4 MAR, 2022
By Sebastien Galy
The war in Ukraine creates many uncertainties in the market, especially on oil prices. However, the odds of a super spike in oil prices as happened in the 1970s are not large. Ukraine and Russia have an economy smaller than Italy which means that while it is a growth shock, it is a moderate one for the world economy.
What matters is the impact of the war on inflation and a sentiment that may be unstable. The world economy is already growing at too rapid a pace which means it is inflationary and a consequence of this is that the supply of oil can barely keep up with demand. To add to this, oil importers now ask for a discount of up to seventeen dollars to buy Russian oil (Ural) in anticipation of European consumer boycotts. This may increase, though at some point, consumers will vote with their wallet and return to buying Russian oil at the pump. Finally, some will argue that Russia could curtail its oil and natural gas output. This is unlikely, as it will increasingly need hard currency to import a large variety of goods as Russia has a weak industrial base. Nonetheless, Russia may increase its oil supply by less than expected in order to squeeze prices higher and generate more hard currency revenues. That means oil and natural gas prices could still go higher.
The extent of the oil shock largely depends on the intensity with which oil prices increase and how long they stay elevated. That is mostly a function of how fast global demand reacts to oil prices, when consumers are as a whole richer than they were a few years ago. Russia needs urgently dollar revenues and a large oil shock would hurt China at the wrong time. Hence, Russia is unlikely to curtail significantly output lest it lose the help and support of its key ally.
For the Eurozone, this oil supply shock is combined with a broader demand shock as exports to Russia and Ukraine are severely curtailed. The ECB has flagged that it will delay the decision to tighten monetary policy, with the first rate hike priced now for January 2023. The problem is that the ECB is faced with a potentially stagflation scenario as consumers and corporates are deeply unnerved while inflation potentially surges. The average household is probably not consuming much right now, troubled as they are by the war in Ukraine and the fear of rising fuel prices. Over a period of many weeks, this should reverse as tempers calm. Governments are also likely to spend more in core Europe with for example Germany set to slowly spend 100bn in defense spending. Hence, over a period of several months, the ECB is likely to once again turn less dovish and start an earlier but slow pace of rate hikes.
For the US, the problem is an inflation rather than a direct growth shock. US inflation and demand is more sensitive to elevated oil prices – nonetheless overall demand is very robust. The Fed’s Chairman pointed to the Ukraine war impact as very uncertain, in other words, oil price dynamics are now uncertain. The Fed is on its way in March to what will likely be a series of six rate hikes as expected, but is open to a faster pace should inflation persist. While the Fed may prove eventually more hawkish than expected on rates, it is likely to prove more prudent now on balance sheet reduction given the large impact the announcement had on the equity market.
In the current environment, short duration positions in fixed income continue to make sense. European equity valuations are no longer so extreme, reducing the value of fixed income as a safe haven. Hence, we continue to see the value in the alpha capability of short-duration Covered Bonds.