By Andrea Siviero, Investment Strategist, Ethenea

Andrea Siviero

24.02.2022 - The global economy finds itself in a particularly dangerous juncture. Exceptional policy support engineered by policymakers around the world helped the global economy to exit the pandemic-induced recession of 2020. The economic recovery has been unusually rapid and particularly strong and the sharp increase in aggregate demand could not be matched by an unpaired supply.

Inflation has been rising globally in 2021 and central banks in advanced economies have recently signaled a sharp hawkish pivot and accelerated the unwind of their pandemic policy support. The environment of persistent high inflation and softening economic growth is however particularly worrisome and has given rise to suggestions that the global economy may soon enter a period of economic stagflation.

Geopolitical challenges

The decision of Vladimir Putin to attack Ukraine will not only cause immense damage to the Ukrainian people and the Ukrainian economy and could trigger the outbreak of a broad and destructive armed conflict in Europe but hugely increase the downside risks to the global economy.

The conflict in Ukraine, together with the ensuing US and European sanctions increases pressure on commodity and energy prices, and will cause slower economic growth. The global economy is hit by a combined supply and demand shock that will weaken economic growth and further intensify inflationary pressures.

The region involved in the conflict (Ukraine and Russia) is one of the main sources of raw material of all kinds: oil, gas, grain, minerals, metals, etc. A sustained spike in energy and commodity prices will feed into price pressures with considerable risks of inflation becoming entrenched, triggering longer lasting second round effects.

With inflation stubbornly high, softening economic momentum and policymakers starting to withdraw policy support, an exogenous stagflationary shock of this sort is particularly worrisome and extremely challenging for policymakers trying to start their normalization process. It represents an important hurdle to the global economy equivalent to a significant foreign tax to growth for the western economies.

How will policymakers react? While the situation is heterogenous across regions and it may be too early to draw conclusions, fiscal and monetary authorities will likely have to carefully reassess their normalization plans. The aggressive tightening policies currently discounted by markets may well have to be revised down and adapted to the new reality. The path to an economic soft landing in advanced economies is still open but risks have increased considerably.