Overview:
- As tighter supply and demand will lead to higher oil prices, even if tensions between Russia and Ukraine ease, energy prices will still face asymmetric risks.
- The indirect impact of high oil prices on economic growth should be manageable and would prompt central banks around the world to temper their hawkish stances.
- We expect that despite the volatile geopolitical situation, investors will return to global growth fundamentals and related policies. The configuration should beware of "reflexive" drastic adjustments.
As the situation in Ukraine continues to develop, investors are full of questions about the current economic and market situation, and this article aims to answer some of the questions.
What impact will the crisis have on global energy prices?
Russia produces 13 percent of the world's oil and 17 percent of its natural gas. However, EU countries are more dependent on Russia's energy than they are: currently, a quarter of the EU's crude oil imports and 40% of its gas imports come from Russia. For the EU, the impact of supply disruptions will be very limited by accelerating imports from other sources, and EU energy inventories will be depleted by the time they enter winter after an unusually cold autumn, which has also exacerbated recent price volatility. We believe that eu sanctions against Russia so far are aimed at minimizing the impact on energy supply, but energy prices will remain highly sensitive to further developments.
Energy price risk is asymmetrical. If supply disruptions worsen, oil prices could rise sharply. If the situation eases somewhat, we expect energy prices to fall, but tighter supply and demand in the market could keep oil prices at historically high levels. In the long run, other sources of supply may help restore the equilibrium between supply and demand. Other possible sources of supply include a boost to market access for Iranian supplies if the U.S. lifts sanctions on Iran after the resumption of the nuclear deal, in addition to the release of the global strategic oil reserve and capacity growth in other oil-producing countries, including the United States. However, this still takes some time, and it will not solve the problem of short-term supply disruptions.
Will a spike in oil prices to $100 a barrel lead to a recession?
We believe that the U.S. economy will not be affected. We judge that middle- and high-income consumers have saved enough during the COVID-19 pandemic to cope with spending. Low-income households are expected to receive government subsidies. U.S. President Joe Biden may seek new legislation to push for an extension of the family tax credit. Moreover, while inflation remains high, low unemployment is driving wages up, with the lowest wage earners seeing the biggest increases. While inflation in the United States has accelerated to 7.5 percent, an acceleration in wage growth (by more than 5 percent) will at least support real incomes.
The spike in oil prices is more challenging for low- and middle-income emerging economies and Asian economies, where households spend more on food and energy but do not enjoy higher wage increases. Its government may need to increase fiscal support, including cutting fuel taxes or providing energy subsidies, to offset increased spending on necessities to safeguard spending on consumer discretionary goods.
Chart 1: Asset class returns since February 15, 2022
% Total Return (Local Currency)
Sources: Bloomberg, China Securities Index, U.S. Commodity Research Agency, FactSet, ICE Bank of America Merrill Lynch Fixed Income, ICE-Intercontinental Exchange, London Bullion Market Association, MSCIGlobal, S&P US, Tokyo First Market Index, JPMorgan Asset Management. Past performance is not a reliable indicator of current and future performance. Reflects the latest data as of February 28, 2022.
In the face of commodity-fueled inflation, will central banks everywhere have to speed up the pace of interest rate hikes?
In our view, the answer is no. We expect that as central banks around the world begin to recognize the downside risks to growth posed by rising commodity prices, they will put growth first and normalize policy in a more gradual manner. Expectations for a 50 basis point rate hike by the Fed and the Bank of England at their next meeting have fallen to 20 percent, compared with 80 percent in previous weeks. Market expectations for policy rates for the year have also fallen, with investors now expecting at least one reduction in the number of rate hikes by the Fed and the Bank of England compared to a few weeks ago.
For Asian central banks, the urgency of following the Fed's interest rate hikes before the Ukraine crisis erupted was not high. Inflation in the region remains manageable, and many economies in the region are still in the early stages of the COVID-19 recovery. The recent rise in commodity prices should strengthen investor caution.
Which areas are more susceptible?
Due to its high dependence on Russian energy, the risks to the European economy are the most prominent. In our view, given the impact on local revenues, it is unlikely that Russia will have an extreme situation of cutting off all gas supplies. Europe's banking system is also at risk. But according to the Bank for International Settlements, the total exposure to risk is $89 billion, which still appears to be under control. We also believe that the ECB has the most leeway to slow down the pace of monetary tightening, as the more modest wage pressures in Europe should cushion the impact of economic activity and spreads in peripheral countries.
U.S. consumers may be more sensitive to rising gasoline prices, but the oil and gas industry tends to benefit from increased economic activity. In 2019, the United States became a significant net exporter of energy, so the adverse impact on economic activity during periods of high oil prices was not as severe as historically seen.
In emerging markets, there are winners and losers. Commodity exporters will benefit from higher prices. But unlike developed countries, emerging-market central banks may be forced to tighten policy in the face of rising inflation, which will lead to a slowdown in economic activity. As a result, the performance of each market will be significantly differentiated in emerging market benchmarks. The MSCI Asia Emerging Markets Index has fallen more than 6 percent in the past two weeks, while the Latin America Emerging Markets Index has fallen less than 2 percent. For Asia, while most economies are net energy importers, their current-account surpluses should provide some degree of protection from currency depreciation. The real interest rate differential between Asian currencies against the dollar is also at a multi-year high, which will provide additional buffer space.
Chart 2: Performance of asset classes in different time frames after geopolitical events
Source: Bloomberg, U.S. Commodity Research Agency, FactSet, S&P USA, JP Asset Management. U.S. stocks are represented by the S&P 500 Total Return Index, 10-year Treasuries represented by the value of the Bloomberg Barclays U.S. Treasury Leading Index 10-year Total Return Index (unhaled in U.S. dollars), and oil prices represented by the global ICE Brent crude spot price (USD/barrel). Past performance is not a reliable indicator of current and future performance. Unless otherwise noted, the data used are daily. Data on U.S. Treasury bonds during Iraq's invasion of Kuwait were not available. Oil prices prior to September 1982 are regularly published annual data. *Due to the lack of total return data, the S&P 500 index and 10-year Treasury price returns are used for this period. Reflects the latest data as of February 28, 2022.
Investment implications
Historically, geopolitical events, even those involving major energy-producing countries, have not had a lasting impact on markets. Looking back at past data, stock market sell-offs associated with geopolitical events tend to be short and violent, and depending on the market's response to unexpected events, the sell-offs do not last longer than a month. The market reaction can be quite intense, as in the Ukraine crisis, stocks sometimes fell by more than 10%. But in most past geopolitical events, when investors assess that the macro environment has not changed significantly, markets tend to return to their previous levels in less than a month. Of course, if there were a major change in the economic growth environment (such as the oil crisis of 1973), the stock market could be sold off on a larger scale and it would take longer to recover the losses.
Given the potential consequences of a prolonged conflict between Russia and the West, reducing portfolio risk could be attractive. However, if Western countries fail to implement energy-focused sanctions, the market may return relatively quickly to a broader trend in 2022, where interest rates rise slightly and market performance rotates towards value plates, benefiting benchmark markets such as Europe.
We would like to caution that at this stage, in addition to adjusting the portfolio to a more neutral position, the allocation should beware of "reflexive" over-adjustment.
To be clear, we expect investment in the renewable energy transition to intensify as a result of the crisis, both in the short and long term, as rising energy prices and energy security scares exacerbate climate concerns.