Putting commodities in context after the invasion of Ukraine

The devastating human impact of Russia’s invasion of Ukraine is still, quite rightly, the key concern for people across the globe. But alongside the shocking effect it’s having on people’s lives here and now, more and more stories are appearing in the media about how it might impact the world economy. With rising oil and grain prices fuelling volatility in markets, we provide some important context for the long-term investor.

ECONOMIES STILL GROWING

The impact on commodities, such as grain and oil, and the consequences of that on consumers and investors worldwide – such as rises in energy and food prices – have been a particular worry. However, it is important to bear in mind that developed economies are still seeing growth, having experienced a healthy recovery coming out of lockdown in 2021.

The unemployment rate in the US and UK has fallen back close to the historically low levels which prevailed before the pandemic. In addition, excess savings accumulated through the pandemic are also a consumer buffer from higher prices.

ENERGY ALTERNATIVES

Russia is the world’s third biggest oil producer and the second biggest natural gas producer. European reliance on Russian gas is well-known, and replacing these supplies is challenging even though the energy intensity of the world economy has decreased dramatically over the last 50 years. There is an expectation that OPEC, of which Russia is not a member, will increase supply to help make up shortfalls and help normalise prices. And, while we won’t see solutions overnight, we have already seen long-term deals between western countries and other energy suppliers, such as the gas partnership between Germany and Qatar.

Countries can also dip into their strategic reserves if needed. The UK government has made clear that “like other countries, the UK holds oil stocks in the unlikely event of a major oil supply disruption”.

Looking further ahead, Russia’s action will likely speed up Europe’s shift to renewable sources of energy.

This has been complemented by the International Energy Agency’s 10-point plan, which aims to reduce the EU’s dependence on Russian gas (last year Russia provided 45 per cent of the bloc’s imported gas) and mitigate the current rise in energy prices before next winter.

AGRICULTURAL COMMODITIES AND FOOD PRICES

Russia and Ukraine together make up a quarter of global wheat exports, and sanctions or a ban on exports - which may interrupt farming activity - are likely to have a major impact on food prices worldwide.

However, markets were dealing with rising wheat prices well before the invasion. February was the 22nd consecutive month that UK wheat futures gained on the year, according to the Agriculture and Horticulture Development Board, while global wheat prices had been in ascendancy for some time, gaining over 50% since the start of the pandemic.

However, undeniably, the invasion has pushed up agricultural commodity prices: the price of corn, of which Ukraine is the world’s fifth largest producer, having also risen. This will have a bigger impact on consumers in emerging markets where food – and energy – make up a larger part of the consumer basket compared to developed countries where it has declined significantly over the last 50 years.

INFLATION: A REALITY CHECK

Higher transport and food costs will push prices up. This will compound inflation that was already rising before Russia’s invasion. In the UK, inflation grew by 6.2 per cent in the 12 months to February 2022 – its highest level in 30 years. This was in conjunction with the strength of consumer demand when economies exited lockdown.

Meanwhile, living costs, though elevated, are unlikely to run away: “In the near term, there are upward inflationary pressures and inflation will likely peak at levels higher than we originally expected: around 8 per cent. It does not take away from downward pressures in the second half of the year, although we acknowledge that it may not fall as much as previously thought,” says Monique Wong, Executive Director, Coutts.

WHAT CAN POLICY MAKERS DO?

Central banks and governments have the power to respond and address the impacts of rising prices in a number of ways:

• Higher interest rates. Historically, central banks do not raise interest rates in the face of higher energy prices because it acts as a tax on the consumer. However, already rising inflation and tight labour market conditions produce a set of challenges for them. Going forward, they will have to weigh up the balance between inflation and economic growth. We believe they will ultimately err on the side of growth. However, there is clearly a degree of uncertainty around this and the potential for policy error.
• Price caps and subsidies. The UK government has already committed to giving millions of households up to £350 as part of its Energy Bills Rebate. While subsidies can help the most vulnerable in the short term, they can also encourage spending further down the line and give companies clear revenue streams for the future – making them attractive to investors.
• In addition to the £9 billion set aside to help families with energy costs, UK Chancellor Rishi Sunak recently announced in his Spring Statement:
  • 0 per cent VAT on solutions for green energy and energy efficiency
  • a cut of 5p per litre to fuel duty for the next 12 months
  • an autumn cut to business rates

The government’s moves are designed to help households and businesses deal with the impact of rising costs.

IT'S ALL ABOUT LONG-TERM PERSPECTIVE

What’s most important is that the effects on markets caused by rising commodity prices (due to the invasion of Ukraine), are ‘known unknowns’. Coutts portfolios have diversification built into their asset allocation architecture to provide ballast against uncertainty. There are a mix of higher quality and defensive positions such as global healthcare and Chinese government bonds, balanced against opportunistic allocations such as Chinese equities.

Ultimately, Russia’s invasion will negatively impact short-term growth. As politicians and diplomats work towards a peaceful resolution, Coutts continues to monitor developments and focus on its goal of responsible investing for the long term.

We believe that remembering the above mitigating factors and investing in best-in-class companies with strong balance sheets and cash flows is a good approach.