Macro Insights Weekly: Stagflation watch?

Commentary: Stagflation watch?

The macro clouds of uncertainty have darkened in recent weeks. As the sanction list lengthens, so does the risk of retaliatory measures from Russia, as well as further volatility in energy markets and asset price correction. We are worried that this is not a crisis that can end quickly, and therefore we have to worry about ramifications for the global economy.

For starters, Russia and Ukraine’s outsized role in energy and food-grain supply has spooked markets. Russia is the largest exporter of crude oil presently, amounting to 5mn barrels/day, 60% of which goes to Europe and 20% to China. There is nowhere close to sufficient supply available elsewhere on the margin to plug this gap in the short run, so we think that independent of the course of the crisis, Russian oil will continue to flow. The US, which receives about 5% of its crude and other petroleum product imports from Russia, may be the only major power in a position to impose a ban. Nonetheless, these considerations have destabilised the energy market, pushing up crude prices by over 20% in just two weeks.

As for Ukraine, it is a major exporter of food grain, accounting for 16% of wheat and 12% of corn exports worldwide. These products were already riding a bullish wave in 2021, and now they have caught further momentum. Wheat prices have risen by 45% and corn prices by 25% so far in 2022, after rising by more than 20% last year. For importers of these products, the developments are alarming.

These are pure supply shocks, which can lead to demand destruction at some point. Two conditions are needed for that: first, the high prices have to persist at this level for months to come; and second, they would have to hurt sentiments, balance sheets, and credit worthiness materially to start biting into consumption and investment.

As Russia faces deep contraction in its GDP due to sanctions, the incentives for its government to continue to supply energy to world markets will remain strong, we are sure. Iran could bring about 1mn barrels/day of crude to the market if and when its nuclear deal with the US is reactivated. US shale producers will bring in an additional 0.7mn this year, with further increases expected in 2023 and 24. Putting these together, we think oil can only go so far.

But even as crude soars past $125, the real price of oil remains 20-25% below the peak seen a decade ago. Moreover, real incomes have gone up by 20-30% since then, corporate and household balance sheets, which were reeling from the aftermath of the global financial crisis then, are in considerably better shape now, and global energy intensity is lower by 10%. The world economy’s ability to absorb this shock is greater, we are sure.

Asia, largely an importer of energy, will find ongoing developments uncomfortable, but the region has sufficient depth to take on elevated oil and gas prices, in our view. Inflation is low compared to the US/EU, which makes for a gentler starting point. Supply-side inflation would not have to be confronted vigorously, especially as output gaps are wide. As for the mounting import bills, currency buffers are greater than they used to be, and overall current account balances are favourable. Pain from commodity inflation is unwelcome but, somewhat tolerable for now.

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