Not in Kansas Anymore

Investors navigating daily market volatility must come to terms with rising risks that we are entering a very different world.

This year’s market losses reflect rising prices and falling demand. But that’s not all. Investors are also grappling with an unsettling feeling that they are now buffeted by an entirely new and perplexing set of economic, financial, and political forces.

It may not be as disorienting as the?Oz?that greeted Dorothy after a tornado swept away her home, but we can all agree with her that we aren’t in familiar Kansas anymore.

Much of the current market turmoil rests on a desperate longing for a return to “normal” and few signs we will get there soon. Inflation may actually linger higher for longer. Growth may remain sluggish. And the headlines from Russia, China, and the Middle East leave everyone feeling unprepared for the geopolitical tensions ahead.

Economically, the biggest changes may come to trade patterns. The pandemic shock forced companies to run higher inventories and search for alternative suppliers. “Friend-shoring,” in the words of the Biden administration, may not require sourcing all garden equipment from a NATO ally nor does it mark the end of globalization. Nevertheless, thoughtful managers will want to carry backup inventories and identify additional suppliers for when the next crisis hits. Tightening sanctions on the world’s second-largest oil producer have also triggered a massive reorganization of global energy markets. European trade patterns, in particular, will feel the brunt.

Most important for the current outlook, however, are inflation levels that look much stickier than the textbooks predict. Central bankers are determined to protect their credibility, which raises fears that the medicine they are delivering today will have substantial negative side effects well beyond next year.

We will eventually get back to a world of lower rates that support more demand again, but?growth forecasts?look dismal for now. Tightening policy to combat inflation has brought big changes to global financial flows, too, as easy money turns scarce and balance sheets face a protracted period of stress.?????

In every tightening cycle, something always breaks, although it’s usually in a part of the market that even professional investors don’t watch closely. Sometimes it’s Mexico, sometimes it’s Orange County, sometimes it’s Lehman Brothers. Distress in the U.K. pension system was not on anyone’s radar even a few months ago, but financial dislocation usually appears where markets expect it least.??

What may come next is anyone’s guess. Bankers and finance officials assembled at the?World Bank and IMF annual meetings?recently in Washington, D.C. didn’t get much beyond the list of usual suspects in Emerging Markets. But developing countries with enough heft to disrupt global markets actually look surprisingly resilient these days, many having raised rates early in anticipation of the stress.

The only thing we know for sure is that an extended period of a strengthening dollar, rising interest rates, and weakening growth will expose weaknesses that will be hard to foresee.

Politically, rising tensions with China mean that what was once the world’s greatest economic opportunity is now among its greatest sources of risk. Russia looks consigned to a lengthy period of isolation, although fresh waves of populism may test U.S. and European unity in imposing sanctions. Meanwhile, Iranian demonstrations and a Saudi government that is testing the limits of U.S. patience raise the prospects of a very different configuration for Middle East politics.

There may be a glimmer of hope and encouragement. For all the horror from Ukrainian battlefields and all the rising rhetoric in every exchange between Washington and Beijing, the world’s richest economies have shown remarkable cohesion. For all the talk of U.S. decline, the dollar’s strength reflects abiding confidence in U.S. institutions, and its?reserves status looks enduring?in spite of the geopolitical shifts.

However, better alignment among the richest economies of the G-7 exposes the rising tensions with the emerging countries in the G-20, including not just Russia and China, but fence-sitters like Saudi Arabia, Turkey, and India. Companies and investors will want to avoid getting caught wrong-footed amid these unfamiliar global dynamics.

In time, investors may look back at this period as a time when fears peaked before more familiar economic, financial, and political patterns returned. For now, the preponderance of evidence suggests we are headed for something very different and disorienting. Even if “there’s no place like home,” it may look quite unfamiliar when we get there.

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Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.