Russia’s invasion makes it more difficult for central banks to keep inflationary pressures at bay. Rising commodity prices weigh on the cost of living in the US and Europe. Restrictive effects of the Ukraine war on economic recovery are also increasing, but a full-fledged stagflation scenario so far appears premature, one investment strategist told InvestmentOfficer.
Central banks around the world were poised to fight inflation while counting on continued strong economic growth. But now they may see growth falter while prices continue to rise and have to deal with a dilemma that standard monetary policy strategies cannot easily resolve.
The risk of persistent inflation and stagnant growth is increasing. Nevertheless, a repeat of the stagflation scenario of the 1970s seems avoidable for the time being.
Two variants
BlackRock strategist Lukas Daalder wonders whether the ECB will opt for more aggressive monetary tightening in the event of this temporary shock. The ECB’s Schnabel recently hinted that she did not expect the Ukraine conflict would lead to a tightening of policy, he said.
“The inflation outlook for the next ten years - they are now just above 2 percent for the eurozone - is not particularly alarming,” he said.
Daalder said he believes it is too early to consider a stagflation scenario. He makes a distinction between a single quarter of negative growth combined with rising inflation - strictly speaking, stagflation - or a prolonged period of low or negative growth and rising inflation, as in the 1970s.
The first variant certainly cannot be ruled out, especially if Russia turns off the gas tap. However, to what extent this will become a long and lasting problem for financial markets is questionable: in the first quarter of 2021, for example, there was also this kind of stagflation. “Did that play a major role in financial markets at the time? No.”
Question marks over continuing inflation
According to Daalder, the second variant does pose a threat to financial markets, as it presents central banks with a dilemma: Raise interest rates to curb inflation or lower interest rates to counter the weakening growth?
“The point here is just that you need continued price increases to keep the inflation part of the stagflation scenario alive. While that is possible, at the moment it seems to be more of a one-off, yet sharp, rise in the price of energy, which calls into question the lasting nature of inflation,” Daalder said.
Wim Barentsen, chief strategist at Achmea IM, is not convinced. He sees a sharp rise in prices of energy commodities and expects these will remain at a high level for a long time if Russia shuts off the gas tap.
Part of the production capacity will then come to a standstill. This scenario is comparable to a stagflation shock such as the 1973 oil crisis. “The economic and financial damage of such a stagflation shock is huge and will be felt worldwide. A major trade war is not on the cards now, but it is another factor that could lead to stagflation.”
Little that ECB can do
Olaf van den Heuvel, CIO at Aegon Asset Management, sees economic risks heightened by the conflict and slowing growth. “Monetary policy can still be tightened, but we don’t think it’s possible to raise interest rates,” he said.
Under normal circumstances, a central bank can put a good brake on inflation from the demand side of the economy with interest rates. “Now there is an external shock, so the ECB can raise or lower interest rates but that instrument is not working now. Not a drop of extra oil will enter our country,” says van den Heuvel. “All of society is hit when the oil and gas prices go up, that already slows down the economy. The ECB doesn’t have to do anything for that anymore.”
As far as oil is concerned, the problem is not that big, said Van den Heuvel, pointing out that an oil price shock usually is short-lived. The price is high now, but in the end it will fall to its “magic” long-term average of $65 a barrel, he said.
The price shock in the gas market, on the other hand, is more problematic, Van den Heuvel said. “Gas is much more difficult to transport, so the price will definitely rise there and that shock will not be short-lived.”
Protection in the portfolio
Most asset classes do not fare well in an environment of lower growth and higher inflation. Index-linked bonds (ILB) and commodity investments, including energy and gold, are the exception. Through these investments, a portfolio can be made less sensitive to a steep rise in inflation, said Barentsen.