The first quarter of 2022 has been highly eventful. January’s market turbulence was caused by an increasingly hawkish Federal Reserve (the Fed) and February’s was caused by geopolitically induced volatility due to the conflict in Ukraine. March was a mixed month with most equity markets rallying but with typical flight to safety assets such as sovereign bonds struggling.

What all three months of the quarter to date have in common is the continued acceleration in CPI inflation which, as of the last print, stands at a 40 year high of 7.9% in the U.S. This compares to the Fed’s target inflation rate of 2%. Admittedly the Fed tends to track PCE which usually runs lower than CPI but even this is 6.4%. Whatever inflation measure one uses the picture is the same. This is not just a U.S. problem, inflation in the Euro area stands at 5.9%, the highest since the formation of the single currency.

Markets have been taking stock of this accelerating inflation and pricing in ever aggressive tightening of Fed policy. As can be seen from the graph below this is captured in the implied December 2022 Fed Fund Rate. This shows what the market expects the base U.S. interest rate to be in December 2022. As can be seen, at the beginning of the year this was forecast to be 0.8% and is now just below 2.5%

Even before the Ukrainian conflict, inflation was becoming a problem with the Fed dropping the word “transitory” when referring to inflation late last year. The conflict has just added further fuel to the fire with commodity prices spiralling as markets fear significant supply constraints. Some of these constraints are not necessarily short term either; for example Ukrainian farmers have to start planting various agricultural crops shortly for next year’s harvest. Clearly this Spring’s planting season will be disrupted leading to shortages next year.

As well as the implied Fed Funds Rate, another key metric investors look at is the steepness of the U.S. yield curve, that is, the difference between short term interest rates and longer term interest rates. One such metric is the so called 2s 10s, the difference between the yield on a 2 year US Treasury bond and a 10 year Treasury bond. When the 2 year yield is higher than the 10 year yield, many investors see this as a predictor of a recession. It’s important to bear in mind that historically the average period between this occurring and a recession has been 18 months but nevertheless this is an ominous sign for the years ahead.

The economy is decelerating from its unprecedented 2021 pandemic recovery speed but is still expected to expand in 2022 at twice the pace of its long-term trend growth rate. Wage and employment cost growth have also accelerated to the highest levels in the post-Global Financial Crisis era, whilst consumer price inflation is at a 40-year high. However, consumers, corporations, and banks are cash rich, and remain in a good position to withstand higher borrowing costs as the Fed prepares to increase interest rates to tame inflation. The labour force participation rate continues to rise slowly but is still notably below its pre-pandemic level, despite 2 million young workers entering the workforce during the pandemic.

Economic growth expectations for 2022 are decelerating quickly as sanctions on Russia and escalating commodity prices bite. Consumer sentiment remains resilient relative to other regions and savings should provide a meaningful buffer. Consequently, Eurozone inflation expectations are converging towards US inflation expectations as the Ukraine crisis worsens, translating into an energy crisis. French President Macron is the clear frontrunner for re-election in April.

Rising consumer price inflation has now hit the highest level since 1992, caused in part by surging energy bills. A triple whammy of rising inflation, increasing interest rates, and higher taxes are expected to hurt household disposable incomes and could cause a cost-of-living crisis, potentially pushing the British economy into stagflation.

Japan’s economic recovery still lags behind other major economies but is catching up and helped by a recently announced large fiscal stimulus package from newly elected Prime Minister Kishida. Headline consumer price inflation has accelerated to above long-term levels and is gathering momentum, but core inflation excluding food & energy prices has fallen back deeper into deflationary territory indicating that most of Japan’s inflation has been imported.

Chinese property curbs and zero covid policy have substantially constrained credit demand from the property and consumption sectors. However, the broader economic slowdown is moderating as the credit and aggregate financing cycle is bottoming and tax cuts are being implemented, a sign of policymakers’ determination to stabilise the economy and boost consumption growth. Unlike most global economies, inflation pressures are low and still retreating in China, resulting in the PBoC being the only major central bank to cut interest rates this year.

Despite a buoyant global economic recovery in 2021, the BRITS economies are still expected to grow at an even pace this year relative to their developed market counterparts where policy support has been greater and vaccination programmes have been more widely available.

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