The Outlook for Q2 of 2022

by Sean Tweedie | April 13, 2022

As we transition into the second quarter of the year, we look at the various factors at play that have an impact on the markets.

The war between Russia and Ukraine is still a hot topic amongst investors. It continues to weigh on sentiment and poses a significant risk to global growth. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire however they could turn out to be a hoax, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but one can expect more fighting in the near term. Putin will need to ensure his legacy among his fan base in Russia is upheld which can only be done through an outright win of the war to ensure Ukraine’s military neutrality. In turn, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarizes and swear off joining NATO unless Russian forces first withdraw.

The direct effect of the war on the global economy is likely to be relatively small. Together Russia and Ukraine account for 3.5% of global GDP. Exports to Russia and Ukraine only amount to 0.2% of G7 GDP. For the most part, corporations have little direct exposure to Russia, although there are a few exceptions. See Figure 1.

Figure 1

In contrast, the indirect effects are significant. For one, Russia is the world’s second-largest producer of oil, accounting for 12% of annual global output, and the world’s foremost exporter of natural gas. Half of Europe is reliant on Russian natural gas exports. Russia and Ukraine are also significant agricultural producers. Collectively they account for around 25% of the world’s wheat exports with much going to the Middle East and North Africa. See Figure 2.

Figure 2
Additionally, Russia produces two-thirds of all the ammonium nitrate which is the main source of nitrogen-based fertilizers.

The war has seen commodity prices rise. Initial estimates are that the higher commodity prices will likely displace some spending on goods and services. This will impact negatively on global growth. Not only are energy prices rising but so too are food prices which leaves many emerging market economies vulnerable. Additionally, the imposition of sanctions will negatively impact the global supply chain, particularly due to the further delays in semiconductor production. Most semiconductor-grade neon (which is used in high-precision lasers) comes from Ukraine. This is exacerbated by additional logistical delays in the shipping industry and raised air freight costs because of the avoidance of contested airspace.
See Figure 3.

Figure 3
Importantly, investors should keep an eye on Covid-19 developments. The latest strain of Omicron, BA.2 appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, and parts of Asia, and has begun to rise in North America.

In China, the authorities have locked down Shanghai, home to 25 million people. Unfortunately, China’s success in suppressing the virus has left much of its population with little natural immunity as well as little artificial immunity due to the questionable efficacy of its vaccines. China’s zero-Covid policy means that they are more likely to adopt severe lockdown restrictions which in the near term poses a risk to growth.

Under conventual circumstances the job of Central Banks is difficult. On the one hand, they must tighten quickly enough to keep long-dated inflation expectations anchored. On the other hand, the Fed wants to avoid tightening so quickly that it causes a recession. U.S inflationary expectations have not yet unanchored to the topside, yet the war has increased the odds that it might. The commodity price shock, as well as the additional impact on the global supply chain that we noted, will create additional price pressure in the months ahead relative to what would have otherwise been the case. The Federal Reserve will likely raise the Fed funds rate to around 2.8% by the end of 2023. The OIS (Overnight index swaps) curve suggests a 50-basis point hike at the May meeting. The impact that this has on the currency depends largely on what other Central Banks are doing.

While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If U.S inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar. The dollar is a countercyclical currency: It usually weakens when global growth is strengthening more relative to U.S growth and strengthens when global growth is weakening relative to US growth. Should the political landscape stabilize, and pandemic worries subside, global growth should see an increase which will provide a headwind to the dollar. The dollar is also overvalued by around 20% on a Purchasing Price Parity basis, meaning that over the longer term the dollar is due for a correction.

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