The result of the war and economic sanctions on Russia is that UK inflation will probably surpass 8% in April, and remain above 5% by the end of the year, while GDP growth will be just 3.5%. What’s more, those parts of the UK and global economies that have not yet come out of the pandemic’s supply shocks will soon experience further setbacks.
This crisis will impact almost all businesses and consumers directly via higher energy costs. Oil prices, now at $125 a barrel, have increased by almost 40% over the past two weeks and petrol prices are likely to reach £1.80 a litre in the coming weeks.
What’s more, natural gas prices have surged to about £5.60 per therm, dwarfing the £4.50 level reached in December. Businesses aren’t protected by Ofgem’s energy price cap and will feel the pain over the next few weeks, especially if they’re major consumers of energy. Indeed, we would not be surprised to see industrial users of gas and electricity opting to shut down rather than pay current prices. To ensure the supply of critical materials like CO2, the government may step in as it did back in December.
The status quo implies a one percent drag on growth, so we have reduced our 2022 growth forecast from 4.5% to 3.5%. If oil prices stay around $130 for any significant length of time, we will have to revise down that forecast again. The chances of a recession later this year or early next dramatically increase if the conflict widens and oil prices move towards $150 a barrel.
Inflation will surge
The surge in oil prices, which feeds through into CPI inflation with a lag of only a couple of weeks, will ensure that inflation peaks above 8% in April when the Ofgem price cap is set to rise by 54%.
The biggest impact could come in October, however, as that’s when Ofgem is due to review its price cap. The cap will probably be raised by around 30%, but if natural gas and electricity prices remain at current levels, it could go up by as much as 75%, that would be enough to push CPI inflation above 9% in October.
In addition, over the next six to 12 months the surge in the prices of agricultural commodities and many base metals will feed through into higher prices for everything – from bread to washing machines.
Overall, we have revised up our inflation forecast to peak at 8.2% in April and to average just over 6% in 2022 as a whole, but the risks are weighted heavily to the upside.
Another supply chain crisis in the making
The best example of how the crisis might spark another supply chain crunch is in the palladium market, where Russia’s share of the global production is just over 45%. Palladium is used to produce the advanced microchips used in vehicle production, so this will impact manufacturing firms (especially in the motor vehicle sector). But all middle market businesses should be prepared to scour their downstream supply chains for areas that may be vulnerable to supply disruptions from Russia.
The goal of the current sanctions regime is to constrain Russia’s ability to finance its war in Ukraine, and to create the domestic conditions in the Russian domestic economy that could lead to a ceasefire. Over the coming days, it is highly probable that another round of sanctions, including on oil and natural gas exports, will be imposed worldwide. That will result in the removal of five million barrels of oil each day from the global market.
This, in near real time, is causing the collapse of the Russian economy, its currency regime, and its finance and banking systems.
At this point, the market is pricing in an 80% probability that Russia will default on its more than $478bn external debt. To put that in context, it now costs $4m plus a $100,000 annual premium for Russia to issue $10m of debt, which means it’s not going to happen even outside of the economic sanctions on the economy.
While it is early days in the sanctions regime, it would appear that the Russian economy is on the verge of a devastating financial collapse given the decline in the value of the ruble, the run on the banks, the imposition of capital controls, and the inability of Moscow to tap its roughly $643bn reserves.
It is highly likely that the EU will move swiftly to cut off natural gas and oil imports from Russia if the Ukraine conflict escalates. Should the US and its major trading partners follow the EU’s lead, it would remove five million barrels of oil a day from global oil markets, about 12% of the total. The result would be a surge in oil prices towards $150 per barrel from current levels of around $125.
That would point to a premature end to the current UK and global business cycle, and to recession in the near term.