As the conflict between Ukraine and Russia causes commodity prices to soar, what might the conflict mean for global growth and inflation, central banks, and living standards?
Russia’s decision to invade Ukraine in February sent a shockwave through the global economy and financial markets. The rapid escalation in military action has been characterised as the biggest security issue in Europe since the second world war, and could result in serious implications for the global order.
Given the possible impact that the conflict could have on commodity markets, trade, and confidence levels, its unsurprising that economists, including at Barclays Investment Bank, have been rushing to downgrade their growth forecasts and increase their inflation projections.
Russia’s impact on the energy market
Commodity markets continue to be at the epicentre of the disruption in global financial markets. At more than 11 million barrels per day (mbpd), Russia is the world’s third largest crude producer and the biggest exporter of oil to global markets, 60% of which goes to Europe. The region imports around 40% of its gas from Russia and about 25% of its petroleum products. Ukrainian pipelines are the second most important route, accounting for around one-third of the flows into the continent.
In the early days of the conflict, energy prices soared as traders feared a supply shock might develop. Markets rapidly reacted to the sanctioning of Russian energy exports, potential damage to infrastructure, and the risk of Russia reducing flows. Brent crude spiked to $139 a barrel on 8 March, its highest level in nearly 14 years.
However, oil prices have since eased on speculation that key gulf producers would increase production levels to mitigate some of the shortfall. Its estimated that Saudi Arabia, Kuwait, and the United Arab Emirates have a combined excess capacity of 2-2.5 mbpd.
The US also has the ability to increase production levels, as an elevated oil price makes its shale producers increasingly profitable. Reports that America is also reviewing oil trading sanctions on Venezuela, which if removed could add around a further 600,000 barrels of oil per day to the market.
Relief for stretched crude markets could also come in the form of a revival of the Iranian nuclear deal. Iran holds the world’s second largest gas reserves and is ranked number four for crude reserves. Reactivating the seven-year-old deal could result in 60-80 million barrels (mb) of oil being released quickly to the market, and pave the way for one mbpd of crude to be added to the global market over the next six to 12 months.
Effect on soft commodities
Soft commodities are also reacting to the potential supply disruption. Russia and Ukraine produce vast quantities of wheat, corn, and sunflower oil, with a combined production estimated at 12% of globally traded calories.
Russia is also the world’s largest producer of potash and nitrogen fertilisers, used by farmers around the world to improve crop yields. In the first two weeks of March, wheat prices surged around 50% and corn jumped to its highest level in close to a decade. The upward surge in the price of essential ingredients could have meaningful ramifications for both inflation and food security, particularly in developing nations.
Potential wider economic repercussions
Persistently higher commodity prices and the potential rationing of energy could hit industrial production levels, corporate profitability, and real household disposable incomes. The exact impact on growth still remains difficult to quantify and depends on the duration of the conflict, extent of disruption to energy supply chains, and effect on business and consumer confidence.
In order to reflect the heightened level of uncertainty, Barclays Investment Bank has downgraded its global growth forecast to 3.3% for this year, from 4.3% at the start of the year. With Europe’s growth profile remaining the most vulnerable to the conflict, we cut the region’s growth projection by 1.7 percentage points, to 2.4% for 2022.
Reaction of central banks to commodities shock
Higher commodity prices add further complexity to the balancing act being performed by leading central bankers. As seen during the coronavirus pandemic, a supply shock risks adding to price pressures and stoking inflation. The increase in energy and food prices can also quickly develop into secondary effects, especially in respect of wages.
We now expect global inflation to average 5.6% this year, compared to 3.2% in 2021. However, the trade shock emanating from the crisis also increases the downside risks to growth. We believe that central banks have enough flexibility to react to weakening activity through policy adjustments, while acknowledging the need to curb inflation.
The March European Central Bank meeting sought to achieve a balanced approach by unexpectedly deciding to slow its bond buying from the start of May. While on rates, officials now say any hikes will be “gradual” and take place “sometime after” bond purchases end, rather than “shortly” after. We anticipate that the central bank will end its quantitative easing (QE) programme in June/July, although we expect rate hikes to be postponed until 2023.
Bank of England carries on hiking
While the UK is less directly exposed to the economic consequences of events in Ukraine, rising energy costs are pushing inflation expectations higher, as the power regulator increases its price caps. The Bank of England expects inflation will hit 8% in the second quarter (Q2) of this year, and warns that peak inflation may only come in Q4. Stronger-than-expected growth and tightening labour markets are also putting pressure on the central bank to reduce its accommodative stance.
At last month’s rate meeting, the Monetary Policy Committee (MPC) raised UK base rates for the third consecutive meeting. The increase to 0.75% marks the fastest pace of tightening since 1997.
We envisage a further 25 basis point (bp) increase will be delivered at the May rate meeting, putting the UK base rate at 1%. However, as consumers and businesses tackle higher energy bills, increasing taxes, and rising interest rates (in what could be the biggest annual reduction in spending power seen by households since the 1970’s), some of the wind may be taken out of the Bank of England’s tightening sails. We suspect that the MPC will embark on a period observation to assess the incoming data, with rates on hold from mid-year.
Business as usual for the Fed
Despite the US Federal Reserve (Fed) downgrading its growth forecast for this year, to 2.8% from 4%, it’s no surprise that the central bank pushed ahead with policy normalisation at its March rate-setting meeting, given that inflation is approaching 8% (a forty-year high) and unemployment is below 4%.
The Federal Open Markets Committee (FOMC) expressed its determination to use its tools to return the economy to price stability after participants ratcheted up their personal consumption expenditures (PCE) inflation projections.
The ramping up of inflation expectations has been driven by policymaker’s expectations that geopolitical developments are likely to extend the duration of supply bottlenecks, and signs that price pressures are starting to spread more broadly across services.
The US central bank hiked the Fed funds rate by 25bp in March, marking the first increase since 2018. Given the relatively hawkish tone arising from the statement, we now expect to see hikes at each of the remaining six meetings. This would equate to seven quarter point hikes in total this year. We think that the tightening process will continue until mid-2023, with the terminal rate for the Fed funds rate being 2.25% -2.5%, which is 75bp higher and six months earlier than we anticipated at the start of the year.
Russian economy to feel the chill
At this stage, the true magnitude of the economic disruption to the global economy from the conflict between Ukraine and Russia remains difficult to fully gauge. We can, however, confidently predict that the size and the scope of the sanctions on Russia announced by the West will continue to impact its economy and population’s living standards profoundly.
The unprecedented set of restrictions have sought to isolate Russia’s economy and expel it from the global financial system. The country’s foreign exchange reserves have been frozen and its banks banned from using the Swift global payments system.
The Russian economy faces an economic crisis that will inevitably lead to a deep recession. Its output is forecast to contract by more than 10% this year. The credit rating agencies have downgraded Russian sovereign debt to junk status, and warned that default could be imminent.
An avalanche of global brands has announced their exodus from Russia, and the rouble has slumped from 83 against the dollar to an all-time low of 139. Its domestic stock market has collapsed and index provider MSCI has removed Russian stocks from its emerging market indices.
Even if a peace treaty between Ukraine and Russia can be agreed, restrictions on trade and sanctions on the latter’s financial system are likely to remain in place for some time. While Russia may seek to forge improved trading relationships with regions beyond the sanctioning countries, this is likely to take a considerable amount of time to achieve and is unlikely to readdress the economic consequences of its disconnection from Western nations.