MACRO AND MARKET PERSPECTIVES

A new supply shock

We believe the drive for energy security will increase inflation and hurt growth in the short term. Greater supply of U.S. and other non-Russian fossil fuels will be needed. Further out, this should reinforce the net-zero transition in Europe yet make its pace more divergent across the world.

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Taking stock of the energy shock

Russia’s invasion of Ukraine is exacting a horrific human toll. In response, nations and governments across the world have come together to sever financial and business ties with Russia. In a drive for energy security, the West is seeking to wean itself off Russian oil and gas – this presents a fresh supply shock in a world that was already shaped by supply. It will make inflation more persistent, slow growth and stoke demand for non-Russian fossil fuels in the short term.

  • The scale of the impact depends on how quickly the West reduces its Russian energy imports. Our base case scenario is a determined reduction as the West and Russia enter a protracted standoff. The reduction could happen more quickly if the conflict escalates. An easing of tensions could slow the process but is unlikely to stop it.
  • In the U.S., the energy shock under a protracted standoff scenario is still less than half the 1970s oil supply shock. It will hit consumers and firms, but the economic impact will be smaller than in the past given greater energy efficiency and the U.S.’s role as a net primary energy exporter. We see growth staying above trend because the activity restart had generated strong growth momentum prior to the shock.
  • Outright stagflation is a more serious risk in Europe given its reliance on Russia for roughly 40% of its gas supplies. We estimate our baseline scenario could add 1-1.5 percentage points to euro area inflation and shave up to 3 percentage points off growth – or more if energy prices return to their mid-March highs.
  • We think the risk of inflation expectations de-anchoring – and central banks being forced to slam on the policy brakes in response – has risen. If higher inflation becomes the rule, central banks may destroy demand by raising rates past their neutral point and into restrictive territory.
  • This shock will probably reinforce the net-zero transition in Europe. The U.S. won’t feel the same push as Europe: it is a net primary energy exporter, will need to increase production to compensate for reduced Russian supply to Europe, and has a lower energy cost burden.
  • Traditional energy stocks are doing well in the short term due to a greater need for additional non-Russian supplies and higher prices. But the transition’s momentum means renewable energy is performing well at the same time.

Living with inflation

The Fed has signaled that it would rapidly raise rates and it may need to go beyond its current estimate of neutral policy rates – the point at which they are neither stimulating nor restricting the economy. For the moment, we think this is tough talk.  Supply-driven inflation can be dampened only at high cost to growth, which the Fed hasn’t shown an intention to tolerate. But the risk of the Fed slamming the policy brakes has grown. As we discuss later, it might become necessary if inflation expectations keep drifting up amid an outlook of even longer-lasting high inflation.

Like other central banks, the ECB had shifted its outlook towards policy normalization. But the shock may do some of the ECB’s work for it by weighing on activity. That means getting to a neutral setting for policy rates might imply doing very little with rates for now. The ECB gave itself some flexibility on starting rate normalization at its March policy meeting. Yet the market is pricing in repeated hikes.

Even if the ECB doesn’t raise rates much, its ability to further offset the shock is limited, especially with inflation so high. This leaves fiscal policy as the possible cushion.

A dilemma for central banks

Supply-driven inflation presents central banks with a dilemma. Monetary policy cannot stabilize inflation and activity simultaneously, like it can when inflation is driven by excessive overall demand and an overheating economy. Central banks have to choose between inflation and growth. To minimize growth volatility, central banks will want to live with supply-driven inflation – as long as inflation expectations do not become “de-anchored.” De-anchoring refers to when, after a prolonged period of higher inflation, people start accepting that as the norm and change their behaviour accordingly.

This a big global risk to monitor across all scenarios. Even if the direct impact is smaller in the U.S., more persistent inflation and the sticker shock of higher gasoline prices could shape long-term inflation perceptions. The three-year average inflation rate in the U.S. is far above the Fed’s 2% target and is projected to keep rising into 2023 based on consensus and Fed forecasts – see the chart. Similarly, the three-year average inflation rate in the euro area is set to peak at 3.5% in the ECB’s forecasts – the highest since the mid-1990s. This prolonged overshoot of inflation may start to shape consumer and business expectations based on recent trends, and inflation expectations could de-anchor.

Watching inflation expectations
Average U.S. PCE inflation, 1980-2024

This chart shows that the three-year average inflation rate in the U.S. is far above the Fed's 2% target and is projected to keep rising into 2023 based on consensus and Fed forecasts.

Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis, Bloomberg, Federal Reserve Board, with data from Haver Analytics, March 2022. Notes: The chart shows the 3-year average annualized inflation rates for headline U.S. PCE inflation (yellow) and core PCE inflation (orange). Future values are derived from Bloomberg consensus forecasts up to Q3 2022, and thereafter from Federal Reserve projections published in the March 2022 FOMC Summary of Economic Projections.

Behavior changes could prompt higher inflation

The change in behavior could lead to higher inflation becoming embedded in wage and pricing decisions. In that case, central banks would have to act aggressively to correct inflation back to target and reset expectations. This would mean raising rates well above their neutral level, destroying demand and raising unemployment. As we identified in A world shaped by supply in January 2022, the demand destruction and rise in unemployment needed to squeeze inflation down could be very high. So this risk is central not just to the inflation outlook but also to the growth outlook.

