Economic update – March 2022

• Wall St initially sold off on tensions in the Ukraine but bounced back once the invasion started
• US inflation data continues to remain very strong keeping upward pressure on US cash interest rates
• Australian jobs growth strong but wages growth was not

The Big Picture

The events in Ukraine are unfolding rapidly. There has been tragedy and heartache for many. But, the goals of Russian President Vladimir Putin and ‘solution’ remain unclear.

We have neither the expertise to elaborate on the reasons for the Russian invasion or to speculate on how it might end. Naturally, our thoughts are with those who have suffered. We will focus our attention on what we need to consider just to analyse the impact on markets.

The extremes of possible outcomes seem to be many and varied: returning the Ukraine and possibly other countries to the ‘Soviet Bloc’; support for the Ukraine from outside of the region – both arms and troops; a protracted but failed attempt to ‘quell’ the Ukrainians; failure of Putin resulting in the end of his leadership.
Without capacity for fact checking, we are relying on news reports. Russian troops entered the Ukraine in the last week of February resulting in casualties on both sides. It has been widely reported that the Ukrainian resistance has been far stronger than most would have anticipated.

Germany has offered arms to the Ukraine in a big break with tradition. The usually independent Switzerland has joined the move for sanctions on Russia. Many other countries – including Australia, the US and UK – have offered support but there seems to have been no move yet to send troops in. NATO has been readying its defence forces in Latvia.

Russia has reportedly threatened Finland that it will get the same treatment if it attempts to follow the Ukraine in trying to join NATO. In some sense, this conflict has a parallel in the US objection to the Cuban missile crisis in 1962. The US repelled Soviet missiles on their doorstep in that encounter, and Russia might be trying a similar move now.

Although sport and the Eurovision song contest are unimportant when compared to these geopolitical issues, the Russian population might think lesser of Putin when they realise that they have lost the Russian F1 Grand Prix, the Champions League final, various Qatar World Cup (soccer) matches and participation at Eurovision.

Putin might have expected a quick resolution to his demands – whatever they might be – and claimed a big victory as he tries to install himself as a ‘lifetime president’. A protracted affair and losing face over international events might erode his popularity domestically to the extent that a new leadership regime might challenge him.

Unsurprisingly, stock markets fell in value as the invasion neared. What perhaps is surprising is that a rapid reversal started as rockets hit targets in Kyiv (formerly Kiev) – the capital of the Ukraine. It is often the case that bad news such as the rocket strike has a positive effect on markets. Investors and traders might have thought it could have been a lot worse: war could be declared on Russia by the West; or the Ukrainians could simply have surrendered. In other words, markets may have priced in far worse conditions and so this bad news was relatively good compared to expectations.

Since there may well be many more stages in this crisis, it is perhaps unwise to jump in and out of markets as events unfold. Prudent investors set a long-term asset allocation and change allocations in a considered fashion.

It has been reported that talks between Russia and the Ukraine have started. The first round concluded on the last day of February. Many groups in the West – both private and government – having been expressing support for the Ukraine. China has not played its hand yet. One big worry is that, if Russia manages to annex the Ukraine easily, China may be emboldened by the apparent success of the Russian action and may initiate its policy for the re-unification of Taiwan.

There are some clear economic concerns that follow from the conflict. Oil and gas prices rose sharply because Europe’s access to Russian resources were reduced. On top of that, a major oil installation in the Ukraine has been damaged or destroyed. Major oil companies are exiting Russia. Energy prices have been a major source of inflation in western consumer price indexes over the last 12 to 18 months. This conflict can only exacerbate that situation.

The Ukraine and Russia have been supplying a significant amount of grain – notably wheat – to the rest of the world. Food prices will rise as a consequence of limited access to exports.

SWIFT, a global method for settling accounts between banks, is said to be being turned off for some Russian banks. While this would hurt the Russians more, there might be some fall-out to the rest of the world.

A number of high-profile Russians – the so-called oligarchs and highly-ranked officials – are having sanctions placed on them. Air space for Russian aircraft has been limited.

It is difficult to total up the consequences that might follow the invasion. It must have a negative impact on the world but – as with other recent conflicts notably in the Middle East – economic life has gone on for us in the West.

Naturally we wish for a speedy and safe resolution of the conflict. But one thing is certain – raising interest rates in the US, Australia or most other places will have no impact in reducing inflation in food and energy prices resulting from this crisis or from the run-up due to the pandemic.

Before the start of the conflict, pressure was building for various central banks, including our own (RBA), to raise rates to counter inflation. The CME Fedwatch tool that prices expected rate hikes in the US by the Federal Reserve (“Fed”) had placed a 33% probability on there being two hikes at the mid-March meeting. The Bank of England just hiked rates for the second time and New Zealand hiked for a third.

The latest inflation data for the US were quite high – 7.5% for the CPI and 5.2% for the Fed’s preferred “core” PCE inflation that strips volatile energy and food prices out of the calculation.

The probability for a double hike in March was cut from 33% to 6.6% on the outbreak of hostilities in the Ukraine. People are understandably worried that an aggressive Fed would only compound any knock-on effects from the conflict. Caution is warranted!

Interestingly, wage inflation in the US is starting to become an issue. The latest annual wage inflation reading was 5.7%. While that rate is very high, it is about the same or lower than the price inflation data coming through. Workers are not, on average, feeling any increase in so-called real wages.

The reasons for wage inflation are quite well known. Lots of people don’t want to go back to their old jobs either because of the pandemic or because they prefer the lifestyle of working from home. They are having to be paid more to turn up to work! It is important to note that there are 2.9 million less people employed in the US compared to January 2020 when the pandemic was just getting underway. The current situation is not due to new demand but the existence of supply constraints.
Whether or not there are one or two hikes in the US in March, the CME Fedwatch tool sees the funds rate approaching 2% or just above by the end of the year. Conventional wisdom in economics is that monetary policy takes about 18 months to two years to take effect in the real economy. Therefore, if we do see the start of a return to normal ‘neutral rate’ inflation this year, it is likely not due to rate hikes but an improvement in supply-chain blockages and a possible fall in energy prices.