Markets remain volatile with attention focused on the uncertainty created by the Russian-Ukrainian conflict, especially the immediate impact this is having on higher oil prices. We have the following observations as this crisis continues to unfold.
While Russia is a small part of the overall global economy at 1.3% of global GDP (and Ukraine makes up an even smaller part), Russia accounts for about 10% of global oil production and Europe gets about half of its gas from Russia.
With the major role Russia plays in energy markets and Europe’s dependence on Russian gas, the Energy sector is most impacted by the conflict. The global demand/supply balance for natural gas and oil was already becoming tight. Demand has rebounded to pre-pandemic levels, while supply has been slow to recover, resulting in tighter inventory conditions. While it will be difficult to substitute large quantities of Russian oil and gas with alternative energy sources in other countries, it is unclear how much Russian oil will ultimately be lost on global markets—especially given China’s energy needs and recent support for Russia.
The tight energy balance compounded by the conflict is translating into higher energy prices, with Europe having the most exposure due to their dependence on Russian gas. While this presents a major headwind for the European economy, energy consumption amounts to about 2% of European GDP and it would take substantially higher prices to push Europe into recession. European energy consumption reached 7% in 2008, which also coincided with the financial crisis and ultimately recession.
China is the world’s largest crude oil importer, giving them a major incentive to purchase additional Russian energy. Germany, Netherlands, Spain, and Italy are among the top 10 importers and face a significant headwind due to higher energy prices.
While the U.S. consumer faces a headwind due to higher energy prices, the U.S. economy is much more balanced today relative to energy. Shale drilling has enabled the U.S. to become essentially energy independent with many beneficiaries of higher energy prices, unlike the past when higher energy prices were primarily a drag on the economy.
Consequently, we expect the conflict’s effects on the U.S. economy to be limited because the effects of higher energy prices are likely to be far less in the U.S. than in Europe. This is especially true for natural gas due to localized markets and the abundance of U.S. gas. Estimates suggest that a $10/barrel increase in the price of oil boosts U.S. core inflation by 0.035% and headline inflation by 0.20% but lowers economic growth by just under 0.1%. The impact on growth could be somewhat larger if geopolitical risk tightens financial conditions materially and increases uncertainty for businesses.
However, consensus growth estimates for the U.S. economy stand at 3.7% for 2022, well above what is considered the long-term sustainable growth of less than 2%. The U.S. consumer is also well positioned to absorb higher energy costs with over $2 trillion in excess pandemic savings and significant pent-up demand for houses, cars, and travel and leisure. The labor market is also very healthy with about 11 million job openings.
The Omicron wave is receding rapidly, and recent business surveys show growth of private sector output gained considerable momentum in February as companies reported a notable recovery in demand from COVID- related disruptions at the start of the year. Progress is also being made with supply-chain disruptions. This should help alleviate inflationary pressures as the year unfolds, despite the headwind higher energy prices pose.
We do not see this crisis having a major impact on the Financial sector either. The U.S. and European banks have less than 0.2% of bank assets in Russia. U.S. banks are very well capitalized and highly profitable, while defaults are exceptionally low. The banks are well positioned to absorb any losses associated with this crisis.
In summary, we continue to suggest staying the course with long-term investment plans.
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