Implications of War in Ukraine, Day Two

We will update our thinking of the implications of the Russian invasion of Ukraine on a daily basis for the near term.  Our latest thoughts are located below.

The economic fallout from the battle for Ukraine on the U.S. is mostly limited to 1) higher energy prices 2) possible reduced access to certain raw materials, 3) higher food prices.

The energy piece is obvious and far more significant for Europe.  The U.S. is now a net energy exporter.  Expect efforts to divert more energy supplies to Europe.  Fracking allows U.S. oil production to ramp fairly quickly.  Our infrastructure would enable domestic production to add at least 500,000 barrels per day within a few months.  Natural gas supplies could also ramp, although export capacity is severely constrained in the short-run.  The U.S. is already exporting record amounts of LNG and more facilities are under construction, but this can’t happen quickly.  And Federal government policy may reduce its opposition to energy projects that could reach operational status in the near term, notably the DAPL and MVP projects among others.  In the very near future, we may also release more oil from the strategic reserve, if oil prices spike further.  The Middle East could also ramp production of both oil and gas.  While the Saudis declined to do so when Biden requested it recently, the situation has changed.  Anyone with spare capacity will be very tempted to realize greater revenues by increasing output, so we expect increased production.  (If China buys more natural gas from Russia to help them evade sanctions, cargoes bound for China or Asia could be diverted to Europe, as has already happened over the past two months.  This would mitigate the damage done to Russia, but also to Europe.)

Russia is a sizable producer of assorted raw materials, including aluminum, nickel, cobalt, and others.  Anyone who imports such raw materials is already scrambling to find alternative sources.  Australia and Africa are the most obvious beneficiaries.

Ukraine is a major food exporter and agricultural prices were already rising significantly over the past several months.  But Brazil, Argentina, Australia, Canada and the U.S. are also major grain producers, of course.  It seems likely that domestic planting will hit records this Spring.  Other food growers will replace whatever production is lost from Ukraine, possibly fairly quickly.  Other beneficiaries include domestic fertilizer companies and agricultural equipment manufacturers.

More broadly, the invasion will reinforce current negative thinking about globalization, so we should expect more industrial production to be returned back to the U.S.  This implies more domestic investment and also some upward pressure on inflation, since domestic production is more costly.  But this is something that will occur very gradually and its effects will take years to materialize.

We think the market has correctly concluded that the risk of a 50 basis point hike at the March FOMC meeting is highly unlikely, but this was considered unlikely even before the invasion of Ukraine.  Looking further out, the Fed is likely to “continually reassess”, but the Fed will want or need to normalize rates to contain inflation.  So, we judge that they will move gradually at each meeting this year.

We are continuing to review holdings to determine where risks and opportunities may exist.  We will also continue to communicate our thoughts daily as events unfold and we respond with the portfolios we manage.

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