Bloomberg recently reported that the UK’s cost of living crisis deepened and inflation in April hit a 40-year high of 9%, driven by a surge in energy costs. Bank of England Governor Andrew Bailey made headlines with his prediction that a surge in food costs could have “apocalyptic” consequences for the poorest people in society. Consumer confidence reached its lowest in almost five decades, surpassing anything seen during the financial crisis, the pandemic or even the grim days of the 1970s.
The New York Times questions whether recent supply chain turmoil and geopolitical conflicts will result in a reversal or reconfiguration of global production, in which factories that were sent offshore move back to the U.S. and other countries that pose less of a political risk. If that happens, a decades-long decline in the prices of many goods could come to an end or even begin to go in the other direction, potentially boosting overall inflation.
Reuters reported that the Indian government is considering spending an additional Rs 2 trillion ($26 billion) in the 2022/23 fiscal year to cushion consumers from rising prices and fight multi-year high inflation.
The old scourge has reappeared globally. Vitaliy Katsenelson CEO and CIO at IMA, looks at the culprits behind it.
Oil
First, higher commodity prices. Even before the pandemic, the supply of oil and gas was getting constrained by a decline in investment caused by low oil and natural gas prices and petrocarbons falling out of favor with the ESG cult. The pandemic caused a further falloff of investment in the sector. Russia’s invasion of Ukraine forced the world to excommunicate the third largest producer of petrochemicals from modernity.
The oil market has slightly different dynamics from the natural gas market. Oil is a fungible commodity and is easily transported by tankers, and thus it can be (relatively) easily redirected from one customer to another. For instance, if China used to buy oil from Saudi Arabia and now buys oil from Russia, the oil that China stopped buying from Saudi Arabia can now be bought by Germany. That said, Russia produces heavy crude and the Saudis light crude, so refineries need to be reconfigured, and that takes months.
Sanctions on oil will only have an impact on the Russian economy if everyone stops buying Russian oil. If all countries embrace sanctions, then about 8 million barrels of daily oil exports will be removed from the market. That is a lot of oil, considering that world consumes about 88 million barrels a day.
It is unclear if China and India, the largest and third largest importers of oil, will go on buying significant amounts of oil from Russia, as doing so risks damaging their relationships with the West. Neither country wants to be told what to do by the West. They have their own economic interests to consider, but their trade with US and Europe is significantly greater than it is with Russia.
It seems that both countries have been slowly distancing themselves from Russia. For example, the Chinese credit card network UnionPay has quietly cut off its relationship with Russia. Though Russia has an internal credit card network called Mir, since Russia was cut off from the Visa and Mastercard networks and now from UnionPay, Russians have no easy way to spend money when they travel outside of Russia.
This war was a horrible infomercial for Russian weapons, and there is a good chance India may decide to switch to Western weapons, which would bring it closer to the West.
In the short term, the supply of oil from Russia to the world market will likely shrink; it is just hard to tell by how much. The demand for Russian oil has clearly declined, as the (Urals) price is down 30% while global oil prices are making new highs.
Long-term, the oil-supply picture from Russia looks even worse. There was a good reason why Western companies participated in Russian oil projects. A great love for the West was not the motivator that drove Russia to share oil revenues with BP and Exxon. Western companies brought much-needed technical expertise to very challenging Russian oil and natural gas fields. With the West leaving Russia, long-term production of oil and gas is likely to decline, even if China and India continue buying Russian oil and gas.
Gas
Natural gas is a gas and oil is a liquid. Shipping gasses is much trickier than shipping liquids. Natural gas can be transported two ways: by pipelines (the cheapest and most efficient way, but they take years to build) and by LNG ships. LNG stands for liquified natural gas – the gas is cooled to -260F and turned into a liquid. Western Europe, especially Germany, is heavily reliant on Russian gas, which today is transported to Europe through pipelines.
Some smaller European countries are already abandoning Russian gas. Germany and Italy, the largest consumers of Russian gas, promise that they can delink themselves from Russia’s gas in less than two years. This trend will continue; it just won’t happen overnight (or in two years). Call me a skeptic, but I think it will take a long time for Europe to completely abandon Russian natural gas, as building LNG terminals takes years, and so does increasing natural gas production.
Oil and natural gas prices will likely stay at elevated levels or even go higher over the next few years, and the U.S. production of natural gas and oil will likely have to go up substantially.
Food
Russia and Ukraine produce about 15% of the world’s wheat supply. They account for about one third of global wheat exports (or about 7% of global wheat consumption). Russia has slapped a ban on wheat exports. Ukraine’s planting season was likely disrupted by the war. The global wheat supply may decline by as much as 7%.
This sounds like a large number, but it is not outside the historical volatility caused by droughts and other natural disasters, which have historically driven up wheat prices by a few percent.
What concerns us is the skyrocketing prices of nitrogen and potassium fertilizers since the beginning of the war. Russia and Belarus are the second and third largest exporters of potash used to make potassium fertilizer (Canada is the largest producer). Nitrogen fertilizer is made from natural gas. Natural gas prices are up a lot. High fertilizer prices will lead to significant increase in prices of all calories, from corn to avocados to meat.
Food inflation impacts poor countries and the poor in wealthy countries disproportionately. U.S. consumers spend 8.6% of their disposable income on food (down from 17% in the 1960s). In poor countries this number is significantly higher. For instance, the average Ukrainian spends 38% of disposable income on food. Food prices have been going up, but we are afraid that we ain’t seen nuthin’ yet.
Interest Rates
Higher interest rates make all financed goods more expensive, from washers and dryers to cars to houses. Over the last decade we got used to cheap, abundant credit. If inflation continues to stay at elevated levels, cheap credit will become a relic of the past. Mortgage rates in the U.S. have almost doubled from the lows of 2021. The median home price is up. About a third of the country doesn’t own a home but rents. Rents increased in 2021 and continue to rise in 2022.
Now, if you add the increase in energy prices (gasoline and heating), food inflation, and the higher cost of anything that has to be financed, you’ll see how the consumer is being squeezed from every direction.
Supply Chain problems
China is going through another partial shutdown of its economy. Putin made us forget about the coronavirus, but the coronavirus did not forget about us. China – the initial source of Covid-19 – has suffered among the lowest per capita numbers of infections and deaths from Covid. The downside of this is that China has very low herd immunity. And though China has locally-made vaccines, they are not very effective, and China refuses to import Western vaccines.
Chairman Xi banked his reputation on a “zero Covid” policy. Today this policy is being sorely tested. China is shutting down cities that are the size of a largish European countries to keep the virus from spreading. Since China makes a lot of the stuff we consume, they’ll make less of it. “Transitory” supply issues from China will persist and add to inflation.
Deglobalization
The war in Ukraine has accelerated the pace of selective deglobalization, which will lead to higher prices of everything in the long run.
Globalization was a great deflationary tsunami. The pandemic exposed the fragility of our vaunted just-in-time inventory and global supply system. The war in Ukraine reminded the West that the global trade system is built on the assumption that we don’t go to war with our trading partners, and that assumption is broken.
