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February 25, 2022 | 13:33
Russia’s Invasion: Economic Impact
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Russia’s Invasion: Economic ImpactDouglas Porter, Michael Gregory, Benjamin Reitzes and Robert Kavcic |
The immediate financial market response to Russia’s invasion into Ukraine was textbook risk aversion—a heavy selloff in global stocks, and rally into the safe-haven of bonds, gold and the U.S. dollar. Energy prices initially surged broadly. However, there was a swift reversal when it became apparent that Western sanctions would be limited and not aimed at energy. As vividly displayed by the rapid counter-move in markets, what follows next for the global economy is far from clear-cut. Sorting through the potential economic impact of the invasion, there are at least three major unknowns: 1) Does the conflict broaden, and will there be any additional Western response? 2) Can we revisit the initial surge in oil prices? 3) How do central banks respond? |
Assuming the conflict does not spread beyond Ukraine, then oil prices become the fulcrum for the impact on the global economy. In turn, assuming that upside risks to oil prices persist for some time, and $100 is possibly revisited, we look at the potential implications on North America’s economy and on monetary policy. What are the ramifications for inflation? This upside risk to oil prices, as evidenced by Thursday’s short-lived spike, has the potential to complicate an already-fraught inflation backdrop. Every $10 rise in oil tends to boost headline inflation in the U.S. and Canada by roughly 0.4 percentage points. And note that January’s already-lofty readings—7.5% in the U.S. and 5.1% in Canada—had not fully taken on board the rise to $90 oil. (WTI averaged $83 in the month.) Thus, if prices move into triple-digit territory, or head even higher, this factor alone could bump headline inflation by roughly 0.6 ppts. |
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Complicating matters is that the Canadian dollar has not benefitted one iota from the rise in oil prices in 2022, in contrast to the previously tight relationship between the loonie and crude (Chart 1). While good news for domestic producers, this implies that Canadian consumers are facing the full force of higher global oil prices, unlike earlier crude price spikes. |
What are the consequences for Canadian growth? The most important impact on Canada’s economy from the developments in Ukraine is through the commodity price channel. Given that Canada has precious little direct trade or investment with Russia and/or Ukraine, the major economic driver is thus oil prices. Typically, as a significant net exporter of crude, moderately higher oil prices are a small net positive for the Canadian economy. Normally, the big gains for producers outweigh the hit for consumers. However, there can be too much of a good thing, particularly if the rise in energy prices weighs heavily on the global economy and rebounds back onto Canadian exports in other sectors. A rapid rise in energy prices risks doing just that, especially at a time when consumers are already rattled by rising inflation. At best, a further broad-based rise in commodity prices is neutral for overall growth, and may even tip over into being a moderate drag, given the shock to consumers and the sentiment-damaging effect of the invasion. |
What are the implications for U.S. growth? In the wake of the invasion, the U.S. and other NATO countries announced sanctions on Russian commerce and individuals. And, there could be more of these still to come. The key about sanctions is that they are structured to hurt the targeted country much more than they may affect the country imposing them. While specific U.S. companies and industries might experience a noticeable impact, we’re talking deep into the decimal places in terms of impacting GDP growth. Interestingly, Russian energy exports weren’t touched. European NATO members, given their reliance on these exports, were the most concerned about this. However, petroleum imports were the largest contributor to America’s $23 billion trade deficit with Russia last year (including topping Canada as the largest foreign supplier of gasoline). Other channels through which these events could impact growth include the erosion of purchasing power and confidence. Russia and Ukraine are major producers of such items as wheat, corn, oil and natural gas, pointing to potentially higher food and energy prices. So, while the energy sector should find some lift from higher prices, this will likely be offset by lower ‘real’ spending throughout the economy. On top of higher inflation, increased uncertainty over how this is all going to end should weigh on both business and consumer confidence. However, the U.S. economy is hitting this potential growth headwind with a running head start. This week it was reported that consumer spending (just under 70% of GDP) expanded a strong 2.1% in January or 1.5% in real terms. Recall, payroll job growth was almost half a million in the month with household employment expanding more than a million. And, businesses are not only hiring more; they are also investing more. This week, durable goods orders and shipments both registered 1%-plus gains in January. The bottom line is that short of major escalation of the conflict, the U.S. economy should keep its stride. |
What are the consequences for the Bank of Canada? Russia’s invasion isn’t expected to have a significant impact on the Bank of Canada’s broader views on the outlook. While speculation of a 50 bp hike next week should be put to bed, the domestic backdrop and fiery inflation still demand rate hikes from the BoC. We continue to expect a 25 bp hike at the March 2 meeting, likely the start of a series of moves. Indeed, the sharp move higher in energy prices this year only reinforces inflation concerns, though there’s the added layer of growth risks as well due to the extent of the increase in gasoline prices and because of the Russia/Ukraine conflict itself. We’re not changing our forecast for the BoC, but uncertainties have ramped up. While we firmly anticipate at least a few initial rate hikes, if this conflict drags on, keeping upward pressure on energy prices and weighing on global growth, the end point for policy rates becomes the bigger question. The risks appear skewed to a lower end-point for policy rates until this conflict quiets. |
What are the implications for the Federal Reserve? The Fed is poised for policy rate liftoff on March 16, reflecting a pressing domestic inflation problem—a problem that appears poised to worsen given the conflict's impetus to food and energy prices. With the Fed already being perceived as ‘behind the curve’, we doubt these events will stay the Fed’s hand next month. However, current weakness and volatility in global financial markets, along with increased global economic risks, will at the very least, likely temper some of the most aggressive calls for the Fed (e.g., a 50 bp hike). Follow-up moves in May and June (which we expect) are at greater risk of being temporarily postponed. Recall the postponement of subsequent rate hikes after December 2015’s liftoff owing to “global economic and financial developments”. Much will depend on the European economic consequences of the current conflict and its potential escalation. At this point, we remain comfortable with our call for 125 bps of total rate hikes this year, in this very fluid environment. |
Does it alter the Canadian regional growth picture? We expect Alberta to lead the country with 5.0% growth this year, and 3.9% in 2023. There is a rekindled optimism in the province that only high oil prices can create. While a capex boom in new project development is not likely, as seen earlier in the 2000s, industry cash flow and local incomes will be well-supported. Alberta’s jobless rate should converge back down toward the national average over the forecast horizon, after struggling with a soft labour market in the years leading up to the pandemic. That said, we don’t see an extreme disparity in growth versus regions such as Ontario and Quebec, which will also remain drivers. Will it boost government revenues? Alberta, Saskatchewan and Newfoundland & Labrador are positioned for good-news budgets this spring. (Alberta’s 2022 budget was released Thursday.) While a surge in oil prices on the back of a geopolitical event likely won’t alter medium-term budget planning assumptions, it just reinforces near-term upside in revenues. Alberta’s FY22/23 small $0.5 bln surplus estimate was based on $70 WTI. Every $1 increase adds roughly $500 mln in revenue, and that relationship strengthens as prices rise and more projects reach payout status. Suffice it to say that we could see larger surpluses. Credit spreads in oil-producing provinces have already compressed. Alberta 30-year spreads have narrowed to the tightest level in almost three years versus Ontario, about 4 bps back. Note that the last time Alberta ran a balanced budget (FY14/15), Alberta 30-years traded about 20 bps through Ontario. Federal government revenues will also benefit from higher incomes and nominal GDP, but could be dampened if the surge in oil chokes off other discretionary spending and growth. Our current forecast assumes nominal GDP growth at least a full percentage point stronger than Ottawa assumed in the fall fiscal update, for 2022 and 2023, so there is likely some modest upside on the revenue front. |