Stormy times for the finan­cial markets

In the medium term, the Russian economy could be cata­pul­ted back into the 1990s as a result of econo­mic sanc­tions impo­sed by the West. The effects of this reces­sion on global econo­mic growth are mana­geable. Russia’s share of global gross dome­stic product (GDP) is only 3%. The damage comes more from the disrup­tion to the commo­dity markets. In addi­tion to oil, gas and coal, Russia is also an important supplier of metals for the semi­con­duc­tor and auto­mo­tive indus­tries and the most important produ­cer of ferti­li­ser and wheat. Since Ukraine is also a major wheat exporter, the price of staple food­s­tuffs is exploding.

A new oil crisis?

In many deve­lo­ping count­ries that depend on wheat imports, there is a risk of famine and poli­ti­cal unrest. Western econo­mies are less reli­ant on these imports and food gene­rally accounts for a smal­ler propor­tion of living costs. The main concern here is energy prices and disrup­ti­ons to supply chains due to a shortage of criti­cal metals. Even before the Russian inva­sion, infla­tion in the US had reached its highest point in 40 years, at 7.5%. The crisis in Ukraine evokes memo­ries of the oil crisis of the 1970s. 

Increased energy efficiency

Fort­u­na­tely, today’s oil price crisis is not quite so prono­un­ced. The rise in prices since their lowest point in 2020 is indeed compa­ra­ble with the 1970s, but the price per barrel of USD 20 at the height of the COVID-19 pande­mic did not repre­sent long-term equi­li­brium. In addi­tion, global energy depen­dence is consider­a­bly lower today, thanks to impro­ve­ments in effi­ci­ency and the move towards a service economy. And in 1973 about one barrel of oil was needed to gene­rate USD 1,000 of GDP at today’s prices. Today, as a global average, only 0.4 of a barrel is requi­red and in the US only 0.3. Thanks to frack­ing, the US is now the biggest oil and gas produ­cer in the world and is almost self-sufficient. 

Energy makes up only 7.5% of the basket of goods used to measure consu­mer prices in the US. Despite this, long-term infla­tion expec­ta­ti­ons show a striking corre­la­tion with the oil price and have risen further since Russia’s inva­sion. The expec­ted hike in prices puts pres­sure on consu­mer confi­dence, parti­cu­larly if wages do not rise to compen­sate, as it means house­holds have to tigh­ten their belts. The Fede­ral Reserve is faced with the diffi­cult task of contai­ning infla­tion with a carefully control­led econo­mic slow­down to avoid trig­ge­ring a reces­sion. This kind of soft landing is perfectly possi­ble. In the US, precis­ely because of the tight labour market, rising wages are the most signi­fi­cant driver of infla­tion, which should stabi­lise consu­mer beha­viour. Howe­ver, with the war in Ukraine the risk of reces­sion has greatly increased – even more so in Europe than in the US.

End of the peace dividend

The long-term conse­quen­ces of the war in Ukraine go beyond the risks of infla­tion and reces­sion. Follo­wing the end of the Cold War, western natio­nal budgets were reli­e­ved of a huge strain due to their decre­asing mili­tary expen­dit­ure. Other use of these funds enab­led an increased social gain in prospe­rity – a pheno­me­non refer­red to as a ‘peace divi­dend’. The conflict in Ukraine means this may be about to change. Regard­less of how Europe and the US react to the crisis in the short term, in the long term they will have to invest more in defence at the expense of social prio­ri­ties. Germany has announ­ced its inten­tion to increase mili­tary spen­ding from 1.4% to more than 2% of its GDP. In addi­tion, parti­cu­larly in Europe, invest­ment in rene­wa­ble ener­gies must be spee­ded up in order to reduce inde­pen­dence on Russian gas.

The conflict has streng­the­ned mili­tary alli­ances such as NATO and econo­mic blocs such as that between the US and EU and between China and Russia, acce­le­ra­ting deglobalisation. 

Rising demand for capital

Over the past few deca­des, demo­gra­phic deve­lo­p­ments in indus­trial count­ries have led to higher savings rates and incre­asing digi­ta­li­sa­tion to a lower demand for capi­tal, leading to a steady reduc­tion in real inte­rest rates; i.e. nomi­nal inte­rest rates less infla­tion. Due to increased invest­ment in arma­ments and rene­wa­ble energy, the demand for capi­tal is now rising once again. Deglo­ba­li­sa­tion has also affec­ted capi­tal invest­ments within natio­nal borders. Although tech­no­lo­gi­cal progress can absorb some of the demand for capi­tal, it cannot compen­sate enti­rely. As soon as infla­tion figu­res have peaked, real inte­rest rates are likely to rise. This is crucial for the valua­tion of shares, as it forms the basis of discoun­ting of future profits. For inves­tors, the adjus­t­ment process to a higher natu­ral real rate results in lower yields and grea­ter uncer­tainty. Howe­ver, when the new equi­li­brium has been reached, higher yields can be expec­ted for stocks and bonds alike, as the provi­sion of capi­tal must be compen­sa­ted accor­din­gly due to the higher demand for capital. 

In the mean­time, inves­tors should build suffi­ci­ent reser­ves into their port­fo­lios in order to stay abre­ast of the chal­len­ging climate. When selec­ting stocks, inves­tors should focus on sensi­bly valued, high quality compa­nies that thanks to high margins can cope with both infla­tion and an econo­mic slowdown.