Investors entered 2022 with growing optimism. The Nasdaq, Dow Jones Industrial Average, S&P 500, and TSX were all trading at or near record levels. And major financial institutions remained bullish, with Goldman Sachs predicting the S&P 500 would rise an additional 10% in 2022 to end the year at 5,100.

The TSX, which finished 2021 up 20% was, according to strategists at BMO Capital Markets, expected to rally an additional 12% in 2022, exiting the year at a record high of 24,000. There was more than enough reason for the optimism. If a global pandemic and one of the sharpest economic contractions couldn’t derail the stock market, what could?

It turns out, so-called temporary inflation wasn’t as transitory as first thought. And it’s wreaking havoc on the stock market and global economy.

Over the opening weeks of 2022, all of the major North American indices began to slide on growing fears about rising inflation, higher interest rates in Canada and the U.S., and geopolitical tensions in Ukraine.

By late January, the S&P 500, Dow Jones and Nasdaq had fallen into correction territory, which is defined as a 10% drop from its most recent peak. The downtrend was exacerbated in February on the heels of Russia’s unprovoked attack on Ukraine.

In Canada, March inflation hit a 31-year high of 6.7%. In the U.S., March inflation jumped to 8.5%, the highest level since 1981. In Europe, which is the world’s largest economic region, inflation has soared to a record 7.5%.

How Exactly Does Inflation Affect the Global Economy?

Inflation and its damaging effects on the global economy was not an issue during the pandemic. In fact, Canadian inflation stood at just 1.4% in May 2020 with interest rates at record lows. Quarantine orders and the shuttering of the global economy meant there was little demand for many goods and services.

All of that changed in early 2021 with the successful roll-out of vaccines and opening of the economy. Inflation has been climbing steadily higher since then on supply chain issues and strong consumer demand. This makes everything more expensive, from food and energy to shelter costs and transportation.

Artificially low interest rates are a big part of the problem. When the economy is doing poorly, central banks, including the Bank of Canada and U.S. Federal Reserve, lower their lending rates. This encourages banks to lend and businesses and consumers to borrow and spend.

When the economy gets too hot, central banks raise their key lending rate making it more expensive to borrow. The hope is that this will slow down economic growth and curb inflation. When inflation is under control, between one and three percent, the economy can prosper.

There is concern that the Bank of Canada, Federal Reserve, and other central banks waited too long to raise their rates. Now they need to play catch-up.

In April, the Bank of Canada hiked its overnight lending rate to 1.0% from 0.5%. That’s the biggest one-time increase since 2000. The Bank of Canada typically adjusts its policy by 0.25% at a time. The Federal Reserve has signaled that it will raise interest rates by 0.5% too. A 0.75% hike isn’t off the table either.

A big concern, though, is that exceptionally strong interest rate hikes could put the brakes on the global economy, so much so that it tips into a recession.

Citing inflationary pressure and the economic fallout from the war in Ukraine, the International Monetary Fund has since cut its global GDP growth forecast to 3.6% in 2022 and 2023. The World Bank also cut its global GDP economic forecast for 2022 to 3.2% from a previous estimate of 4.1%.

Taken together, global inflationary pressure coupled with rising interest rates, and the war in Ukraine is undermining supply and demand metrics, cobbling consumer sentiment, and threatening global economic growth.

About Evolve ETFs

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