Has the Ukraine War’s Inflation Impact Peaked? What Investors Should Watch

The war in Ukraine that began in late February 2022 as Russia launched missiles and airstrikes across the country marked the first major invasion in Europe since WWII. These actions injected volatility into commodities and equities markets that rippled across all asset classes, with investors bracing for the uncertainties emanating from the conflict.

The months that followed have brought not only a tragic loss of life, but massive disruptions in Ukraine’s major exports. Agricultural commodities, such as wheat, have been substantially cut off, while sanctions against Russia have disrupted oil supplies to big customers in Europe and elsewhere. Moscow took retaliatory steps against the EU by reducing natural gas flows and sending the commodity’s price up almost tenfold. All this has created shortages of agricultural, mining, and energy commodities in countries that rely on Ukraine and Russia for such inputs. It also has contributed to massive price spikes felt across both emerging and developed markets.

Six months into the war, the question for investors has become, have we seen the worst of the disruptions and inflation spikes that have dogged markets since the initial invasion? And have the markets now absorbed and habituated themselves to the ongoing volatility emanating from these events, and if so, have attendant inflationary pressures peaked?

We believe markets appear to have calmed somewhat and are pricing in a prolonged conflict, but with somewhat better insight into what it will mean for energy and food prices. And while risks and unknowns clearly remain, we’re seeing signs that the worst of the disruptions may be behind us.

Food and other commodities shortages may be easing

Russia and Ukraine are critical to global grain balances and trade flows. With a 28% share, Russia (18%) and Ukraine (10%) represent the largest world wheat export bloc, and each country produces 15% of global barley exports. Ukraine is also the world’s fourth-largest exporter of corn.1 Recent agreements to allow grain shipping out of Ukraine have led to some softening of food commodities’ costs, especially those in wheat and barley.

As the chart shows, the two countries’ combined production is dominant or significant in other commodities as well. These include, critically, natural gas, crude oil, and fertilizers, among others.

Ukraine and Russia Are Significant Contributors to Key Global Commodities

Source: Citi Research as of August 2022.

Disruptions in energy signal a bleak winter for Europe, but longer-term supply is strong

Europe, which relies on Russia for 40% of its oil and gas, could be facing a cold winter if it cannot come up with workable alternatives. Some options include tapping suppliers in Africa and importing more natural gas liquids (NGLs) from the US, along with energy rationing and a reluctant regression to coal.

Still, it’s important to note that while the war is exacerbating short-term disruptions in oil supply, it does not alter the underlying long-term abundance of crude globally. The world has ample oil supply potential at $50-$60/bbl breakevens. An analysis by Citi of 300 projects across multiple geographies and sources (shale, deep water, and conventional) indicates a long supply curve out to 2026, with large forecast additions even at $50-$60/bbl. These estimates indicate further potential to offset Russian oil with other sources.

Projected Additional Crude Supply Curve at Various Breakevens

Source: Citi Research and Bloomberg data as of August 2022.

Moreover, crude oil’s sharp appreciation – which was driven by a confluence of the sudden escalation of global geopolitical risks, energy companies’ focus on dividends instead of output growth, and the post-Covid global demand recovery – has begun to abate. As the chart below shows, rising US (green line) and OPEC (blue line) volumes more recently have contributed to some stabilization in the oil market.

Despite OPEC’s Resistance and the US Focus on Dividends, Production Is Growing

Source: Citi Research and Bloomberg Data as of August 2022.

All told, despite the recent spike, we believe the long-term outlook for oil is bearish, barring another tail-risk event. Looking further ahead, oil futures for 2023-2025 imply large inflation-adjusted declines in the price of crude (see table).

Oil Futures Through 2025 Indicate Big Price Drops

Source: Blomberg data as of August 2022.

China and India will likely weather the impact

While some observers have indicated that India and China could face a steep increase in domestic inflation as a result of the Ukraine war, we believe the impact will not be as high or as lasting as many predict.

India is heavily reliant on imported commodities, including food and beverages, which make up nearly half the country’s Consumer Price Index (CPI) basket, with fuel and energy making up about 9% (see charts below). India’s fiscal 2023 consensus CPI forecasts increased from 5% before the Ukraine invasion to 6.7% now, according to Bloomberg – a meaningful but not severe impact.

India's CPI Basket Is Food and Energy Heavy

India's Food and Beverage CPI Has Many Imported Components

Source: Citi Research, Bloomberg data as of August 2022.

The impact on China, which is less reliant on imported commodities relative to India, is still less significant: Fiscal 2022 consensus CPI forecasts increased from 2.2% before the invasion to 2.3% currently.

China's CPI Basket

Breakdown of China's Food and Beverage Basket

Source: Citi Research as of August 2022.

Inflation expectations may soon turn more sanguine

While we believe the worst of the commodity inflation resulting from the Ukraine War may be receding, this trajectory could, of course, change with an abrupt escalation in the conflict. That said, our long-term outlook for oil remains bearish given the ample potential supply globally, which points to declining prices over time. We believe the markets have adapted to and priced in the volatility attendant with developments in Ukraine and that inflation expectations could soon turn more optimistic.

Mr. Shumelda is a native of Ukraine with more than 20 years of asset management experience and contributes to the management of PineBridge’s Global Emerging Market, Emerging Europe, and Global Focus strategies.