Miscalculations and Recalculations

RUSSIA’s President Vladimir Putin has fully miscalculated the West’s response to his invasion of Ukraine. The speed, strength and unity of global sanctions is bringing about economic collapse in his country. A survey of economists by the Bank of Russia indicates the economy will contract 8% in 2022 and inflation will surge to 20% by the end of the year.1

The Russian invasion of Ukraine, and the deep human, political and economic impact it is bringing about is forcing a reassessment by leaders globally around political and military alliances, energy and food security as well as economic and supply-chain dependence. The globalization and economic interdependence developed over the last 30 years means this redefining of the global architecture will not be instant and require multiple reworkings.

Even if a peaceful solution is found in the near term, continued instability in the region will weigh on Western leaders’ collective consciousness. They have been reminded of the lessons of the Cold War and the original intent behind NATO; this will drive policymaking for decades.

POWELL’S MISCALCULATIONThe US Federal Reserve (Fed) looks to have underestimated the underlying price pressures that have accumulated in the US economy. Fiscal stimulus, multiple rounds of quantitative easing (QE), and supply disruption from COVID-19 have driven wages and, in turn, inflation higher. Further increases in energy and food prices post-Ukraine have now firmly placed the Fed “behind the curve.”

The policy challenge of raising rates to bring down inflation, in the full knowledge that it risks slowing the economy, suggests future economic data are going to look distinctly stagflationary, which creates further challenges for the Fed.

THE EARNINGS CHALLENGEThe growth scare post-Ukraine, significantly higher US interest rates over the next 12 months, combined with the impact of rising input costs, implies slower future profit growth. Consensus expectations for the MSCI World Index is for mid-single digit earnings growth in 2023.2 However, the risk is skewed toward downward revisions to earnings next year.

Emerging markets are expected to witness a recovery in earnings growth to low double-digit levels in 20233, driven primarily by a recovery in China and India. While there are risks to earnings in both these markets, decisionmakers in China are easing policy to offset risks to growth.

AN EASING OF TENSIONS IN ASIAThe developing new world order will force a recalibration of China’s entire stance on building regional influence in Asia via military projection. Primarily, this could mean a review of its plans for reunification with Taiwan.

The West’s response to Putin’s invasion of Ukraine suggests China’s position of “not ruling out force” in unifying Taiwan with the motherland could be re-examined. A rebalancing of the approach to emphasizing soft power to encourage Taiwanese reunification over the long term would be positive for East Asia.

Markets have yet to focus on a less talked about but likely further positive spillover from these events, that is, the thawing of Sino-Indian tensions across the Himalayas. Relations between Delhi and Beijing last ruptured in 2020 and a pragmatic Chinese leadership should correctly weigh, albeit belatedly, that their strategic interests here will be better served through socio-economic cooperation rather than military expansion.

The potential easing of tensions is most positive for Taiwan and could bring about some reduction in its long-term equity risk premium but is also clearly positive for India and East Asia.

CHINA: STUCK IN A CYCLE OF COVID-19While the rest of the world slowly but surely reopens post-COVID, China’s zero COVID-19 policy implies they are stuck in a cycle of spiking cases and lockdowns. Unlike the rest of the world, a combination of relatively limited vaccine efficacy and no herd immunity means a renewed spread could have a major health impact with human cost and bring about further economic disruption.

This will likely create demand destruction as well as supply chain tightness and add to global inflationary pressures.

COVID-19 aside, policymakers have committed to further policy loosening to support a slowing economy, as well as completing the regulatory review of the web economy. This means that the Chinese market will be supported, particularly in the face of growing uncertainty elsewhere.

RECALCULATING THE BENEFICIARIESThe sharp shift in events in 2022 has shaken emerging markets and attention has pivoted to the beneficiaries of this new landscape.

In 2021, Brazil retreated with rising political risk from the upcoming presidential elections as well as a tightening monetary policy stance. In contrast, this year the market has witnessed a sharp recovery. With historically low valuations,4] its position as an energy and commodity exporter plus high relative real interest rates, we think Brazil will continue to be a relative beneficiary globally.

The Middle East markets are a further contrast, benefiting from the combination of higher energy prices, a powerful fiscal backdrop and continued social and economic reform. As a relative newcomer to the global emerging markets universe, we expect to see this region to continue benefiting from increased portfolio capital flows, with Saudi Arabia a particular beneficiary.

1 The Bell, The First Forecasts of Falling GDP and Rising Inflation, March 10, 2022

2 MSCI, Bloomberg consensus expectations as of March 30, 2022. There is no assurance any estimate, forecast or projection will be realized.

3 Ibid.

4 Bloomberg consensus expectations as of March 30, 2022.

Manraj Sekhon is the CIO of Franklin Templeton Emerging Markets Equity.