The war in Ukraine is first and foremost a humanitarian tragedy. However, Russia’s invasion and the international community’s response to it is also likely to have far-reaching economic consequences. In this month’s commentary, we take a look at some of the ways the conflict might impact the global economy, both in the months ahead and over a longer time frame.
The most obvious way in which the conflict will impact the global economy is via commodity prices. Although both Ukraine and Russia do not account for a large share of the world economy (Russia accounts for around 1.7% of global GDP1), they play a disproportionate role in the supply of commodities. Russia is a big supplier of oil and natural gas (accounting for around 12% and 17% of global output respectively), as well as a range of industrial metals, including aluminium (6%), nickel (6%) and palladium (44%)2.
As regards agricultural commodities, Russia and Ukraine combined account for around 30% of global wheat supply3 and are also big exporters of sunflower oil, corn and fertiliser.
Higher commodity prices and inflation
Unsurprisingly therefore, the prospect of disrupted supply, along with the impact of sanctions and trading partners’ desire to wean themselves off Russian exports have resulted in sharp swings in commodity prices. At the time of writing, the price of a barrel of Brent Crude oil was trading at US$108 per barrel up from around US$94 before war broke out4. Natural gas prices have seen renewed volatility and wheat prices are up nearly 70% compared with a year ago5.
The CRB index, a broad measure of commodity prices, is trading close to 8-year highs and has risen around 50% over the last 12 months6.
This ‘supply shock’ is likely to have a ‘stagflationary’ impact on the global economy: lifting consumer prices and denting economic activity.
The precise impact on inflation rates will depend on the course of commodity prices going forward, the degree to which higher input costs are passed on to the end consumer and how policymakers react. Even if the conflict is brought to a swift end, sanctions might still remain in place and customers will remain wary of relying on Russian supply, suggesting that energy/commodity prices are unlikely to fall back dramatically in the near-term.
As a result, inflation forecasts have generally been revised up in recent weeks. JP Morgan, for example, sees recent developments adding around one percentage point to global inflation by the end of 20227.
Weaker growth
Rising wholesale prices for oil and gas are already impacting consumer prices. Via their direct impact, prices for petrol in the UK and the US have hit record highs and household heating bills are set to rise sharply. This ‘energy tax’ might lead to some reduction in the consumption of energy (driving less, turning down the thermostat etc.) but is also likely to eat in to households’ real disposable incomes, leaving less to spend on non-energy goods and services.
Producers of oil and gas will benefit from higher prices and potentially step up investment. But with household consumption generally making up around two thirds of global GDP, growth is likely to take a hit and forecasts for economic growth this year have been revised down. For example, JP Morgan have shaved 0.8 percentage points off their 2022 global growth forecast as a result of recent developments, and now sees a rise of 3.1% year on year (y/y) in Q48.
Sharp rises in energy prices have, of course, been a precursor to outright recessions in the past, most notably during the oil price shock following the Arab oil embargo of 1973. A reduction in the oil intensity of global GDP (a unit of GDP requires around half as much oil now as it did during the 1970s due to improvements in efficiency and the growing role of the services sector9) is a mitigating factor at the current juncture. In addition, many households in the developed world will have built up excess savings during the pandemic, which should provide some cushion against the shock to real incomes.
Recession risk
However, if the supply shock intensifies, the risk of recession will clearly rise, particularly in the European Union, where Russia supplies around 25% of oil imports and 45% of its natural gas10. Although the EU has pledged to reduce its reliance on Russian energy, it has not gone as far as the UK and US which have outlined plans to ban Russian oil imports.
In the event of further disruption to Russian oil and gas supplies (due to an expansion of sanctions to include the energy sector, damage to physical infrastructure etc.), the shortfall would be nigh impossible to make up quickly from other sources. This would raise the prospect of rationing or ‘demand destruction’ via a further sharp increase in prices. Rystad Energy, a Norwegian research company, see the oil price rising to US$240 per barrel – a level that would trigger a global recession - if more European countries join the US oil embargo11. Goldman Sachs reckon that in the event of Russian gas being shut off completely, GDP in the eurozone would be hit by 2.2% relative to baseline12.
As well as the impact from higher energy costs, a sharp rise in food prices is also likely to take a heavy toll, particularly in developing economies where foodstuffs account for a greater share of household spending. The FAO global food price index had already hit a record high before the war broke out13 and is likely to rise further as a result of the higher cost of fertilizer, wheat, soybeans and other foodstuffs. In turn, this raises the risk of political unrest (higher food prices were one factor that sparked the uprisings that led to the Arab Spring in 2011) and widespread food export bans.
Supply chain disruption
The fallout from the war in Ukraine also threatens to exacerbate the global supply chain issues resulting from the coronavirus pandemic. Trade routes have been disrupted by the closure of Ukrainian ports and Russian airspace, as well as other factors including trade financing/insurance difficulties and shortages of skilled crew, many of whom come from the two warring countries.
The war has once again highlighted the interconnectedness of the global economy, with a range of industries likely to be affected by the conflict. Several European car manufacturers have had to halt production due to a lack of wiring harnesses that are normally made in Ukrainian factories, which currently lay idle. Production of semiconductors is under renewed threat from a shortage of neon, a gas used in the manufacture of chips, around half the global supply of which comes from Ukraine14.
Disrupted supply of computer chips will have further knock-on effects in the manufacture of vehicles, household appliances etc. The service sector could also be impacted; for example, Deutsche Bank risks losing a quarter of its investment bank IT specialists, 1,500 of whom work in offices in Moscow and St. Petersburg which could potentially be affected by sanctions.
