The shock of the utility bill

April 07, 2022

We’re all feeling the impact of higher commodity prices in our everyday lives. Polina investigates how investors can think about protecting their capital.

Have you checked your electricity bill lately?

We have been confronted with a bill dilemma in the block of flats where I live. The block has shared communal services and the electricity bill has increased fourfold in the last three months. As a result, the residents are faced with the dilemma of either shutting down the facilities or seeing our service charge raised by 15% to accommodate higher electricity costs.

We are all feeling the impact of higher commodity prices in our everyday lives. If the Covid-19 crisis has resulted in a heightened focus on the proximity of supply chains, an implication of the Russia/Ukraine conflict has been an increased focus on the security of raw material supply.

What are the likely implications of higher commodity prices on global economies? How should investors think about ways to protect their capital?  Firstly, when we think about the impact of commodities, we have to separate the impact of price and volume changes. Secondly, the impact of these changes varies depending on the type of commodity.

Prior to the conflict, Russia supplied 11% of global oil. JP Morgan analysts suggest that if oil prices rise to between USD150 and USD180 per barrel during a two-month period, this would increase global inflation by three percentage points and reduce global growth by the same amount.

Looking at the volume implications, the precedent set with the OPEC oil embargo on the US in 1973, when oil volumes were cut by 25%, translated into a six-percentage point loss in US GDP.

This time around, the intensity of the supply shock is likely to be less severe given that energy usage per unit of GDP has reduced by 50% and the Russian supply can be partially replaced. For example, Saudi Arabia alone could increase its oil supply by up to one million barrels a day, which would cover 40% of Russian oil supply.

Russia was also a big supplier of other commodities, including 25% of global gas and 11% of global wheat. Those commodities are more difficult to replace in the short term. Gas infrastructure is key. At this stage, European economies are not in a position to shift away from Russian gas in favour of other producers. They are likely to be faced with two options:

(1) Increase investments in renewable energy sources, which is a two-year investment process with inconsistent supply.

and/or

(2) Bring back less eco-friendly options.

For example, restarting 70% of coal-fired electricity plants in Europe could likely replace 25% of Russian gas supply to European economies. There is also an option to bring nuclear facilities back online. Needless to say, the second option is likely to be sensitive from an ESG perspective. Some countries would have to reconsider their environmental targets and carbon neutrality objectives.

Wheat supply is another challenge. Replacing Russian wheat is not straightforward. While India can try to increase its wheat supply to other countries by 70% in order to make up for 25% of total Russian wheat exports, quality control is likely to be an issue.

So how do global economies deal with the implications of higher raw material prices and lower volumes this year?

This is likely to increase social risks and translate into both higher inflation and more pressure on the fiscal deficits through subsidies across the world. Countries like Egypt will be faced with difficult choices. The primary fiscal surplus and a strong relationship with the IMF could help the country navigate this crisis. However, high inflation (3–5% increase vis-a-vis the target for Egypt) and a larger fiscal deficit would be inevitable outcomes.

Against that backdrop, global central banks are quite constrained when it comes to the amount of policy accommodation they can provide. Core rates are likely to continue rising in light of further inflation pressures.

Where does it leave emerging market economies?

70% of emerging market countries are commodity exporters. Elevated commodity prices are likely to give a meaningful boost to the current account surpluses of a number of emerging market countries. By region, the Middle East and Latin America – which account for the majority of the asset class – are likely to be the key beneficiaries.

What about globalisation? Does the Russia/Ukraine war mark the end of globalisation that has provided big benefits to emerging market economies?

I don't think so.

Both the pandemic and the war might have slowed down the pace of globalisation. But globalisation has been much more about manufacturing and service sectors than the primary sector.

Russia may be one of the mines/wells/farms contributing to the global economy, but it has never really been part of the global manufacturing supply chain, as it has accounted for less than 2% of global trade. Commodities will continue to be shipped around the world just as they have been in the past.

In a world of low growth and double-digit inflation, cash is burning a hole in investors’ pockets. What are the ways to protect your capital?

Real assets and high-income instruments are the answer, in my view. Within fixed income, emerging market hard currency debt offers double-digit yields with relatively low duration. This is not a bad alternative to offset 7–10% inflation, as long as default rates remain below double digits, which is our expected forecast.

We also believe the tailwinds of high commodity prices and higher rate policy rates will provide support to emerging market currencies and local inflation-linked assets.

In times of high inflation and low growth, we are likely to face difficult decisions. In my block of flats, the residents are unlikely to be happy with either option: a meaningful increase in the service charge or a shutdown of communal facilities. Often in times like this, it’s about choosing the least bad option. Thankfully, investors have more alternatives when it comes to protecting their capital.

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