Ukraine and the U.S. Economy
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Published on March 7, 2022
Former RAO Speaker at the Americas 2021, Dr David Kelly, Chief Global strategis at J P Morgan share his thoughts on where we are now and the week ahead as the battle for Ukraine gathers more and more casualties, both human and financial.
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
In the week ahead, the world’s attention will continue to be focused on the horrific human consequences of the Russian invasion of Ukraine. However, American investors will also be considering what it means for financial assets. While the most severe economic consequences will likely be felt in Europe, the most important effects on U.S. portfolios depend on the implications of Ukraine for the U.S. economy.
Any such assessment needs to start with some assumption on how the conflict could play out. There are, of course, a multitude of scenarios, some dire and some a little more optimistic. However, probably the single most likely outcome, as of today, is one in which Russia makes further territorial gains in Ukraine but is unable to create any stability with the Ukrainian people and army waging a vigorous guerilla war against the occupiers.
In response, the West would likely gradually escalate its sanctions on Russia. This would inflict economic pain on the Russian people as would the cost of running the war in Ukraine. For the West, however, the single biggest economic impact would be via a partial or total cutoff of Russian energy.
This would be particularly painful for Europe. In 2019, Russian imports accounted for roughly 26% of European oil consumption and 37% of European natural gas consumption. Europe’s natural gas dependence on Russia is particularly problematic because, while oil is a global commodity, natural gas, at least in the short-run, is a regional one. While Europe could import more oil from other countries, for natural gas it is hard to see how it could increase supplies or cut demand enough to avoid a massive price spike.
For European consumers, higher energy costs are already taking a toll. In the absence of significant income support from either national governments or a new European economic stabilization fund, an energy shock could trigger a recession.
For the United States, the situation is less dire. A recession in Europe would have a negative impact on U.S. exports to Europe. However, exports account for less than 11% of U.S. GDP and, as was the case with the Asian financial crisis of the late 1990s or the European debt crisis of the last decade, the U.S. economy has generally been able to weather sharp downturns in other global economies.
That being said, rising oil prices would likely have a significantly negative impact on the U.S. economy. As this is being written, the April contract for West Texas Intermediate Crude has spiked to $123 per barrel as the U.S. and Europe are considering banning imports of Russian Crude. In 2021, the average price of a gallon of gasoline in the United States was $3.09. If oil prices stayed at $123 per barrel for the rest of the year, gasoline would likely average close to $4.20 for the year, adding over $1,000 to the expenses of the average household.
This would not, of course, be the only inflationary impact of the Russian invasion of Ukraine. Extra demand for LNG could keep U.S. natural gas prices somewhat higher than they had been previously while diminished supplies of grains and fertilizer from Ukraine and Russia would boost global food prices. This could well boost CPI inflation to 8.0% year-over-year in March.
Thereafter, a number of factors could help dampen oil prices including greater U.S. shale oil production, greater output from Iran if it rejoins the Iranian nuclear agreement, greater output from other members of OPEC in the face of high prices and a diversion of more Russian crude to China allowing China to reduce its purchases from OPEC nations. High oil prices and a slower-growing global economy would also, of course, reduce the demand for crude.
Because of all of this, it is quite possible that oil prices will spike in the short run but then fade in the months ahead. However, for the overall inflation outlook, a further period of high headline inflation could lead to faster wage growth and higher inflation expectations converting some transitory inflation forces into something stickier.
For U.S. economic growth, the impact of an energy shock would be unhelpful. However, it probably wouldn’t trigger a recession for three reasons:
First, entering the spring of 2022, the effects of a two-year pandemic are finally fading. This is unleashing huge pent-up demand for travel, entertainment and leisure services and greater spending in these areas in the months ahead could offset cutbacks elsewhere caused by higher gasoline prices.
Second, the economy is currently experiencing record excess demand for labor. Last Friday’s February jobs report showed strong momentum across the board. Based on these numbers, we believe February wage and salary income rose by 0.8% month-over-month and 11.5% year-over-year. Moreover, we expect Wednesday’s JOLTS report to show roughly 10.8 million job openings, implying a record 4.5 million gap between the number of job openings and the number of unemployed workers. Ukraine will undoubtedly hurt business confidence. However, starting from such an excess demand for workers, U.S. labor markets are likely to remain tight throughout the year.
A third reason for hope lies in policy. Congress and the Administration are acutely aware of the economic hardship inflicted on lower income consumers from higher food and energy prices. This increases the possibility of some further fiscal spending in a reconciliation bill and reduces the risk of higher taxes.
In addition, monetary tightening should be less severe and more predictable. When Fed Chairman, Jerome Powell was testifying to Congress last week, he explicitly stated that he was inclined to propose and support a 25 basis point hike in the federal funds rate at the March FOMC meeting, effectively taking a 50 basis point hike off the table. He also noted his desire to avoid adding uncertainty to an extraordinarily challenging and uncertain moment.
The bottom line for investors is that Ukraine has added to global inflation, reduced prospects for global economic growth and greatly increased uncertainty in the short-run. However, the pressure on the U.S. economy so far does not look sufficient to push America into recession. While there is every reason to be cautious and very well diversified in the short run, long-term investors should still be thinking about how to position portfolios for the long run when both the pandemic and, hopefully, the impacts of Putin’s invasion of Ukraine are in the rear-view mirror.
Disclaimer
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
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Chief Global Strategist at J.P. Morgan Asset Management
