Ukraine war to cut growth, up inflation

We see an era of structurally higher commodities prices ahead. Why? First, look back. Prices ran up because the economic restart drove demand amid abnormally low supply. The West has tried to wean itself off Russian energy after years of declining investment. Now, look forward. We see structurally higher prices amid tight supply for energy and rising demand for metals that will be critical to power the path to reach net-zero carbon emissions by 2050.

Download full commentary (PDF)

Energy shock

U.S. and European energy prices, 2021-2022

The Ukraine war has caused a spike in energy prices, putting a damper on growth and exacerbating supply-driven inflation. Europe is most exposed. Natural gas prices have surged beyond 2021 peaks, as the red line in the chart shows, before reversing a bit last week. The big difference with 2021: High energy prices are now the cause of a downdraft in growth, whereas they were the outcome of strong growth then. The culprit is Europe’s reliance on Russian gas in an already tight market. The powerful economic restart from the Covid-19 shock in 2021 had already exposed mismatches in the region’s energy supply and demand. This was aggravated by a mix of geopolitical factors and weather-related supply disruptions just as European inventories were low. The recent surge in European energy prices has pushed the region’s energy burden as a percentage of GDP to above levels reached in the early 1970s, we calculate, whereas the U.S. is still well below it. This is why we think the impact of the current energy shock for Europe could be on par with previous severe episodes such as the 1973 oil embargo.

Higher energy prices are a material, global shock. Europe is facing a large, stagflationary shock, in our view.  Analysts are ratcheting down their growth forecasts and upping their inflation projections. This is not over, and we believe the European Central Bank (ECB) growth forecasts understate the shock’s impact on growth. The U.S. is in a better spot, in our view. The shock is less than previous energy crises. The U.S. also has a larger growth cushion thanks to the strong restart’s momentum – even if some of European weakness is bound to spill over.

How will policymakers respond to the poisonous combination of slowing growth and rising inflation? Central banks have to normalize policy as the economy no longer needs stimulus, we believe, so policy rates are headed higher. The ECB last week said it would phase out asset purchases and left the door open for a rate increase this year – the first in more than a decade. The U.S. Federal Reserve this week is expected to announce its first rate hike since the Covid shock, while the Bank of England and a slew of emerging market central banks are set to hold rates or raise them. We still see a historically muted cumulative response to inflation; more aggressive tightening would come at too high a cost to growth and employment. Central banks will be forced to live with inflation. But it’s tough to see central banks coming to the rescue to halt a growth slowdown in this inflationary environment. Our conclusion: central banks are less likely to shape macro outcomes going forward. That leaves fiscal support. The war has raised the prospect of fiscal stimulus to achieve energy security and up defense outlays, but we see this taking time. 

The imminent hit to growth has reduced the risk that central banks slam the brakes and aggressively raise rates to contain inflation. So what are the risks? In the short run, escalation of the war and more energy supply shocks are key catalysts for more risk-off market moves. We see a risk of inflation expectations becoming unanchored in the medium term, causing central banks to raise rates sharply. Energy prices are now driving growth, rather than being the result of it. This raises the specter of stagflation–something that was not in play before due to the economy’s strong growth momentum.

What does this mean for investments? We prefer to take risk in DM equities against the inflationary backdrop of negative real bond yields. We expect the global energy shock to hurt corporate earnings, especially in Europe. Recent market declines reflected this, we believe, and the region’s stocks are highly geared toward global growth. We stay underweight government bonds. They are losing their diversification benefits, and we see investors demanding greater compensation for holding them amid higher inflation and larger debt loads. Within the asset class, we prefer short-dated and inflation-linked bonds.