Deglobalisation
In the short term, renewed shortages are likely to further depress economic activity and put upward pressure on prices. In the longer term, they could give another fillip to the process of deglobalisation, as companies look to reduce the risks associated with complex supply chains and move to prioritise resilience over efficiency. From a national standpoint, there is likely to be a further drive towards self-sufficiency (for example in the area of semiconductors), while companies may become increasingly wary of investing in emerging market economies due to the risks involved.
This process seems set to result in higher costs for businesses, which are also likely to rise as a result of expanded legal departments required to comply with a growing list of sanctions, and increased spending on information technology to counter the growing threat of cyber-attacks (Russia accounts for most state-sponsored computer hacking15). In turn, higher business costs will lead to squeezed profit margins and/or higher prices for end consumers.
Increased government spending
While increased uncertainty and squeezed real incomes will weigh on private sector spending, the conflict is set to usher in an increase in government outlays, most notably in Europe.
In the near-term, governments will incur the costs of accommodating and integrating Ukrainian asylum seekers who are currently fleeing their country. In 2017, the OECD estimated the first-year cost of each asylum application at US$10,00016, although this cost is likely to fall in subsequent years as refugees find jobs and pay taxes. Nearly three million people have left Ukraine so far, and the UNHCR estimates that this could rise to four million17. However, these figures could prove to be on the low side, and some estimates suggest that spending in some European countries could increase by 0.5-1.0% of GDP this year18.
A longer term pressure on public spending will be the investment needed to reduce dependence on Russian energy exports, along with measures to mitigate the negative impact of elevated energy prices on household budgets via subsidies and/or transfers. In the EU, the cost of building a new energy infrastructure to facilitate more widespread use of liquified natural gas, along with the accelerated rollout of renewable energy sources is likely to primarily fall on the public purse.
The end of the ‘Peace Dividend’
As well as energy security, spending on the military is also likely to increase in response to the heightened risk of conflict. The German government has already announced that it will increase defence spending to above the 2% of GDP NATO guideline level (spending was around 1.53% in 2021)19. With most other European countries spending less than 2% of GDP on defence20, others are likely to follow Germany’s example. Away from Europe, it is telling that Beijing recently announced a 7.1% increase in its defence budget this year21.
All of this demonstrates the pressure for increased military expenditure as geopolitical tensions rise and the so-called ‘peace dividend’ (which has enabled resources to be diverted to non-defence budgets, such as healthcare, over the last 60 years or so) evaporates. By way of example, defence spending in the UK amounted to around 7% of GDP during the 1950s and has steadily fallen to around 2% today22.
This pressure for increased government spending, most acute in Europe, will leave governments facing difficult choices: will higher defence spending come at the expense of reduced spending in other areas? Will taxes rise? Will larger budget deficits be financed by increased debt? Or will central banks come under pressure to fund budget deficits by maintaining quantitative easing, or bond-buying, programmes? The answers to these questions will ultimately play a key role in shaping economic performance going forward.
Elevated uncertainty
Coming on the back of the coronavirus pandemic, there is little doubt that the war in Ukraine has ratcheted up the level of uncertainty and instability in the global economy. Downside risks would clearly shift up another gear if the war results in escalating tensions with China, which plays a more important role in the world economy than Russia does.
Although a global recession is not a base case at this stage, the near-term impact looks set to be ‘stagflationary’, with increased spending (on defence, alternative energy, cybersecurity etc.) and a further move towards deglobalization amongst the likely longer-term consequences.
We can but hope that diplomatic efforts bring a swift end to the fighting. However, the economic consequences of the war threaten to reverberate long after the guns have fallen silent.
15th March 2022
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.
1 JP Morgan
2 JP Morgan
3 https://www.ft.com/content/e6a28dd9-ecea-4d67-b6b5-a50301b731b2
4
https://tradingeconomics.com/commodity/brent-crude-oil
5
https://tradingeconomics.com/commodities
6 https://tradingeconomics.com/commodity/crb
7 JP Morgan – Global Data Watch – 4th March 2022
8 JP Morgan – Global Data Watch - 4th March 2022
9 https://www.ft.com/content/cc513e50-eb68-43aa-b718-fcb4f8031c03
10 https://www.cnbc.com/2022/03/08/eu-pledges-to-cut-russian-gas-imports-by-two-thirds-before-next-winter.html11
https://fortune.com/2022/03/09/worst-case-oil-forecast-240-per-barrel-global-recession/
12 https://www.cnbc.com/2022/03/11/goldman-predicts-what-will-happen-to-europes-economy-if-putin-shuts-off-gas.html
13 https://www.fao.org/worldfoodsituation/foodpricesindex/en/
14 https://www.reuters.com/technology/exclusive-ukraine-halts-half-worlds-neon-output-chips-clouding-outlook-2022-03-11/
15 https://www.rferl.org/a/russia-microsoft-state-sponsored-hacking/31499069.html
16 https://www.oecd.org/els/mig/migration-policy-debates-13.pdf
17 https://data2.unhcr.org/en/situations/ukraine
18 https://www.niesr.ac.uk/publications/economic-costs-russia-ukraine-conflict?type=policy-papers#:~:text=Main%20points,2%20percentage%20points%20in%202023.
19 https://www.reuters.com/business/aerospace-defense/germany-hike-defense-spending-scholz-says-further-policy-shift-2022-02-27/
20 https://www.nato.int/nato_static_fl2014/assets/pdf/2021/6/pdf/210611-pr-2021-094-en.pdf
21 https://www.reuters.com/markets/asia/china-defence-spending-rise-outpace-gdp-target-this-year-2022-03-05/
22
https://researchbriefings.files.parliament.uk/documents/CBP-8175/CBP-8175.pdf