Conflict in Ukraine

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The war in Ukraine leaves open the odds of a sharp increase in oil and natural gas prices that might force the Fed and ECB to hike faster than is currently expected.

1. Conflict in Ukraine

On Thursday, President Vladimir Putin ordered the invasion of the Donetsk region after recognizing the two Russian speaking separatist enclaves of Luhansk and the one within Donetsk. This may be a prelude to a conquest of Eastern Russian speaking regions or the entire country. The scope and duration of the war is at this point unclear as is typical in the early days of a war – indeed fighting is reported close to Kiev. As a consequence, the European Union and United States are moving to a far more comprehensive set of sanctions. In the United States, this has bipartisan support. Possible sanctions include access to the all-important SWIFT payment system (some European countries oppose this), access to dollar funding and closure of subsidiaries of Russian banks in the United States. For now, the United States approved export controls and blocking new dollar transactions with Sberbank and VTB Bank, Russia’s largest two banks. Germany already suspended the approval process for the Nord Stream 2 gas pipeline from Russia. Meanwhile the EU’s Ursula von der Leyen stated that “We will freeze Russian assets in the European Union and stop the access of Russian banks to European financial markets.” Note that US, German, French and Italian banks tend to be exposed to Russian businesses. Indeed, the EU approved sanctions on the financial, energy and transport sectors among others.

2. Commodity prices could spike more

Natural gas supply is not easily fungible so it matters a lot where it comes from and supply could be curtailed from Russia as a retaliation. Thankfully, the winter is mild and spring is approaching. Europe has some natural gas reserves and can over time import liquid natural gas by ship. Germany and Italy are the primary European beneficiaries of Russian natural gas, with Germany importing 55% of its natural gas and Italy 25%. Russia could potentially cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock and potentially some rationing (according to Eurasia research).

On the other hand, oil, copper and wheat produced in large amounts by Russia are fungible commodities which means they are easily exchanged around the world. Hence, sanctions have a limited impact. What matters though is if Russia tempers the output of OPEC+ at a time when demand is so strong that supply can barely keep up. Oil is also a substitute source of energy for electricity, when natural gas may end up in short supply. However, over a month or two, encouraged by the US government, the shale oil supply could increase potentially causing a hike in oil supply.

3. Impact on inflation

The risk on demand of a spike in natural gas and oil prices is more severe for the US, where more people depend on driving to work than in Europe. Nonetheless, this feeds into expectations of more and earlier monetary tightening by the Federal Reserve and ECB which then pushes equity markets lower. Will consumer demand for oil naturally recede? The odds are strong this will eventually happen if we get a significant price spike.

What does it mean?

In such an environment, short-duration covered bonds continue to be of significant interest. Infrastructure is a reasonable hedge against inflation, while companies with stable and predictable cash flows, found in some flexible solutions, continue to be a way to position for a far more cautious equity market. Flexible solutions also have the additional advantage of quickly shifting their asset allocation.

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