Pandemic, war and fixed income – undeterred by volatility

How can we navigate market shocks?

Lenin once said ‘there are decades when nothing happens, and then there are weeks when decades happen’. Well, we have been living in a decade of major shocks and are going through weeks that have already been more disruptive than most people’s entire lifetimes.

The global economy and markets, indeed, the entire international system, are under assault. Just as the world was starting to emerge from the most severe pandemic in a century, comes the largest, most disruptive war at the heart of Europe since World War II.

The humanitarian tragedy is already beyond words, inflicting loss of lives and livelihoods that can never be overcome. Collateral damage to the Ukrainian and Russian economies, plus knock-on effects on the rest of the world, will take much time to repair.

As the invasion began, much of the world economy including the US, Eurozone (EZ), UK and many Emerging Markets (EMs) were growing fast. But inflation was already persistent, and increasingly broad-based across many countries and day-to-day items.

War and retaliation threaten to bring down growth but boost inflation. This is due to the importance of Ukrainian and Russian exports of grains, energy, metals and minerals.

So, as citizens, savers and investors we face a mix of uncomfortable realities and uncertainties that make it hard to know how to think about the economy and markets.

Looking through the long-term effects of pandemics and conflicts on inflation, growth and the behaviour of markets, we have a key takeaway:

Eventually, crises pass, as a resilient world economy and financial markets regain their footing.

Pandemics = deflation, but wars = inflation, throughout history

History has shown that major pandemics have almost always been deflationary and wars, inflationary. It is intuitive, as wartime governments mobilise entire societies and economies. That’s because people and production are drafted into the war effort, and physical capital and productive capacity are destroyed. 

Plus, currencies are often debased as money is printed to finance the war effort. War bonds are issued, which savers and financial institutions are encouraged or required to buy at below market interest rates. Wars are inflationary from both a monetary perspective and in terms of the pressure on real resources.

Pandemics are deflationary. Societies have locked down in response to severe outbreaks of new diseases since the Plague of Justinian. Lockdowns demobilise the economy – almost the exact opposite of a war.

Demand is destroyed, or at least suspended, but not supply. Past pandemics often killed large swathes of peoples, comparable to major wars, reducing consumer demand (and the workforce). But, usually, physical productive capacity was untouched with the net effect tending to be demand deflationary.

Historic pandemics and wars accelerated economic cycles

Typically, growth and inflation move in the same direction. Private demand and public policy – both central bank monetary policies and budgetary policies – are aligned.

Historically, pandemics or wars have had a similar impact to conventional upturns and downturns on markets. But their effects have been even more pronounced, like an economic cycle on steroids.

The effect of wars and pandemics on interest rates – and hence on bonds – is opposite. High inflation, and the pressure on real economic resources, have typically driven up interest rates in and after wars. But real rates usually fall.

The impact of wars and pandemics on labour markets and wage rates is more mixed. Wages tend to rise after pandemics largely because workers have more bargaining power. Waging major wars often led to a shortage of labour, but returning soldiers also needed work.

Supply shocks, wars and revolutions in commodity producers have caused “Stagflation”

In modern times, wars and revolutions have sometimes been accompanied by major supply shocks. This has been particularly noticeable for crucial commodities needed for energy, such as oil, and contributes to rising inflation.

Stagflation refers to high and rising inflation despite falling or negative growth. When wars have been concentrated in commodity-producing countries, like today’s Russia/Ukraine conflict, with limited direct impact on commodity-importing countries, the result has often been “stagflation”.

In supply shocks, unlike conventional cycles or historic wars and pandemics, growth and inflation have pointed in opposite directions. 

Pandemics, wars and markets – is this time different?

How does this all apply to today’s global economy? We believe there is a strong case that this time is different in terms of both pandemic and war.

In the COVID-19 pandemic, we avoided the traditional deflationary pressure of pandemics. We saved jobs, replacing income for those who could not work, and kept the economy generally afloat. We did not see deflation and, if anything, high inflation.

In the Russia/Ukraine war, an interruption in global energy, metals and grain supplies may well be taking shape. This puts upward pressure on inflation around the world. It also weighs on growth by hitting real incomes and spending on items other than energy and food.

The combination of sanctions with restrictions, or even the destruction of export capacity, could be similar to the Arab and Iranian oil embargoes of 1973 and 1979. These embargoes contributed to highly inflationary recessions.

An embargo by Russia on exports or even by the West on imports from Russia is conceivable. Even if it doesn’t come to a full-blown interruption in supply, the effects could be like the 1991 Gulf War. That conflict led to severe energy price increases which coincided with economic slowdown.

That said, any stagflation should be less severe than in the 1970s. That’s because the Arab and Iranian oil embargoes followed dollar devaluation and Fed easing in a global economy which was much more energy intensive than it is now.

The energy shock is likely to be less severe in the US, which is now closer to energy self-sufficiency than Europe. That’s because Europe depends heavily on Russian energy exports.

Food prices are also likely to see serious upward pressure, as soft commodity prices rise sharply. Russia and Ukraine are both major wheat and corn exporters for Europe, Africa and much of Asia. The Americas are less directly exposed, but would probably feel the effect through rising grain prices.

So, what’s an investor to do under these circumstances?

Inflation is heading up with bond yields so low, and many traditionally ‘safe’ bonds are expensive. Growth may be heading down, possibly towards recession in some parts of the global economy, with many equity market valuations stretched.

How can investors navigate these challenges and achieve resilient returns?

We’ve sliced and diced return data across asset classes during various growth/inflation regimes. This research suggests that the best approach is a mix of assets, including bonds, equity and gold.

Commodity prices usually rise during high inflation period, so owning equity indices that are heavy in commodity exposure should help. A sharp increase in energy and food inflation is likely to slow expenditure on other items as consumer incomes and spending power come under pressure. This strengthens the argument in favour of fixed-income, especially high-quality government bonds.

As figure 3 shows, commodities and gold outperform when growth falls yet inflation rises. But, as stability is restored, through slowdown and normality through recovery, financial assets tend to perform.

In our view, risk exposures should arguably be moved, rather than eliminated, from the epicentre of crises towards regions that are more defensively positioned. In this case, from Europe, Middle East and Africa towards the Americas and East Asia. Currency exposures could be tilted toward commodity countries (other than Russia, Ukraine), as well as safe havens like the dollar and yen.

Emerging markets (EM) are of course under severe stress. Within EM, some countries are more exposed to the double whammy of rising commodity prices and a strong dollar.

These twin deficit countries, such as Turkey and India, must buy in energy, metals and in many cases grains. At the same time, they have to finance their investment or budget needs at least partly in global rather than fully in domestic markets.

Fixed income remains a crucial part of a portfolio during these periods of volatility

We would argue against shifting significantly away from fixed income under almost any circumstances. That’s because risk and uncertainty are facts of life.

Escalation in the Russia/Ukraine conflict points to risk aversion and higher commodity price as well as potentially lower growth. If there is stagflation, some bonds would benefit from slowdown while others would suffer from higher inflation.  

In fact, some corporate debt might benefit from higher commodity prices while risk premiums rise for others affected by corporate revenue losses. Likewise, some countries will benefit from stronger exports and currencies than others.

We believe it would only make sense to largely shift away from bonds if a number of factors presented themselves: 

• If today’s ultra-low bond yields were accompanied by a rosy picture of rising growth.
• If we saw more moderate inflation.
• If there was general economic and political normalization.

In today’s world, there is uncertainty but hope for eventual improvement in conditions. As such, we believe a better balance is called for than concentration in cash or risk assets.