The list of things for investors to worry about is growing. In fact, when you are abuzz with feelings of either success or failure is when you want to tighten your process to make sure emotions don’t mess with your head and decision-making.
High up on this list is inflation, which is seemingly everywhere . Bringing down inflation isn’t easy, and the challenge for central banks is even greater because of six intersecting factors that could be putting the global economy on a path to stagflation.
Let’s review six factors now shaking the U.S. and global economies that set the stage for stagflation:
Even before the coronavirus pandemic, the global supply of oil
and natural gas
was constrained by a decline in investment in the sector, caused by low oil and natural gas prices and petrocarbons falling out of favor with ESG supporters. The pandemic caused a further falloff of investment in the sector. Then Russia’s invasion of Ukraine forced the world to excommunicate the third-largest producer of petrochemicals.
The oil market has slightly different dynamics from the natural gas market. Oil is a fungible commodity and is easily transported by tankers, and thus it can be (relatively) easily redirected from one customer to another. For instance, if China used to buy oil from Saudi Arabia and now buys oil from Russia, the oil that China stopped buying from Saudi Arabia can now be bought by Germany. That said, Russia produces heavy crude and the Saudis light crude, so refineries need to be reconfigured, and that takes months.
Sanctions on oil will only have an impact on the Russian economy if everyone stops buying Russian oil. If all countries embrace sanctions, then about 8 million barrels of daily oil exports will be removed from the market. That is a lot of oil, considering that world consumes about 88 million barrels a day.
It is unclear if China and India, the largest- and third-largest importers of oil, respectively, will continue buying significant amounts of oil from Russia, as doing so risks damaging their relationships with the West. Neither country wants to be told what to do by the West. They have their own economic interests to consider, but their trade with U.S. and Europe is significantly greater than it is with Russia.
It seems that both countries have been slowly distancing themselves from Russia. For example, the war in Ukraine is a horrible advertisement for Russian weapons, and there is a good chance India may decide to switch to Western weapons, which would bring it closer to the West.
In the short term, the supply of oil from Russia to the world market will likely shrink. Long-term, the picture looks even worse for Russia. There’s a good reason why Western companies participated in Russian oil projects, while a great love for the West was not the motivator that drove Russia to share oil revenues with BP
and Exxon Mobil
Western companies brought much-needed technical expertise to very challenging Russian oil and natural gas fields. With the West leaving Russia, long-term production of oil and gas is likely to decline, even if China and India continue buying Russian oil and gas.
2. Natural gas
Let’s turn to the natural gas market. Shipping gasses is much trickier than shipping liquids. Natural gas can be transported two ways: by pipelines (the cheapest and most efficient way, but they take years to build) and by LNG ships. LNG stands for liquified natural gas — the gas is cooled to -260F and turned into a liquid. Western Europe, especially Germany, is heavily reliant on Russian gas, which today is transported to Europe through pipelines.
German politicians, in their fervor to go green, abandoned nuclear power, which produces zero CO2, switched to intermittent “green” wind and solar (and fell back on dirty coal) and tied their future to a shirtless Russian dictator. I discussed this topic before — you can read about it here.
Some smaller European countries are abandoning Russian gas. Germany and Italy, the largest consumers of Russian gas, promise that they can delink themselves from Russia’s gas in less than two years. This trend will continue; it just won’t happen overnight (or in two years). Call me a skeptic, but I think it will take a long time for Europe to completely abandon Russian natural gas, as building LNG terminals takes years, and so does increasing natural gas production.
Oil and natural gas prices will likely stay at elevated levels or even go higher over the next few years, and the U.S. production of natural gas and oil will likely have to go up substantially.
Russia and Ukraine together produce about 15% of the world’s wheat
supply. The two countries account for about one-third of global wheat exports (or about 7% of global wheat consumption). Russia has slapped a ban on wheat exports. Ukraine’s planting season likely has been disrupted by the war. The global wheat supply may decline by as much as 7%. This sounds like a large number, but it is not outside the historical volatility caused by droughts and other natural disasters, which have historically driven up wheat prices by a few percent.
“ High fertilizer prices will lead to significant increase in prices of all calories, from corn to avocados to meat. ”
This is not my main worry. I’m concerned about the skyrocketing prices of nitrogen and potassium fertilizers since the beginning of the war. Russia and Belarus, respectively, are the second- and third-largest exporters of potash used to make potassium fertilizer (Canada is the largest producer). Nitrogen fertilizer is made from natural gas. Natural gas prices are up a lot. High fertilizer prices will lead to significant increase in prices of all calories, from corn to avocados to meat.
Food inflation impacts poor countries and the poor in wealthy countries disproportionately. U.S. consumers spend 8.6% of their disposable income on food (down from 17% in the 1960s). In poor countries this number is significantly higher. For instance, the average Ukrainian spends 38% of disposable income on food. Food prices have been going up, and I’m afraid that we ain’t seen nuthin’ yet.
4. Interest rates
Higher interest rates make all financed goods more expensive, from washers and dryers to cars to houses. Over the past decade we got used to cheap, abundant credit. If inflation continues to stay at elevated levels, cheap credit will become a relic of the past.
Now, if you add the increase in energy prices (gasoline and heating), food inflation, and the higher cost of anything that has to be financed, you’ll see how the consumer is being squeezed from every direction. My sense is that government-massaged inflation numbers are low, despite being at multi-decade records. A more realistic number is much higher, as is suggested by import and export inflation numbers, which are not adjusted by the government, and are running at12%–18%.
5. Supply-chain problems
Another culprit responsible for higher inflation is supply chain issues. China is going through another partial shutdown of its economy. Meanwhile, the coronavirus did not forget about us. China has suffered among the lowest per-capita numbers of infections and deaths from COVID-19. The downside of this is that China has very low herd immunity. China has locally made vaccines, but they are not highly effective, and China refuses to import Western vaccines.
China’s “zero Covid” policy is being sorely tested. Since China makes a lot of the stuff we consume, they’ll make less of it. “Transitory” supply issues from China will persist and add to inflation.
Finally, the War in Ukraine has accelerated deglobalization. Globalization was a great deflationary tsunami. The pandemic exposed the fragility of our vaunted just-in-time inventory and global supply system. The war in Ukraine reminded the West that the global trade system is built on the assumption that we don’t go to war with our trading partners. The war in Ukraine broke that assumption and accelerated the pace of selective deglobalization.
Taking these factors together produces one likely outcome: higher prices for everything and a subsequent period of crippling economic stagflation.
Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates. He is the author of Active Value Investing: Making Money in Range-Bound Markets, and The Little Book of Sideways Markets.
Here are links to more of Katsenelson’s views of the inflation landscape (read, listen) and how to invest in inflationary times (read, listen). For more of Katsenelson’s insights about investing, head to ContrarianEdge.com or listen to his podcast at Investor.FM.