On Tuesday (8 March 2022), US President Joe Biden banned imports of Russian oil and gas into the US. The United Kingdom said it would phase out its imports of Russian oil by year end. The European Union (EU), which depends on Russia for around 40% of its gas supplies, announced a plan to reduce its Russian gas imports by two-thirds within a year but stopped short of a ban.
The explicit targeting of Russia’s energy exports moves us firmly into the downside scenario for global growth and risk assets as energy prices spike. (See our previous report, War in Ukraine: The next chapter, for more details)
Severe energy price shock will hurt global growth; downgrading our GDP forecasts
The global economy is thus set to face a severe oil shock. This will have major implications for the macroeconomic outlook this year.
First, oil prices are set to trade near record levels. We now forecast Brent crude prices will trade in an elevated range of USD110-170 a barrel over the next few months and our new 3-month forecast is USD140 a barrel, far above the USD80 levels seen at the start of the year.
Second, global growth will slow more sharply this year. We downgrade our forecast for global growth by almost a full percentage point to 3.7%
in 2022 from 4.6% previously. The world economy’s recovery from the pandemic will slow sharply from last year’s five-decade high of 6.0% growth in 2021. Global growth, however, will still be buttressed by economies reopening this year. Thus, our lower forecast of 3.7% is still above the 3.0% average annual growth rate achieved by the world economy since the 1970s. We therefore do not anticipate the global economy as a whole to experience recession in 2022.
The slowdown from the oil shock will fall disproportionately on those economies that are more dependent on energy imports.
Third, inflation is set to worsen with the oil price shock from the war. Thus, despite slowing growth, we expect the Federal Reserve (Fed) and Bank of England (BoE) will raise interest rates steadily this year. In contrast, the European Central Bank (ECB) is likely to be cautious as the Eurozone is exposed to disruptions in Russian energy exports and major refugee flows coming out of Ukraine.
Fourth, the USD will stay in demand. The greenback is likely to benefit from higher Fed interest rates and safe-haven seeking inflows as volatile markets keep investors risk-averse.
Last, bond yields are likely to remain volatile. Steady Fed rate hikes this year may flatten the Treasury yield curve further, increasing the risk of the curve inverting. This would be a signal that the US economy may fall into recession.
Stagflation fears and risk aversion favour Gold in the near term
Gold is a beneficiary of stagflationary concerns fuelled by the spike in energy prices. A risk averse financial market backdrop favours the USD and there is probably greater scope for gold to strengthen against European currencies. We have low conviction whether gold can continue to stay high beyond the near term.
Amid reports that the EU is considering sizeable joint bond sales to finance energy and defence
spending, fiscal policy to deal with the immediate impact of the Ukraine crisis on European growth would be supportive of the EUR. But given the Euro area’s greater reliance on Russian gas markets, the EUR remains vulnerable to the threat of disruption to Russian gas supply.
A worsening Eurozone external account due to elevated oil and gas prices along with risk of the ECB sounding more dovish in the short term could push the EURUSD to 1.05 in 3 months’ time (previous: 1.09). There will be scope for a stronger EURUSD once the energy storm subsides but prospects for EUR recovery may not figure much as an immediate focus. We target the 12-month EURUSD at 1.09 (previous: 1.12).
Switching to a more defensive stance; downgrading Equities to Neutral
We are adopting a more defensive stance in our asset allocation strategy by downgrading Europe equities from Neutral to Underweight. This reduces our overall equities exposure to Neutral. We remain overweight in Asia ex-Japan equities, where we see better risk-reward beyond the near term turbulence.
Europe is in the eye of the storm; China looks relatively better positioned: Although all regions would be impacted by higher energy prices, Europe is in the eye of the storm with its heavy reliance on Russian energy – a key reason why the EU has been reluctant to join the US in banning energy imports from Russia.
Higher oil and gas prices would have a greater impact on Europe, and if there is a significant disruption in energy supplies, the fundamental economic shock to Europe would be greater than other regions. By comparison, China is less vulnerable to such a shock as it lacks both Europe’s exposure to Russian natural gas and the tight labour market in the US. The People’s Bank of China is also on a policy easing path, diverging from the policy trajectories of central banks in other key regions. Valuations are undemanding and we retain our Overweight on Asia ex-Japan, though we caution that rising Covid-19 cases in China and Hong Kong may dent sentiment in the near term.
We see more opportunities in Asia ex-Japan but would also highlight that pockets of opportunity exist in the other regions. For instance, sustained high energy prices would increase the incentive for businesses to pivot more towards renewables, benefiting certain companies in the Industrials and Utilities sectors. Certain commodities-related companies would also benefit from higher energy prices, though investors should be prepared to ride out significant price volatility. On a geographical basis, countries that are more energy self-sufficient and have higher reserves would also stand in better stead to ride out the energy crisis.
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