Impact of the drive for energy security

• We see the West’s drive for energy security slowing growth, increasing inflation and stoking demand for non-Russian fossil fuels to alleviate consumer pain.
• Data last week showed U.S. inflation at 40-year highs and a robust labor market. We expect the Fed to deliver on this year’s projected rate rises and then pause.
• Global activity gauges this week may show how surging commodities prices are affecting global economies. We see Europe as most vulnerable to the shock.

The West is trying to wean itself off Russian energy in the wake of the tragic war in Ukraine. We see this hurting growth and increasing inflation in the short term. More supply of U.S. and other non-Russian fossil fuels will be needed to alleviate pressured consumers. This is a shift in global supply, not an increase. The drive for energy security should reinforce the transition to net-zero carbon emissions in Europe, and we see the transition’s speed now diverging more across regions.

Europe’s energy conundrum

The war in Ukraine is taking a horrible human toll, upending lives, and resulting in food and energy insecurity around the world. It has spurred a drive to secure energy supplies and led to price spikes – presenting a fresh supply shock in a
world that was already shaped by supply. Among developed markets, the situation is acute in Europe. A surge in European energy prices means the region is now spending almost a tenth of its GDP on energy, the highest share since 1981. See the red line in the chart. This is why we think the impact of the energy shock will be greatest in Europe, and we see a risk of stagflation there. See Taking stock of the energy shock of March 2022 for full details. The U.S.’s energy burden (yellow line) is less than half Europe’s. We expect the energy shock to hit U.S. consumers and businesses, but see a much smaller economic impact than in the late 1970s. Why? The economy is more energy efficient these days, and the U.S. is now a net exporter of energy. We see U.S. growth staying above trend, thanks to the strong underlying momentum from activity restarting after the pandemic shutdowns.

The scale of the impact depends on the speed at which the West reduces its imports of Russian energy. Our base case is a steady reduction as the West and Russia enter a protracted standoff. Further escalation of the Ukraine war could speed this up. An easing of tensions could slow the process but is unlikely to stop it.

All this means Europe will need greater amounts of gas and other fossil fuels from the U.S. and elsewhere. The massive gap cannot be filled fast enough by ramping up the supply of renewables and nuclear energy or reducing demand via efficiency and conservation measures. Fossil fuel output in the U.S. and elsewhere needs to rise to make up for the shortfall caused by the effective stranding of Russian production. It is a shift in fossil fuel production, not an increase in demand.

This doesn’t mean the net-zero transition is being derailed, in our view. The world needs fossil fuels to meet current energy demands, given the way economies are wired today. At the same time, high energy prices ultimately reinforce the drive to cut carbon emissions. Why? They act as a sort of carbon tax on consumers, make renewables more competitive, and spur energy efficiency and innovation. Higher energy prices will hurt U.S. consumers as well, but also herald increased U.S. fossil fuel output. As a result, we may not see the same impetus to reduce emissions there as in Europe. Conclusion: We see the transition’s path diverging even more across regions.

What does all of this mean for investments? On a tactical horizon, we are underweight government bonds and prefer equities over credit in the inflationary environment. Many DM companies have been able to pass on rising costs, and we see low real rates, the restart’s economic growth cushion and reasonable valuations favoring equities. We have cut our overweight to European equities as we see the energy shock hitting that region hardest. Also, prices have rebounded from the year’s lows. In addition, we see the shock creating investment needs in both traditional energy and renewables in the near term. The transition requires the world to go from shades of brown to shades of green, in our view.

On a strategic horizon, we have long argued that a tectonic shift of investor preferences toward sustainability would trigger a great repricing of assets across the board over time. This is why we incorporated climate change in our return and risk assumptions. We now have evidence of this repricing, and believe most of it is yet to come. This doesn’t mean sustainable assets always go up – but we believe it should add to their performance over time.

Market backdrop

U.S. inflation data for February showed price increases hovering near 40-year highs. The report showed a further rotation back to services spending as the economy, and away from goods spending. Jobs data showed a robust labor market. We see the Fed normalizing policy and delivering on its projected rate path this year but then pausing to evaluate the effects on growth. We believe the eventual sum total of rates in this cycle will be historically low, given the level of inflation.

Assets in review
Selected asset performance, 2022 year-to-date return and range

Macro insights

The fallout of the war in Ukraine looks set to hurt economic activity in Europe substantially more than in the U.S.
Consumer confidence in the euro area has taken a knock almost as big as it faced at the start of the pandemic, as the
orange line in the chart shows. European businesses also appear less confident about the next six months. A survey of
German firms by the Ifo Institute reveals the sharpest decline in expectations on record (yellow line). The reverse is true in the U.S. A Philadelphia Fed survey of non-manufacturing companies shows a pick-up in sentiment (pink line).

This aligns with our view that the European economy is more at risk than the U.S. from the commodities shock. It also
shows the shock is broader than the effect of higher energy prices alone. For example, supplies of key production
components such as car parts have been disrupted, posing extra risks for manufacturers. Plus, dented confidence can
drag down consumer spending and business investment. We think consumers are now less likely to spend excess savings built up during the pandemic. See our macro insights.

European sentiment plunges
Euro area and U.S. survey data, 2020-2022

Investment themes

1 Living with inflation

• We expect central banks to quickly normalize policy. We see a higher risk of the Federal Reserve slamming the
brakes on the economy to deal with supply-driven inflation after raising rates for the first time since the pandemic.
• The Fed has projected a large and rapid increase in rates over the next two years. We see the Fed delivering on its
projected rate path this year, but then pause to evaluate the effects on growth.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting
rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
• We believe the eventual sum total of rate hikes will be historically low, given the level of inflation. DM central banks
have already demonstrated they are more tolerant of inflation.
• The Bank of England hiked rates for a third time but signaled that it may pause policy normalization on concerns
about the growth outlook from spiraling energy costs. This is the bind other central banks will likely face this year.
• The European Central Bank has also struck a hawkish tone, planning to wind down asset purchases and leaving the
door open for a rate increase later this year. We expect it to adopt a flexible stance in practice given the material hit
to growth we see from higher energy prices.
• Investment implication: We prefer equities over fixed income and overweight inflation-linked bonds.

2 Cutting through confusion

• We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and
new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
• We saw the confusion play out with the aggressively hawkish repricing in markets this year – and central banks have
sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to
contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
• The sum total of expected rate hikes hasn’t changed much even with the Fed’s hawkish shift.
• Investment implication: We have tweaked our risk exposure to favor equities at the expense of credit.

3 Navigating net zero

• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that
investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
• The West’s decision to reduce reliance on Russian fossil fuels will encourage fossil fuel producers elsewhere to
increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater
energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter
than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher
inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match
governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from
the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.

Directional views
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, April 2022

Granular views
Six- to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, April 2022