June 9, 2022
2 mins

A new world order: How should I invest?

June 9, 2022
2 mins
David Bailin
Chief Investment Officer and Head of Citi Global Wealth Investments
SUMMARY

2022 has seen a reset of the international world order and the end of boom conditions in markets. Despite uncertainties, we see many reasons to be fully, but wisely invested.


A new world order

Imagine the past thirty months as a novel. It would most certainly appear on best-seller lists as an unbelievable work of dark, dystopian fiction: A pandemic that shutters the world economy, China applies extreme restrictions to shield its citizens from the virus, a silent chasm between the world’s superpowers and their leaders widens, the West appears to be in internal and collective political disarray, leading to an opportunistic Russian President sensing an historic opportunity to restore Soviet dominion over Ukraine.

Imagine Vladimir Putin talking with Xi Jinping during the blizzard days of February, preceding China’s COVID-bubble Winter Olympics. Certain of their strength and unity of purpose, they jointly agree to condemn the US and NATO, declaring theirs to be a friendship with no limits. Together, they sought a transformation of the global governance architecture and world order.

In cowboy parlance, them is fightin’ words. However, the growing vulnerabilities of the West that preceded Putin and Xi’s Eastern confab were numerous and profound. Institutions such as the United Nations and its Security Council, NATO and multi-national agreements such as Strategic Arms Limitation Talks (SALT) appeared to be less influential than they once were.

The storming of the US Capitol on 6 January 2021 - beamed to audiences globally - portrayed America as internally divided. Even the slogan Make America Great Again somehow implied that some in the US no longer saw their nation as a global superpower and ethicist.

No wonder that columns of Russian tanks and a hundred thousand strong infantry poured confidently into Ukraine just four days after the Winter Olympics concluded.

In a terrific plot twist, Putin grossly underestimated Volodymyr Zelensky, a former TV actor, who has galvanized his country in wartime, turning down an offer of political exile with the phrase I need bullets, not a ride. The Russian president did not understand that a Churchillian leader could use the internet to greater effect than any state-sponsored cyberattack hitherto.

Zelensky has proven especially formidable because his character is robust and his defense of democracy is clear. He broadcast the resolute and collective commitment or regular women and men to take up arms. And he has appeared live, in wartime, before the legislatures of multiple countries.

The Russian president did not recognize the preparations that NATO and the US had made in training and arming the Ukrainians, nor the provocative, rapid and overwhelming impact the war would have on Western economic, political and military policy.

In the war’s first hundred days, the tens of billions of dollars in military and humanitarian aid supplied by a unified West were sufficient to enable the Ukrainians to limit the territory Russia could attempt to control. Economic counter-warfare using unprecedented and lasting sanctions to sever financial and trade lines between Russia and the West were unleashed.

More than 400 companies simply closed their doors in the heart of the former Soviet Union, reflecting the values of the people who worked for them. Even previously neutral countries have decided to join NATO, as commitments to see it redouble its power and preparedness became a certainty.

All this empowered President Biden to make it explicit and real to President Xi that America and its allies were willing to punish China economically and severely if it directly aided Russia militarily.

This is the story of the past 30 months. Well, not entirely.

There was also this global meltdown in financial markets and an extraordinary global recovery that followed. There was this torrent of liquidity that enabled millions of homebound consumers to empty a just in time supply chain using their mousepads and e-payments.

New technologies enabled new traders to bid up everything from digital currencies to real estate in the metaverse, to turn zombie companies into multibillion dollar survivors and, ultimately, to drive valuations to unsustainable levels as companies began burning cash to pull forward revenues without regard to profitability. Such was the market euphoria of the 2020-2021 pandemic period.

But no wave of such magnitude and exhilaration could be without consequence.

The Return of the Incredible Shrinking Wallet, an epic political thriller starring an inflation-infused villain siphoning consumer pockets worldwide, came to your home streaming service. The scarcity of energy, agricultural products, rare commodities and even baby formula became this novel’s second narrative, a cost of war, the price we pay for growing frictions in a deglobalizing world economy and a reminder that the pandemic continues.

Enter the Federal Reserve, the world’s economic savior in early chapters, but now the Darth Vader character in June 2022. Can the Fed slay the wallet-killer without destroying the global economy (before it’s too late) or has it unleash Father Inflation determined to unleash unlimited destructive power? Markets are volatile. Investors are panicked. Where do you hide?

Now, this is genuinely the story of the past 30 months. It is also the story of our lives, and it is reflected at this very moment in our investment portfolios. Many have too much cash and are poorly positioned for the next months and years. This is not the way the novel should end. Welcome to our Mid-Year Outlook 2022!

 

It is much easier to see where you’re going, when you can see clearly where you have been.

 
David Bailin
CIO, Citi Global Wealth

How should I invest?

While it may be viewed as too simple or even radical to see 2021 as a time of excessive investor exuberance, there are many observations and data points to suggest that it was exactly that. The distortions caused by the pandemic, the wartime-scale stimulus used to successfully counteract it and the can’t lose behaviors exhibited by investors all speak of a boom.

