The answer to the question is yes, but at what level?
The announcement on Friday by the US Secretary of State that the US and its allies were in talks about banning Russian energy exports, sent oil and gas prices soaring and delivered another blow to equities. Right now, Brent oil prices are $120 a barrel. As a rough rule of thumb, that level would produce a significant economic slowdown. At $150 a barrel, we’d get a recession. Oil prices may have risen steeply but natural gas prices in Europe have increased even faster. Doubling over the last week.
A recession would hit earnings, already under pressure from rising wages and other input costs. The war in Ukraine has disrupted supply chains that were just beginning to recover from the pandemic. I don’t know about you, but I had no idea that neon was a key input to the manufacture of certain semiconductors or that Ukraine was the world’s biggest producer.
Economic momentum was strong before the war in Ukraine
All this sounds very gloomy, but before you bail out of all your risk assets let’s look at some positives. First, there was considerable economic momentum before Russia invaded Ukraine. US employment has been very strong, and Purchasing Managers’ Indices were in expansion territory and rising – led by the UK. US corporates reported healthy profits for the end of last year. European corporate earnings were evening better and Europe’s economy was generally expected to show good growth this year – faster than the US.
All that was before the war of course, and expected earnings growth is now likely to fall as a result, especially in Europe.
Equites have already fallen, the world index is down 12% year-to-date, with European equities underperforming badly.
Short-term supply pain, longer term is a different story
So, a good deal of bad news is already priced in. Russia is such a big producer of oil and gas that it will be very difficult to replace supplies quickly. Given time though, it’s a different story.
As you can see from the chart above, US energy exploration has already started to pick up and will rise further. President Biden’s decision to restrict drilling on Federal land has limited the response. But in contrast to past oil price shocks, we now have a large and growing supply of renewables and the world is starting to wean itself off fossil fuels. That shift away from fossil fuels will accelerate. The futures market sees oil prices as $75 a barrel in 5 years’ time. That’s up from $60 a barrel pre-Covid. Yes, a significant increase but manageable.
Nervous now, but there could be a buying opportunity soon
All in all, we think markets will continue to struggle in the near term given the surge in energy prices. But the time is drawing near when risk assets could start to recover. Much will depend on how Russia behaves in Ukraine – and we offer no forecasts on that – and also on whether the ban on Russian energy exports is actually implemented. The damage inflicted on the Russian economy from sanctions already imposed – both by governments and businesses – has been considerable.
These are nervous times. If you’ve taken a defensive stance and built up your cash reserves – well done. It probably is still too early to move back into a pro-risk stance. There may well be a further sell-off in the next week or two; that may be the buying opportunity.
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