• Central banks face the challenge of controlling inflation without denting growth.
  • Inflation—along with tightening monetary policy—is squeezing corporate margins.
  • As markets continue to try to price in changing conditions into asset valuations, maintaining broad-based diversification is key.


By Sarang Kulkarni, portfolio manager, investment-grade credit, and Michael Pollitt, head of credit research, Vanguard Europe

As 2021 came to an end, central banks started to shift from the view that high inflation was transitory – in other words, that it would decline to more normal levels over time. As the chart below shows, inflation was expected to peak around the start of 2022 and then drop over the course of the year. But as 2022 began, it became clear that high inflation in developed economies was going to be more persistent than anticipated.

Headline CPI actual inflation and forecasts (year-on-year, %)

Sources: Vanguard calculations, using data from Bloomberg and Refinitiv. Data from 31 January 2019 to 30 November 2023. Solid lines represent actual inflation; dotted lines represent forecasted inflation.

As economies around the world reopened from Covid-19-related restrictions and supply-chain disruption eased, many market participants expected that the supply of goods and services would rise to meet the pent-up demand that came out of the pandemic, putting the brakes on inflation.

2022 was supposed to be the year of transition for monetary policy. With employment strong, but inflation running high, most central banks in developed markets saw this as an opportune time to start tightening monetary policy, which had been running at abnormally easy levels.

Policymakers had been broadly expecting a smooth transition over the next few years to the point where monetary policy and inflation would reach more normal levels, as the table below illustrates.

Bond markets, for their part, had already started pricing in this transition, with yield curves starting to flatten as yields on shorter-dated bonds rose more than those of longer-dated bonds to reflect the anticipated path of rate hikes.

Central bank tightening schedule 

Source: Vanguard

Inflation now likely to be higher for longer

Russia’s invasion of Ukraine has shocked us all. While the political and social ramifications have had a sudden impact for those close to the warzone, the direct and indirect economic ramifications are still unfolding. However, what is clear is that the primary channel for economic impact has been an increase in commodity prices, in particular energy. As a result, the global economic recovery from Covid-19—which was starting to gain momentum before the Russia-Ukraine conflict erupted—has now been called into question. And unlike the economic shock created by the pandemic in 2020, the energy shock is expected to have the opposite impact on inflation – it is expected to go even higher, while growth slows down.

The conundrum for central bankers is how to disentangle this inflation risk. Can they engineer a soft landing from very high rates of inflation? And what is the exit strategy for sanctions imposed against Russia? Clearly the war in Ukraine complicates matters, with a key risk being a potential stagflationary (that is, stagnant economic activity amid high unemployment and inflation) shock.

Modelled impact to our baseline forecasts: euro area GDP and inflation

Source: Bloomberg Economic Forecasting Model and Vanguard. As of 1 March 2022.

Notes on scenario forecasts: “Mild” – oil at $100 and mild financial conditions shock; “Moderate” – oil at $125 and moderate financial conditions shock; “Significant” – oil at $150 and significant financial conditions shock.

Corporate margins squeeze

Thanks to their diversified business profiles and proven ability to access liquidity, most investment-grade corporates were able to recover quickly from the pandemic, as evidenced by their solid earnings growth and margin recovery through 2021. Now, however, the war in Ukraine is likely to stall this recovery and place pressure on margins, primarily through rising energy costs and falling consumer confidence.

If companies can pass on costs to customers, they usually will. For example, many consumer goods companies have already flagged potential pass-on increases in their prices as a result of the spike in energy prices, and the UN World Food Programme has said that food could rise by as much as 20% due to the conflict in Ukraine1.

It is not yet certain to what extent supply chains will be disrupted, but transport routes close to the conflict zone will likely be affected, and in the short term there will be increased competition for scarce resources. Several western companies have also taken the decision to close their businesses in Russia, leading to a loss of future revenue, although this should be of minimal impact to most European corporates, given their limited economic exposure to Russia.

With such a rapid onset of hostilities in Ukraine, it will take time before companies disclose more information on the impact on their bottom line. But what is clear is that credit spreads have very rapidly widened, with some sectors, such as airlines, particularly hard hit.

This widening in spreads reflects the deterioration in earnings expectations, driven not only by strained fundamentals but also by the tightening monetary conditions. The chart below shows how earnings revisions have spiked downwards since the outbreak of the conflict.

Earnings revisions suggest impending downgrades in Q2

Source: Bloomberg, as at 23 March 2022. Data covers period 18 January 2019 to 23 March 2022.

Discipline amid the uncertainty

As the situation evolves, asset valuations will reprice to reflect the new environment – potentially one of higher inflation and lower growth. While some market segments—such as short-dated bonds—have priced in this scenario relatively quickly, valuations in some other asset classes reflect a more ambivalent outlook. With volatility and uncertainty elevated, the path from current valuations to where the market finds an equilibrium around fair value will probably not be straightforward.

This case in credit valuations underscores why it is often wise to keep emotions out of investment decision making. In the current environment, the outcome and duration of the conflict in Ukraine is uncertain and the full extent of the impact on the economy unknown. Investors may sometimes feel the urge to respond to market moves and shift away from a strategic, long-term and diversified asset allocation. But attempting to time the market is fraught with difficulty. Instead, keeping a broad-based exposure across different regions, asset classes and sectors is often the best way to navigate a crisis.


1 Source: UN World Food Programme, 11 March 2022. www.wfp.org

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