Please find below an update on the conflict in Ukraine, courtesy of JP MORGAN ASSET MANAGEMENT.
The human toll of any conflict is devastating and events unfolding in Ukraine are deeply upsetting. This note seeks to answer the economic and market questions we are receiving.
How will the crisis affect global energy prices?
Russia accounts for 13% of global oil production and 17% of global natural gas production. However, the EU’s reliance on Russian energy sources is far greater: around a quarter of EU crude oil imports and 40% of natural gas imports currently come from Russia. There is only limited scope for the EU to offset any disruption in supply by accelerating imports from other sources, and recent price swings have been exacerbated by the fact that EU energy stocks started winter at depleted levels after an unusually cold autumn. Sanctions imposed to date have been designed to minimise the impact on energy supply, but energy prices will remain highly sensitive to further developments. The risk to energy prices is asymmetric. We could see significant moves higher in the event that concerns around supply disruption worsen. If the situation calms, we would expect energy prices to decline but the tight supply/demand balance in the market is likely to keep prices at elevated levels relative to history.
Will USD100/ barrel lead to a recession?
In our opinion, no. Our judgment is that middle to upper income consumers have sufficient savings from the pandemic to support spending. We expect lower income households to receive government subsidies. President Biden is likely to try to find new legislation to push through an extension for the family tax credits. In addition, although inflation is high, low unemployment is spurring rising wages, with low-wage earners experiencing the strongest gains. In the US, inflation has accelerated to 7.5% but real incomes have been at least supported by an acceleration in wage growth to more than 5%.
Will central banks have to hike more rapidly in the face of higher commodity-driven inflation?
In our opinion, no. We expect central banks to prioritise growth and so see central banks normalising policy more gradually as they acknowledge the downside risk that higher commodity prices present to growth. Market pricing for a 50-basis-point hike from the Federal Reserve (Fed) and Bank of England (BoE) at their next meeting has fallen to 20%, whereas in previous weeks it had been as high as 80%. Market pricing for policy rates by the end of the year has also fallen, with investors now expecting at least one fewer hike from both the Fed and the Bank of England than they did a few weeks ago.
Which regions are more vulnerable?
The European economy is most exposed given its high dependency on Russian energy. We see the extreme scenario where Russia cuts off all gas supplies as unlikely given the effects it would have on Russia’s income. Europe’s banking system is also exposed. But according to the Bank for International Settlements the total exposure is USD89bn which appears manageable. Our judgment is also that the ECB has most scope to slow the pace of monetary tightening because wage pressures are less acute which should cushion economic activity and spreads in the periphery.
The US consumer can be sensitive to rising gasoline prices, but the oil and gas sector tends to benefit from increased activity. The US became a significant net exporter of energy in 2019 so periods of higher oil prices are not as detrimental to activity as we saw historically.
In the emerging world, there are winners and losers. Commodity exporters are benefitting from higher prices. However, unlike in the developed world, central banks may be forced to tighten policy in the face of rising inflation which would slow activity. There is therefore a significant dispersion of market performance amongst EM benchmarks. MSCI EM Asia is down over 6% in the last two weeks, while EM LATAM has fallen less than 2%.
What should investors do?
Historically, geopolitical events, even those involving major energy producers, have not had a lasting impact on markets. Looking back at equity market sell-offs relating to geopolitical events, they have tended to be short and sharp, with sell-offs not lasting much longer than a month as markets react to the sudden event. The size of the market reaction can be considerable, as it has been in this instance, with equities sometimes falling more than 10%. But in most previous geopolitical incidents, markets have tended to recover to their prior level in under a month, after investors assess that the macro environment has not materially changed. Of course, if the growth backdrop has materially changed, as it did with the 1973 oil shock, then it can lead to a more material sell-off and a longer period to recover losses.
De-risking a portfolio might be tempting given the potential consequences of a meaningful prolonged period of conflict between Russia and the West. However, it is possible that absent the introduction of energy-focused sanctions, investors could turn back to the broader 2022 narrative relatively quickly – one of modestly higher interest rates and a rotation of performance towards value segments of the market, which benefitted benchmarks like Europe.
At this stage we caution against knee-jerk outsized swings in allocation beyond taking portfolios to more neutral positions.
One thing does seem abundantly clear: in the short term and long term we expect the crisis to intensify the investment in the transition towards renewables as higher energy prices and fears of energy security add to existing climate concerns.
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