Threat of supply shortages are fueling commodity price surge

• Given Russia’s global production in energy, food and industrial metals, possible export embargoes could reduce supply at the time when the global economy is recovering from the COVID-19 pandemic. This has already pushed global commodity prices higher. 
• There is considerable difference in natural gas prices in the U.S. compared with Europe and Asia. This is because Europe and Asia are buying from similar sources, especially in liquefied natural gas (LNG), and therefore the prices they face are much more in sync. The U.S. natural gas supply is largely independent from Europe and Asia, which explains the much less dramatic rise. 
• This would mean Asia and Europe would face greater inflationary pressure from gas prices in months ahead. Europeans are already anticipating a much more expensive heating bill in the coming winter, which could impact on their spending on other items.  This could be helped if their governments provide some cash subsidies to offset the extra expense. 

Limited scope for other regions to offset supply disruptions

• Russia produces around 10 million barrels of oil each day with half of this output exported. Limiting Russian oil exports could make the global supply shortage worse. The blue line on the right hand chart shows that U.S. oil inventory is already running at a multi-year low and the same is true for other major economies. 
• The scope to offset Russian oil supply disruption is limited, especially in the short term. OPEC has missed its 400,000 barrels per day production increase by a significant margin due to reduced production capacity. A possible Iranian nuclear deal could see sanctions lifted but it will also take time for Iran to boost capacity and export their production. Members of International Energy Agency have in total 1.5 billion barrels in Strategic Petroleum Reserve. They have already announced to release 60 million barrels to meet demand. Yet this is equivalent to around 12 days worth of Russian exports, so more could be needed if the supply squeeze continues. 
• Another potential source of supply increase is from the U.S., especially the shale oil industry. But as shown by the grey line on the right hand chart, the industry has yet to pick up investment in new oil rigs in a meaningful way. They are taking a more conservative approach in investment after several years of over investing, funded by borrowing. Persistent high oil prices may attract them to start investing again. 　

Russia’s influence on commodities goes beyond energy

• In addition to oil and gas, Russia is also a major producer in industrial and precious metals, including gold, platinum, nickel. It also uses its energy resources to refine aluminium, which is an energy intensive process. It is also a major producer in wheat and fertilizers. Hence, disruptions in exports of these raw materials would not only lead to higher prices, but also potential disruptions in global supply chain. 
• Ukraine is also a significant exporter of wheat to the EU. It is also a major source of noble gases used in the manufacturing of semiconductors, including neon, argon and xenon. Ukraine is responsible for 70% of the world’s supply of neon. For now, chip makers have sufficient stock of these raw materials for production to avoid supply chain disruptions. 　

Rising commodity prices will have a diverse impact

• The direct impact on global growth comes from the drag of higher energy and commodity prices. But not all countries will face the same headwinds and some may even benefit. Australia, Brazil, Canada and Colombia are net exporters of energy and in a better position to handle the impact. Meanwhile, Chile, and South Africa have higher net exports of industrial commodities as a share of GDP. The U.S. is also largely self-sufficient in industrial commodities and energy. Higher prices could in fact lead to an increase in investment for developed economies, adding momentum to growth, or offsetting fiscal challenges in some emerging markets.
• In contrast, Japan and a number of large European economies are net importers of energy. Governments may need to increase fiscal spending to offset the sharp rise in household spending on fuel and food via subsidies or temporary reduction in fuel taxes. Meanwhile, South Korea and India could see their current account position undermined by larger import bills and would need to be more mindful of pressure on their currencies. 
• Given the economic connection between Russia and Europe, the European economy bears the greatest downside risk to growth, while other parts of the world will face varying economic shockwaves of varying magnitude. Those countries with a larger share of commodity exports could be more resilient in this crisis and would be an option to diversify portfolios. 

Higher energy price means delay to peak in inflation

• Rising energy costs have added at much as 2% to headline inflation in the U.S. as the price of oil has doubled compared to 12 months ago. The average price of oil in March 2021 was around USD 60 per barrel.
• Had the oil price remained at USD 105 per barrel, the year-ago comparison would have become much smaller and the impact on headline inflation much less and the peak in U.S. inflation would have come much sooner.
• Oil at USD 120 pushes out the peak in inflation, not only as it contributes to the energy component of the inflation basket, but may have a pass-through impact to broader inflation in the U.S. economy. 　

More inflation but fewer rate hikes

• The consensus view of inflation has changed markedly since the middle of last year. In June 2021, consensus expected inflation to fall back towards 2% in the U.S. over the course of 2022. However, recent events have adjusted that view to a much higher peak in inflation and a landing point closer to 4% by year-end.
• It is possible that inflation in the U.S. will be over 8% in the coming months and that the peak will happen later than the current consensus given the sharp rise in commodity prices. Crucially, it also means that there will be more inflation in the economy than thought just a few months ago.
• Central banks are less likely to respond to a supply shock as is being experienced with energy and continue on a path to policy rate normalization in the U.S. However, given the downside risk to growth, central banks are likely to be more cautious in their approach, with fewer rate hikes in the U.S. and UK. Meanwhile, the economic threat to the eurozone is such that the ECB is unlikely to change its current accommodative policy stance this year. 　

Major equity markets have been pushed into correction territory, bonds offer little reprieve

• Risk assets have sold off heavily since the middle of February when the concerns around the potential for conflict in Ukraine started to increase. Prior to this, some of the higher-valued and more growth-oriented parts of the global equity market were already coming under pressure from the prospects of rising interest rates.
• The selling pressure has been greatest in Europe amongst the developed markets given the risks to the economy and corporate earnings are the greatest. Given the rise in commodity prices, those markets with a greater weight towards energy and materials sectors have not seen the same degree of losses. The MSCI World Energy sector is up close to 10% since the middle of February as energy prices have risen. Companies associated with renewable energy have also benefited from the current climate given the expected fiscal spend in Europe to accelerate the transition away from fossil fuels and concentrated energy supply.
• The strength of government bonds to offset the decline in equity markets is evident from the small return on government bonds even as yields fall, given the relatively low starting yield. 

Not all conflicts have the same impact on asset performance

• This table expands on the performance of U.S. and Asian equities as well as the price of oil during a select number of military conflicts since the 1970s.
• We noted that when there is a transmission from the conflict to the economy then the market impact could be greater, but this is not always the case. The Arab spring in 2011 saw the oil price rise nearly 23% in six months to be well over USD 100 per barrel, but both Asian and U.S. equities rallied over this same period. During the North Korea nuclear tensions, equity markets rose along with the oil price, however, this time the oil price was coming from a low base.
• The table illustrates that in nearly all instances, there is an initial risk-off market reaction in equity markets, but it is often up double digits 12 months later. It is not just the movement in oil prices that will determine market behavior, but an assessment of whether the event will fundamentally change the outlook for economic growth and corporate earnings. 

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