As inflation moves higher it means more money
is being taken out of consumers’ pockets
Investment markets continue to endure a volatile period against the backdrop of conflict between Russia and Ukraine. Market sentiment is poor over fears of how the crisis could escalate and, in the meantime, the knock-on effects to the wider economy through rising energy prices.
Over the weekend, oil prices surged dramatically to a near 14 year high of $140 per barrel and the equivalent price of natural gas of c$500. This surge was caused by delays in the potential return of Iranian crude to global markets but mainly as the United States and European allies consider banning imports of Russian oil. Despite other sanctions, the reason this is still only being talked about and has not yet been enacted is because the West is reliant upon Russian oil as the second biggest source of imports. On the flip side, Russia is keen to maintain the status quo because oil accounts for 37% of its exports.
A rising oil price is felt in many ways with one of the most obvious in the UK being the price at the pump. Last week the average cost of unleaded petrol climbed to 151.25p and diesel rose to 154.74p, both record highs, according to RAC data from 7,500 petrol forecourts. Energy prices are likely to stay high in the near term which will mean:
- Inflation remains higher for longer. Energy is a major input into a number of sectors and is involved in key stages of agriculture, manufacturing and supply chains. Energy prices represent 13% of European GDP compared to 3% pre-Covid. Where these costs are passed on, higher energy prices only provide further pressure on existing inflationary concerns. Demand for oil was already accelerating as economies reopen from Covid induced restrictions. As demand outstrips supply, prices were already adjusting higher.
- Lower economic growth. As inflation moves higher it means more money is being taken out of consumers’ pockets, which acts like a tax. One of the biggest drivers to economic growth in developed markets is consumption. If consumers have less money to spend then this is a negative for growth overall.
- A mixed impact on companies. Commodity and oil specific companies are buoyed by recent events and their share prices have performed well as when the cost of production remains flat, a higher oil price only improves revenue and profit. However, a higher oil price is not great news for most companies, particularly airlines, as the costs of this increase squeeze operating margins.
Whilst oil prices are grabbing the headlines because it is the biggest commodity and the resource that economies are most exposed to, it is not the only commodity to be moving significantly higher over recent weeks. Metals and coal prices have already gone up a long way as well as soft commodities such as grain where Ukraine accounts for roughly 16% of global grain exports. We believe that volatility in these prices will continue and the balance of risk perhaps lies to the upside for the prices of these commodities in the short term.
Although Russia has an important role in commodity markets, China is the dominant player. China’s output had been curtailed in the run-up to the Olympics, Chinese New Year and ongoing Covid disruptions. As a dominant supplier of aluminium and steel, modest changes in China’s output could impact supply and demand positively.
Longer-term we were already expecting a higher oil price than pre-crisis due to a function of the lack of investment in new supplies over the last few years. Lessons are learned from every crisis and high oil prices are likely to contribute to the restarting of shale production, notably in the US, and moves to become less reliant upon dominant suppliers. Whilst the world seems keen to transition to greener energy, that does not happen overnight and we will remain reliant on oil in the medium term.
This is a fast-moving situation with volatile market movements based upon headlines and a broad range of potential outcomes. One would hope that we are experiencing a generational event. Current uncertainty and fears for the future are leading to a number of stocks now appearing oversold although they are unlikely to return to fair value until the outlook appears clearer. Clearly, we all would like to see a resolution to this crisis and the resultant reduction in uncertainty for markets but more so to end the suffering for the people of Ukraine.
Our Chief Investment Officer, Alex Brandreth, recently provided a webinar on recent events and this is available to view on the Luna YouTube channel.
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