Conflict and Commodities

Russia’s invasion of Ukraine adds an unwelcome geopolitical layer to the inflation challenge, and yet another reason to reintroduce commodities to the asset allocation mix. Russia’s invasion of Ukraine represented a particularly challenging situation for financial markets last week, after they had already weakened on anxieties about high inflation and rising interest rates.

Even if this military action quickly establishes new facts on the ground, which seems unlikely, the political necessity for punishing and wide-ranging sanctions against Russia means that the economic impact is set to be long-lasting.

The situation amplifies important aspects of our outlook for 2022 and 2023—not only anticipated higher economic and market volatility, but the move to a less favorable growth-inflation mix than what we experienced in 2021, and indeed what we’ve grown used to over the past 20 years. For the same reasons, it also adds support to one of our key asset allocation themes: bringing commodities back into the heart of the asset allocation discussion.

A Major Supplier

Russian exports typically amount to less than $500 billion a year. In the context of total global trade of around $30 trillion, that appears insubstantial.

When it comes to commodities, however, Russia is a major supplier: Raw materials account for almost 40% of its exports. Controversy around the Nord Stream 2 pipeline means that Russia’s role in meeting Europe’s energy needs is well known. But it is also a large supplier of the world’s aluminum, which is already in short supply, as well as significant shares of global palladium, platinum, nickel and copper. Both Russia and Ukraine are major suppliers of wheat. Sanctions and disruption could limit supply of these commodities over the coming months.

There were several reasons why commodities were a key asset allocation theme, even before last week’s events.

A year ago, we were writing about why commodity prices have historically tended to correlate with inflation. More recently, we’ve noted that commodities have tended to perform especially well when inflation was high but economic growth was low or slowing.

We anticipate a move to this less favorable growth-inflation mix over the coming months and years, not least because, as Joe Amato wrote last week, central banks find themselves in the unusual position of tightening policy while growth is declining. While recession in the U.S. is still not our base case, Russia’s invasion of Ukraine is likely to exacerbate the growth and, to an even greater extent, the inflation side of this equation.

Commodities are also geared to the longer-term theme of the transition to a net-zero, electrified economy—a prominent long-term inflationary pressure. We think the price of traditional energy commodities will remain high as supply is curtailed before alternative power is scaled up. Demand for industrial and precious metals is also likely to rise to build the renewable energy, battery and electrification infrastructure of the net-zero economy.

Again, Russia’s importance in the world’s energy, aluminum, palladium, platinum, nickel and copper markets means that sanctions are likely to exacerbate already growing shortages in these raw materials.

Destructive

As well as leading to higher prices across commodity futures curves, growing supply-and-demand imbalances have shifted almost the entire commodity futures complex into backwardation, where nearer-dated contracts trade at higher prices than longer-dated contracts. This creates yet another incentive to invest, as it means that “rolling” from one contract to the next to maintain a long-term position in a commodity generates income.

And, finally, commodities have the potential to act as an important source of diversification when correlations between stocks and bonds are on the rise. Since the beginning of December, according to Bloomberg data, the Bloomberg Commodity Index is up around 22%. Equity markets are double digits into the red. The Global Aggregate Bond Index is down some 3.5%.