Andrew Sheets: Geopolitics, Inflation and Central Banks

As markets react to the conflict between Russia and Ukraine, price moves for corn, wheat, oil and metals may mean new inflationary pressures for central banks to contend with in the coming months.

Important note regarding economic sanctions. This research references country/ies which are generally the subject of comprehensive or selective sanctions programs administered or enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), the European Union and/or by other countries and multi-national bodies. Users of this report are solely responsible for ensuring that their investment activities in relation to any sanctioned country/ies are carried out in compliance with applicable sanctions.

This recording references actual or potential sanctions, which may prohibit U.S. persons from buying certain securities, making certain investments and/or engaging in other activities in or pertaining to Russia.

The content of this recording is for informational purposes and does not represent Morgan Stanley’s view as to whether or not any of the Persons, instruments or investments discussed are or will become subject to sanctions. Any references in this presentation to entities, debt or equity instruments that may be covered by such sanctions should not be read as recommending or advising as to any investment activities in relation to such entities or instruments. Audience members are solely responsible for ensuring that their investment activities in relation to any sanctioned entities and/or securities are carried out in compliance with applicable sanctions.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape, and how we put those ideas together. It's Friday, February 25th at 3 p.m. in London. 

Russia's invasion of Ukraine has grabbed the headlines. There are other commentators and podcasts that are far more knowledgeable and better placed to comment on that conflict. Rather than offer assessment on geopolitics, I want to try to address one small tangent of these developments- the potential impact on prices and inflation. 

Russia and Ukraine are both major commodity producers. Russia produces about 10% of the world's oil, and Russia and Ukraine together account for 1/3 of the world's wheat and 1/5 of the world's corn production, according to the U.S. Department of Agriculture. So, if one is wondering why the price of wheat is up about 18% since the end of January, look no further. 

These commodities are traded around the world, but specific exposure can be even more acute. Morgan Stanley analysts estimate that Russia supplies roughly 1/3 of Europe's natural gas, while analysis by the Financial Times estimates that Ukraine supplies roughly 1/3 of China's corn. 

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. 

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 determines their monetary policy. For now, we think three elements will guide central bank thinking, especially at the U.S. Federal Reserve. 

First, higher policy rates are still necessary, despite international developments, given how low interest rates in the U.S. and Europe still are relative to the health of these economies. Slowing demand, which is the point of 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 .5% interest rate increase. Our economists did not think that was likely, and continue to believe that the Fed will hike by a smaller .25% at its March meeting. 

Third and finally, the duration and scale of these commodity price impacts are uncertain. Indeed, I haven't even mentioned the prospect of further sanctions or other interventions that could further impact commodity prices. In the view of my colleagues who forecast interest rates, that should mean higher risk premiums, and therefore higher interest rates on government bonds in the U.S. and Europe. 

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