When viewed historically, the boom will likely be viewed as a period of excessive equity returns. Peak stock prices reflected far more than projected company profits. Investors ignored the possibility that revenue growth rates would normalize. They assumed the temporary jump in COVID profits would be sustainable.

They even assumed interest rates would stay pegged at zero indefinitely. Such is the nature of speculative, frothy markets where chatrooms became the place where momentum investors sought advice.

The Federal Reserve’s about-face from a provider of economic jet fuel to a beacon of sobriety, and the unexpected, prolonged and bloody war in the Ukraine marked the end of this boom market. In 2022, we have seen a bucket of cold water poured on the economy to fight the major consequence of the boom: excessive inflation.

Through this lens, the correction that began intermittently in the late summer of 2021 and accelerated mightily over the first five months of 2022 was a reset from the excesses of the prior two years.

With the unusual, joint collapse of bonds and equities in early 2022, real interest rates returned to the fixed income market, restoring the diversification benefits of a core asset class, as well as much needed portfolio income.

The speed of the correction that took the S&P 500 Index to near-bear territory on 20 May appeared fast, sharp and deep, but was more likely the mirror image of the rocket recovery of markets just after the pandemic began.

However, investors do not see it this way. And they certainly do not feel it this way. Right now, we see excessive investor pessimism, where the tendency to overweight the probability of a major market decline is too high. Investors are frozen with fear.

Now, there are good reasons for some of that pessimism. We have bullish, base-case and bearish scenarios for the global economy. We call these ROBUST, RESILIENT and RECESSION and we weight their probabilities as of early June 2022 at 20%, 45% and 35%.1

When a recessionary scenario is weighted almost equally to our base case or expected resilient scenario, it indicates that there is more risk in markets than usual.

Interestingly, the biggest risk is not in how the economy is behaving of its own accord. In fact, the resilience of the global economy to COVID, a major European war, a shutdown of large swathes of the Chinese economy and inflation itself is pretty remarkable and often unsung. The ability for technologies to substitute effectively in areas like healthcare, retailing, warehouse management, travel, entertainment and even for office space itself speaks to the economic hardiness we have witnessed across these past 30 months. In fact, these are all good areas for future investment – see Harness the power of unstoppable trends, Cyber security: Defense for data and portfolios and The fintech revolution has far to go.

It is the present response of the Fed that is the market’s biggest risk. The Fed has only a few instruments to fight inflation and they are mighty and lacking in subtlety. One is rates and the Fed has made it clear that higher rates are a near certainty. The second is called quantitative tightening, the reversal of its easy credit policies that ensured the flow of capital as the pandemic struck home in 2020-21. When the Fed lets bonds it has previously purchased roll off, investors will need to step in as buyers for newly issued bonds as they are made available.

This requires enough buyers of sufficient size to step in. And the truth is that we do not know whether the new supply will be met with sufficient demand. If the Fed hikes rates too high, too fast while also reducing market liquidity, a recession can ensue.

This may cause unemployment and other travails that can cause the economy to shrink for a time.

We think that the Fed need not do this to stem inflation.

As Steven Wieting notes in Investing in the afterglow of a boom, a soft landing is possible. We see demand falling already as consumers tighten their belts due to lower levels of savings, lower levels of household wealth and lower wage growth relative to inflation. We also see supplies rising – albeit not in every category, particularly energy and food prices – but across many other categories. Given time, having supply and demand equilibrate is the best cure for inflation.

We do not think investors should sit on cash and try to time the markets. In fact, we think that is a highly risky approach - see The perils of holding excess cash. We have positioned portfolios for this moment of uncertainty – see Our positioning.

Falling markets have caused a reset in many valuations in 2022 – see The long-term outlook for asset classes returns has improved. We believe that high-quality bonds are likely to add real value to portfolios as we enter 2023, as we set out in Bonds are back within Beat the cash thief!

And assuming that there is no recession, but rather a slow, market consolidation, investors will see that the future environment for moderate growth, in both the US and global economy, is positive. Imagine that the novel ends with no further Chinese lockdowns, an end to the war in the Ukraine and meaningful adjustments to global supply chains.

Imagine that inflation is reduced to 3.5% by the end of 2023 and 10-year interest rates in the US were 2.75%. These are our hopes and our views a year or so from now.

As seasoned investors, looking rationally at the data across the global economy, there is little reason to believe that growth is over and that innovation and investment therein is at an end.

And there are several reasons to believe that a more realistic and perhaps more stable world order is possible in the years ahead. China cannot rely on Russia as its strongest ally because the war has negatively impacted so many of its major interests. Furthermore, the reinvigoration of NATO and the possibility of an expanded, global brief for it will certainly inform China’s strategy.

To the extent that the US, Japan and others view Taiwan as they do now Ukraine, there will be more tension – see The rise of Asia: Accelerating G2 polarization. But it also means more opportunities to forge new relationships.

In short, there are many reasons to be wisely invested. Even now. In our Mid-Year Outlook 2022, we show you how.

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OUTLOOK

Mid-Year Outlook 2022

2022 has seen a reset of the international world order and the end of boom conditions in markets. Despite uncertainties, we see many reasons to be fully, but wisely invested. Our Mid-Year Outlook is a critical guide for investors around the globe.

Find out more