Commodity inflation inevitable as Russia invades Ukraine

Markets summary

Russia and Ukraine are both major commodity producers.  Although Russia accounts for less than 2% of global exports, it is a much more significant player in commodity markets.  Russia on its own produces about 10% of the world’s oil,  and controls about another 10% of global copper reserves, while also being a major producer of nickel, platinum and fertilisers.  

Russia and Ukraine together account for a third of the world’s wheat, a fifth of the world’s corn production, and 80% of the world’s sunflower oil shipments, according to the US Department of Agriculture.  Ukraine has steadily increased its exports over the years, and is now a huge provider of raw materials, chemical products and even machinery like transportation equipment.

These commodities are traded around the world, but specific exposure can be even more acute.  Morgan Stanley analysts estimate that Russia supplies roughly a third of Europe’s natural gas, while analysis by the Financial Times estimates that Ukraine supplies roughly a third of China’s corn.  In fact, Ukraine replaced the US as China’s top corn supplier in 2021. 

Ukraine is such a fertile country and has a great agricultural area that it is considered the “breadbasket of Europe”.  Even though the harvesting season is still a few months away, a prolonged conflict would create bread shortages and increase consumer prices later in the year.  Wheat and corn prices were already soaring before the conflict erupted.  Wheat futures traded in Chicago have jumped about 12% since the start of this year, while corn futures spiked 14.5% in the same period.

There are also second order linkages.  Russia produces about 40% of the world’s palladium, a key component for catalytic converters, and about 6% of the world’s aluminum.  But because Russia also provides the energy for a good portion of Europe’s aluminum production, the impact could be even larger on aluminum prices than Russia’s market share would indicate.

While most of the European Union will be affected by the escalating crisis, Germany will be especially hard-hit.  Germany derives most of its energy needs for manufacturing and electricity from the natural gas it gets from Russia.  If tensions continue to rise and we see an increase in disruptions due to further sanctions, it will hold back manufacturing production in Germany.  Factories would need to curtail production which would cascade to manufacturing in other countries.

All this could result in potential disruptions to trade in these commodities which could reverberate for some time, in both their supply and price.  Central banks will need to look at these changing prices and weigh how much they should factor into their medium term inflation outlook, which ultimately determine their monetary policy.  For now, at least three elements will guide central bank thinking, especially at the US Federal Reserve.

First, higher policy rates are still necessary, despite latest international developments, given how low interest rates in the US and Europe still are relative to the health of these economies.  Slowing demand, which is the reason for interest rate hikes, is still important to contain medium term inflationary pressures.

Second, these developments may reduce the odds of an aggressive start to central bank action.  A few weeks ago, markets implied that the Fed would begin with a large 0.50% interest rate increase.  The  current market consensus is that the Fed will hike by a smaller 0.25% at its March meeting.

Third and finally, the duration and scale of these commodity price impacts are uncertain.  Indeed, we haven’t elaborated much on the prospect of further sanctions or other  interventions that could further impact commodity prices.  That would mean higher risk premiums, and therefore higher interest rates on government bonds in the US and Europe.


Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018. 

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