ABSTRACT
The continuing surging inflation due to the supply shocks and the Ukrainian conflict have dominated headlines compounding to the possible repercussions surrounding climate change, further affecting economic and financial indicators in the medium term and beyond. We had previously detailed the likely systemic shifts in the macro and market landscape resulting from the transition towards a greener world: increased inflation, yields and spread risks translating into increased long-term volatility across our investment universe, and dragging down both EPS and valuations. With the EU and US inflation (resp. 8% and 6% YoY) at a multi-decade high, authorities across the world are now compelled to risk recession in the medium term to regain control of the inflation narrative on all available fronts. As in the past, the Fed and BoE have been the most proactive sides in an attempt to regain credibility with normalization expected to be fully underway within the medium term. On the other hand, ECB has been willing to remain behind the curve awaiting for further developments to the Ukrainian conflict and the ongoing energy crisis.
Will the Central Banks succeed in threading the middle road between the risk of persistently high inflation and the risk of recession? During 2022Q1, Treasuries has realized the lowest returns since the infamous 70s and markets are bracing for an increasingly volatile market for at least the medium term. With a higher starting level, US bondholders can hold to the silver lining of higher carry returns in the medium term and beyond, while EU counterparts will likely have to endure lower total returns resulting from the lower rates and delayed normalization. As a consequence of the transition and the current backdrop, the situation for credit spreads will likewise deteriorate in the medium term before stabilizing. Tighter financing conditions and aftershocks of structural shifts in the energy sector will most likely result in higher default rates and wider rates across the spectrum. In such situations, high-yield corporate bonds are likely to undergo significant widening with consequent higher volatility and uncertainty.
Continuing supply-side and material constraints together with higher borrowing rates will put all equities under severe constraints. Medium term focus will be on the reshuffling of innovative, profitable companies with higher prospective growth able to absorb the impending fiscal push in defence and energy sectors versus weaker and non-productive names, ultimately resulting in higher volatility and lower expected returns with respect to figures not incorporating climate change.
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