The article below is from our BRIEFINGS newsletter of 10 March 2022
At the start of the year, Goldman Sachs Asset Management released Investment Ideas 2022, taking a deep dive into the key themes likely to influence investor behavior. But disruptive forces — such as the conflict between Russia and Ukraine — are constantly evolving, presenting new challenges to the global economy. We sat down with Goldman Sachs Asset Management’s Candice Tse, global head of strategic advisory solutions, and Maria Vassalou, deputy chief investment officer of multi-asset solutions, to look at the impact disruption is having and how investors can navigate it.
Maria, the escalating humanitarian crisis in Ukraine is a deeply worrying development that is at the top of our minds. How disruptive could this conflict be in 2022?
Maria Vassalou: First and foremost, this is a human crisis. That is without a doubt the biggest consideration. The geopolitical conflict in Ukraine is disruptive because it reshapes the global economic balance of powers. While Europe is aligned with the U.S. on sanctions, its economy is bearing the bulk of the negative spillover effects of the war given its dependency on Russia for 40% of its energy supplies. The increase of energy and commodity costs is likely to impact European growth dynamics and keep inflation stubbornly high for longer than previously thought.
We see Germany deciding to significantly boost defense spending, meeting NATO’s 2% of GDP target. At the same time, Japan is inviting the U.S. to install nuclear weapons on its soil and Switzerland is breaking from its traditional neutrality by matching EU sanctions on Russia. A new version of Cold War mentality may be emerging, with the potential to greatly affect growth dynamics going forward as well as the global investment landscape.
Candice, how could the Ukraine conflict impact Europe more broadly?
First, trade spillovers from conflict and sanctions may weigh on Europe as the EU runs a trade deficit with Russia. For context, while Russia may only be the U.S.’s 23rd largest trading partner, it is among the top five trading partners for the EU. Still, EU trade with Russia remains a relatively small percentage of overall trade activity at 6% of total extra-EU trade.Second, financial conditions are likely to continue tightening, especially if equities become more discounted and sovereign and credit spreads grow wider. While the impact on financial conditions in Europe has been fairly limited during past episodes (e.g. Crimea in 2014), the risk of tighter financial conditions remains skewed to the downside.
Third, consequences on the European energy market are likely to be most significant, as Europe depends heavily on Russia for its gas consumption. Further escalation may deepen the current energy crisis and lead to higher inflation in Europe, if not the rest of the world.
Maria, in addition to the war in Ukraine, what are other disruptive forces at play?
Maria Vassalou: Inflation is arguably the biggest uncertainty and driver of investor behavior in 2022. It remains to be seen how the tightening of financial conditions affects inflation. Risk to the outlook has very much to do with inflation and the reactions of central banks in their efforts to curb it. No policymakers have ever dealt with this policy situation before so it’s very much unchartered waters.
Inflation is not what people would usually think of as disruptive, but right now, this is probably the biggest disruptive force as it really throws a wrench into the whole playbook of how you invest and how you think of the world. The way it is handled now will affect where we are going to be two years from now and whether we will be growing or in recession.
It will be largely central bank action, especially in the U.S., that will determine whether the economies will face stagflation going forward or recession. In Europe, the EU is considering issuing joint bonds to fiscally support the member states against the financial strain imposed on them from the energy and commodity crisis. Further fiscal stimulus is less likely in the U.S., but how much and how fast the Fed raises interest rates will determine whether the U.S. enters a period of stagflation or whether it experiences a recession in the next 12-18 months. Fewer hikes could result in stagflation whereas a more aggressive tightening cycle could precipitate a recession. Some sources of inflation, such as housing, will be more effectively curbed through a recession as demand decline may cool prices. The task of the Fed of bringing inflation back down to 2% given the forces that fuel it, is extraordinarily challenging from a policy design perspective, increasing the probability of recession.
Candice Tse: We have obviously spoken about some big events currently in play in 2022. But there are some other long-term disruptive themes that cut across every single sector and geography. Those come in the form of: the “techification” of everything; changing global demographics; and the growing importance of sustainability.
First, rapid technology adoption weeds out companies across industries. If they can’t keep up, they don’t stay in business. Over the course of time, the average lifespan of companies, especially in the S&P 500 index, has dropped to 21 years from 35. You can’t just invest in companies and hope they will last for 30+ years. Companies have a shorter lifespan today.
And technology growth is closely interrelated with two other trends that will disrupt markets and the global economy in the future. There are now billions of millennials and Gen-Z’ers around the world – easily making them the largest generation now. Millennials make up the biggest cohort of the adult population, so compared to prior generations, they represent the generation with the greatest earnings and spending power. This generational disruption is happening now.
And finally, many people from these generations have grown up with a different mantra; they want to do good and do well, at the same time. So being socially responsible is important in terms of what they are buying and investing in. Sustainability is key and decarbonization is now one of the most urgent priorities for the world.