Consumers on both sides of the Atlantic are already today struggling with high inflation.  Data last Friday revealed that the annual inflation in the eurozone spiked to 7.5% in March from 5.9% the previous month and similarly to the US, the inflation rate is now almost 4 times above the ECB target of 2%.

With inflation this high, consumers’ purchasing power is literally melting away like snow in the sun.  In the US, private consumption accounts for 70% of gross domestic product and is therefore the main driver of economic growth.  Thus, the big question now is how strongly rising prices will dampen consumption and impact growth.  At the same time, the Federal Reserve is determined to fight inflation by all means.  But if it tightens monetary policy too quickly, this could slow corporate activity and lead to an increase in unemployment.

The risk of stagflation – the combination of weak economic growth and high inflation – has increased in recent weeks.  On the one hand, the growth outlook for the second half of the year has been reduced and, on the other hand, inflationary pressure remains high due to the Ukraine war.  Against this background, the Fed has reduced the GDP growth forecast for 2022 from 4% to 2.8%.  Although this is still above the expected potential growth, the anticipated interest rate hikes during the year could further weaken consumer confidence and strain investors’ nerves again. 

The big unknown is when and how quickly inflationary pressures will ease again.  This could be driven by an easing on the supply side, because the supply chains are functioning again, or on the demand side, triggered by lower growth.  While the first scenario is still possible today, the war in Ukraine could delay or even stall the synchronisation of supply chains.

From an equity market perspective, the above scenario still warrants an overweight position to US equities compared to Europe and emerging markets.  This is a purely relative view, as both economic and earnings growth in the US will experience significant drags, while monetary tightening brings risks of further valuation multiples contraction.  On the other hand, the degree of self-sufficiency in energy, the high liquidity in quality stocks and the massive share buyback programmes lend a certain degree of quality and stability to the US equity market.  

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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