We will all have to live with the consequences of Russia’s actions

Russia’s invasion of Ukraine has quickly become a humanitarian tragedy, with thousands of casualties, more than three million refugees and many more lives disrupted. Sadly, the pain will be even more widespread. Russians who had no part in the country’s invasion have seen their way of life come crumbling down in weeks. And despite the fact that Russia and Ukraine account for a small share of the global economy, the world’s economic prospects have - at the margin - taken a turn for the worse as a result of the huge rise in energy and food prices.

The misfortune is all the greater as it comes just as economies were starting to recover from the damage of the pandemic. Sadly, the consequences of this crisis are again likely to be greatest for both the less well-off in rich countries – and those in less developed and poorer countries. Both spend a greater share of their income on fuel and food than the more affluent.

In economic terms, the invasion of Ukraine could significantly reduce global growth – potentially even leading some countries into recession. Inflation, by contrast, is set to rise further from already elevated
levels. The combination of high inflation and low or negative growth is known as “stagflation” – and it tends to be a difficult environment for financial markets. Corporate profits come under pressure as costs rise faster than revenues. Bond markets also struggle as investors demand higher returns as compensation for inflation. It is still possible that diplomacy will allow this outcome to be avoided or mitigated, but the risks are rising.

Schroders’ economists recently cut their outlook for global growth this year to 3.7%, based on the early assumption that Russia would quickly achieve regime change in Ukraine. Given that this has not materialised, and fighting could still escalate, there could be further downgrades.

Today’s outlook is very different from what we anticipated just a few months ago when the world looked set for another year of stronger-than-average growth. It is now more likely to be in line with the tepid average of the decade leading up to the pandemic.

Energy, metals and food are all becoming more expensive

Price of key commodities has roughly doubled since 2015 (price rebased to 100)

_{Source: Refinitiv Datastream}

Energy and food prices may cause the crisis to spread

Russia is a major supplier of the world’s energy and food. It accounts for 11% of oil production, 17% of gas and 11% of wheat, according to Schroders’ economists. In tightly-balanced markets, as was the case for many commodities prior to the invasion, disruptions to supply on this scale can cause prices to spike. Oil and wheat have both risen by more than 50% since the end of 2021. The increase in gas prices in many European markets has been far more dramatic.

Price moves so far primarily reflect commodity buyers looking to build stocks, diversify supply and avoid the legal and reputational risk of dealing with Russia – rather than actual supply disruptions. As of mid-March, the US, UK and Canada have all announced bans on Russian energy imports - but none is really dependent on them. It’s a different story in Europe, with Germany and Italy importing almost half of their gas from Russia. German Chancellor Olaf Scholz has admitted that a European ban is not currently feasible. However, there is still the possibility that Russia follows through on a threat to cut supply to the continent – which would force energy prices higher still.

Given the uncertainty, the cost of oil and gas is likely to remain high and volatile for the foreseeable future. Recent increases mean that energy costs as a percentage of global GDP are likely to rise to a mid-to-high single-digit percentage – up from just 2% in April 2020, a multi-decade low. The increase is the fastest since the 1970s, when Saudi Arabia and other countries restricted oil supply in response to conflicts in the region.

Higher food prices pose an additional challenge, especially for emerging markets. Wheat and other agricultural commodities were already becoming more expensive prior to the invasion, following several poor harvests and reduced investment in production. Countries such as Egypt and Turkey, two of the largest importers of Russian and Ukrainian wheat, look particularly exposed. In the case of the former, wheat is subsidised by the government and the rise in prices is starting to worry the country’s creditors. In the past, high food prices have triggered political unrest in the region – and were a key factor behind the Arab Spring of 2011.

There are some reasons for optimism, especially if the spike in prices proves short-lived. In developed markets, savings built up during the pandemic will provide something of a cushion for consumers. It’s also worth bearing in mind that economies oil cost more than $100 per barrel on a number of occasions before the oil price crash of 2014. In the past several decades, global output has become less “energy intensive” as more economic activity has shifted online or to the service sector. Additionally, the energy market could see relief from the return of Iranian oil to international markets. The country has over 100 million barrels of oil in storage. This compares to a possible loss of Russian output of three million barrels per day, according to a recent forecast from the International Energy Agency.

Financial risks are rising

We had expected that inflation might start to fall in the second quarter of the year, but this now looks less likely. Headline inflation – which reflects food and energy prices – will almost certainly continue to rise for a period. At the same time, underlying demand could weaken as consumers and companies deal with higher costs. This may well mean that central banks raise interest rates at a slower pace than they – and markets – had been anticipating. Even so, we still expect both the Federal Reserve and the Bank of England to signal their commitment to combating inflation by raising rates in the first half of the year. They may then wait to see whether commodity prices do the job of cooling the economy for them.

Investors are also growing concerned about the losses that will inevitably arise from shutting Russian companies and banks out of the global economy. Many multinationals have now ceased operations in Russia, often at a heavy cost, especially as many have decided to continue to pay employees for the time being. For instance, McDonald’s operations in Russia and Ukraine account for a not insignificant 9% of revenue. There will also be further supply chain issues, in particular given Ukraine’s role as a key supplier of neon, a gas used in the manufacture of semiconductor chips. Meanwhile, banks are taking losses in the billions as they prepare to write down the value of loans and subsidiaries in Russia. These numbers could yet increase, given the warning from rating agency Fitch that Moscow’s response to sanctions could include “selective non-payment of its sovereign debt obligations”. This could cause the cost of capital to rise around the world – reducing banks’ appetite for lending in other areas and further depressing growth.

Tentative signs of diplomacy

There are some signs, at the time of writing, that both the Russian and Ukrainian leadership may now be looking to negotiate. A possible deal would possibly involve recognition of Crimea as Russian, independence for Donetsk and Luhansk and some commitment to neutrality in the rest of Ukraine. However, it is far from clear that any agreement can be reached and it may only come after further escalation. It is also very uncertain if or when Western sanctions would be repealed. It is unfortunately becoming much clearer that Russia’s invasion of Ukraine has the potential to be a significant obstacle for the global economy in the months and even years ahead.