Ukraine Conflict Could Trigger Oil Shock and Global Recession

Summary

• Russia’s global financial footprint is limited, but large in commodities markets.
• The biggest risk from the invasion of Ukraine is a commodities price shock, which could see oil prices rise above their 2008 high.
• A commodities shock could cause a global recession: it would transfer income from commodities importers to exporters, and the latter tend to save more.
• Also, with inflation already high and central banks concerned over the risk of expectations de-anchoring, they would likely tighten in response to the shock.
• In Europe, large infrastructure and defence spending would increase resource pressures.

Market Implications

• Markets are underpricing 2022 Fed hikes.

Russia’s Manufactured Goods and Financial Global Footprint Is Small

Russia is a medium-sized economy with a limited footprint in global manufactured goods and financial markets (Table 1). On a purchasing power parity basis, Russia is the sixth-largest economy in the world, and its income per capita is about half that of the US.

Relative to its income level, size and proximity to Western Europe, Russia’s global financial footprint is limited. This reflects largely the imposition of sanctions following the 2014 invasion of Ukraine. Those saw a dramatic decline in financial flows. For instance, Western banks’ involvement with Russia is limited.

Russian Invasion Could Trigger Global Oil Shock

By contrast with its small financial footprint, Russia is a major player in key energy and other commodities markets (Table 1). The Russian invasion of Ukraine could trigger a commodities price shock because:

• Sanctions will probably persist: their lifting would require a peace deal. That seems unlikely anytime soon.
• While the sanctions leave loopholes for Russian energy exports, Western banks and insurers have stopped doing business with Russian counterparts over regulatory risks. As a result, Russian energy exports have been crimped.
• The energy sanction carveouts could be abolished if civilian casualties continue to mount. That seems likely as Russia escalates its military campaign. Alternatively, though less likely, Russia could unilaterally decide to stop its energy exports.
• Alternative energy supplies are limited. In the US, the shale producers expect only a limited supply increase in 2022. OPEC so far has refused to raise production much and may lack the spare capacity to make up for Russian exports.
• Russia’s and Ukraine’s key roles in wheat, fertilizers and other commodities markets as well as price correlations across different commodities suggest a generalized commodities price shock, not an oil shock (Chart 2). 

Commodities Price Shock Would Lead to Global Recession

A commodities price shock would likely lead to a global recession through two channels. First is a direct demand channel. A commodities price shock transfers purchasing power from net commodities importers to net exporters. The latter typically have a higher propensity to save than the former or take time to recycle their surpluses into demand for manufactured goods exported by commodities importers. As a result, global demand falls.

The second channel is policy related. In both commodities importers and exporters, inflation accelerates due to higher commodities prices. In commodities exporters, higher income from the positive terms of trade shock can add to inflationary pressures. In commodities-importing countries, by contrast, the loss of income is disinflationary.

If the central bank expects the shock to be temporary and/or the economy has spare capacity, it can step back and let the terms of trade shock play out. This time, however, inflation is above target in most countries. And central banks will likely tighten policy, even in commodities importers, which will further depress global growth. And since the shock is global, most countries will tighten policy in sync, i.e., external demand will compound domestic demand weaknesses.

Market Consequences

This analysis suggests the market is too sanguine in its reaction to Chair Jerome Powell’s Humphrey-Hawkins testimony. Powell indicated he supported a 25bp hike at the March meeting. But he also stated he was prepared to hike 50bp per meeting if inflation does not slow in H2 as he currently expects. An oil shock would likely see an acceleration in US inflation and a commensurate policy response by the Fed.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the presentation does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs)