The crisis has caused upwards pressure on commodity prices, with higher inflation and lower growth raising medium-term stagflation risk. If hostilities and inflation continue into 2023, it could damage investment portfolios. The situation will require careful attention.
Inflation fuel began kindling in the mid-2010s due to events like the US-China ‘trade wars’, the shale bubble causing more limited US energy production relative to supply, and growing environmental legislation increasing the cost of energy production and consumption in some countries.
COVID-19 ignited inflation in 2020 as labor supply was lowered and supply chains disrupted, reducing economic output. Demand, however, at least for goods, was supported through stimulus checks and other forms of assistance from fiscal authorities and support central banks monetizing the debt.
Supply chain disruptions and excessive stimulus facilitated January 2022’s 40-year high inflation.1 Expectations of central bank tightening ramped up accordingly. While testing for fixed income and risk assets, this represented traditional, business cycle-related patterns well understood by market participants.
With Russia a key exporter of several commodities and Ukraine a major producer of wheat, the current crisis has exacerbated supply constraints and inflation at a time when global supply chains are recovering from the pandemic.2 The spectre of stagflation is rising.
Figure 1. Russia share of global commodity production
Source: Morgan Stanley research, Goldman Sachs, JP Morgan, Haver, Woodmac. As of 2020.
Ukraine’s share in global supply for wheat and corn is 7% and 22% respectively (Morgan Stanley, IHS Markit, Goldman Sachs).
Figure 2: Commodity price changes since the onset of hostilities
Source: Refinitiv, Bloomberg. Performance between February 23, 2022 and March 18, 2022.
While forecasters expect economic growth to remain positive for 2022, thanks to strong momentum heading into the year, the longer hostilities run and commodity prices remain elevated, stagflation risk increases.
Indeed, it is being priced in. The Bloomberg Commodities index is up 24% and the S&P Global Natural Resources index3 by 12%. Most equities indices are in the red, if not in correction territory. Global nominal government bonds are down by almost 3% and global credit by 4%.4
Equity valuations, measured by the CAPE ratio are, however, at the second highest level ever recorded.5
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The prospect of sanctions on Russia being lifted are remote, even if the conflict ends.
If commodity prices remain high or climb higher, central banks will be faced with two unattractive options:
Scenario 1: Monetary policy-driven recession with inflation kicker.
Risk assets and bond duration would likely suffer initially as rates are hiked beyond what is priced in already. Duration might recover to a degree, as inflation might fall, but expect the recovery for risk assets to be slower, as rates are unlikely to be as supportive as in past recessions. Few assets would do well. Gold can be negatively correlated with equities and could mitigate the shock to a growth asset portfolio, to a degree. However, gold prices are sensitive to real rates and vulnerable if central banks are too ‘successful’, as rising nominal rates and falling inflation would put upwards pressure on real rates. Cash would not give real returns but could be a liquidity source as opportunities arise. Short duration or floating rate credit and tail hedge strategies could be considered.
Scenario 2: Stagflation is a more tangible risk scenario.
Growth assets like equities tend to do poorly in this environment. Some sectors and styles may do better than others. Equities tied to the energy sector could be a beneficiary, as we have seen year-to-date.6 Nominal fixed-income assets suffer in inflationary regimes as their cash flows are eroded. Inflation-linked bonds may perform if real yields fall – not always a given as central banks may hike rates to break inflation expectations.7 Real assets may not do well in the short-term, as rents cannot be revalued instantly and discount rates will rise to allow for higher inflation expectations.
Gold and, potentially, inflation-linked bonds, could do well, subject to real rates not rising too much in the late stages of a stagflationary shock. Commodities usually do well when inflation comes with growth and when stagflation is driven by a geopolitical shock.
We are moving into a world more fragile to future geopolitical and climate-related events, and stagflation remains more than just a tail risk. Portfolio construction must factor this in via a strategic allocation to gold and a commodity allocation which could be implemented via developed market natural resource equity strategies, commodity trend strategies or commodity futures.8 Investors currently without these allocations should be mindful that both gold and commodities/natural resource equities have considerably increased in value year-to-date, and may have priced in elevated stagflation risk to some degree. Near-term future dips may present opportunities for those investors to gradually hedge against stagflation risk in their portfolio for the long term.
 As measured by the Consumer Price Index for all urban consumer: all items in US city average. St Louis Federal Reserve and U.S. Bureau of Labor Statistics (Accessed on March 18, 2022).
 When this paper was published, China was shutting down the large manufacturing hubs Shenzhen and Changchun which could impact semi-conductor, automobile and other supply chains around the world.
 S&P Global Natural Resources index includes 90 of the largest publicly-traded companies in natural resources and commodities. Companies are in three primary commodity-related sectors: agribusiness, energy, and metals & mining (as of March 18, 2021).
 Refinitiv, year to date as of close of March 17, 2022
 See Robert Shiller’s CAPE dataset (accessed on March 18, 2022).
 MSCI ACWI Sector Energy has returned ~16% to year-to-date to March 17 when the MSCWI ACWI as a whole has returned ~-8% (Refinitiv).
 Outlined in more detail in our paper: ‘Inflation-Linked bonds: a real dilemma’. There are also regional differences in inflation-linked bond markets.
 See our paper Commodities in an inflation-aware portfolio for more details.
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