Markets now see a possibility of central banks ultimately raising rates above the neutral level. Encouraged by the Fed, the expected path of the fed funds rate rises to almost 3%. The expected path for the ECB rises to 1% - both above estimates of the neutral rate on that time horizon.

Adding to the Covid-19 shock

We had already seen supply constraints driving high inflation over the past year, fundamentally changing how we consider the macro environment and market implications. The pandemic spurred a huge switch in U.S. consumer spending away from services and towards goods. This elevated goods prices and overall inflation, despite activity not returning to its pre-Covid path. We were in a world shaped by supply and expected the supply side to adjust over time, but the nature of the activity restart meant we were far from 1970s stagflation.

We are now seeing a textbook energy supply shock, more like the 1970s, layered on top of the restart.

Weaning off Russian energy

The West is responding to Russia’s invasion of Ukraine by weaning itself off Russian energy. That’s no mean feat: Russia is the world’s third largest energy producer, accounting for 10% of global oil supply and 17% of global gas supply, according to International Energy Agency (IEA) data as of December 2021. Russia is the EU’s largest supplier of oil, coal and gas: 27%, 47% and 41% of imports, respectively, according to Eurostat data.

The U.S. and UK are banning Russian oil imports, while the EU has declared an ambitious goal of reducing Russian gas purchases by two-thirds by the end of the year. Germany has announced its intention to all but eliminate reliance on Russian gas supply by mid-2024 and become virtually independent of Russian oil by the end of this year. Russian energy production cannot be diverted elsewhere overnight, so global energy supply is effectively being reduced, driving huge energy price spikes. Gas prices have spiked in Europe given the region’s high dependence on Russia. See the chart.

Energy supply shock
U.S. and European energy prices, 2021-2022

This chart shows that gas prices have spiked recently in Europe given the region's dependence on Russian fossil fuels.

Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2022. The lines show the changes in price of different commodities since July 1, 2021. European natural gas price based on European Energy Derivatives Exchange futures, U.S. based on MYM-Henry Hub Gas futures price. Oil price based on ICE-Brent crude futures.

We see three scenarios

We believe the switch away from Russian energy will raise inflation and dampen growth in the short term, while creating the need for greater supply of non-Russian fossil fuels. On a longer time horizon, we also think it will reinforce the net-zero transition in Europe but make it more divergent globally. The extent of the impact in both cases depends on how quickly the West reduces its Russian energy imports. We see three broad possible scenarios:

1) Our base case: a protracted standoff
We see a protracted standoff between Russia and the West, with tensions remaining high. Europe follows a determined path to significantly reduce its reliance on Russian energy by the end of the year. Oil prices settle around $100-130 and European gas prices at €100-115 per megawatt hour (equivalent to around $190-220 per barrel of oil).

2) Easing of tensions
Some form of agreement is reached between Russia and Ukraine. This might slow how quickly the West reduces Russian imports, but does not stop it in our view. Energy prices return to close to December 2021 levels, with oil prices below $100.

3) Massive supply disruption
The cut in Russian imports is much sharper – either due to the conflict escalating and Europe looking to cut all imports of gas even more quickly or Russia disrupting supply. Energy prices surge to mid-March peaks or beyond.

    A major shock to energy prices

    Price jumps this year reflect the supply shock in global energy markets as the West seeks greater energy security and Russian energy routes shift. See the charts. That is stagflationary: it will increase inflation and slow growth. But by how much?

    These charts show the evolution of Brent oil prices and European natural gas prices over historical episodes of energy shocks. Europe's current price shock is larger and faster than the previous episodes.

    Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, March 2022. Note: The chart shows the evolution of Brent oil prices and European natural gas prices over historical episodes of shocks to energy, as defined by Hamilton (2011), ‘Historical oil shocks’, NBER. Data are monthly and assume that the latest daily price is projected forward for the remainder of the month to calculate the current monthly average.

    Slow growth, higher inflation

    In our base case scenario of a protracted standoff between Russia and the West, we estimate that U.S. inflation would increase by around 1 percentage point and growth would be 0.5 percentage points lower – though with much uncertainty on those estimates. This hit to growth is smaller than typically seen after past shocks. Why? First, U.S. industrial production is much less energy intensive than it was in the past. Second, U.S. oil production has risen so much that the country only imports a fraction of its crude oil needs. This means the terms-of-trade shock from a rise in oil prices – whereby imports become more expensive relative to exports, in turn weighing on incomes and consumption – is far smaller.

    So though this is a stagflationary shock for the U.S., we do not believe it threatens outright stagflation – defined as zero or negative real growth for an extended period of time. The post-pandemic restart is not yet complete, and we see growth aligning with pre-invasion expectations that it will be above trend, even as the impact of the energy shock takes hold.

    Europe at risk of stagflation

    The picture looks more severe in Europe. The energy shock under our protracted standoff scenario would be more serious than implied by oil prices alone because of the sharp rise in European natural gas prices. Europe’s reliance on Russian gas would make the gas price shock much larger than a typical oil shock. The share of GDP it would have to spend on energy would be the highest since the 1980s.

    This scenario would see inflation boosted sharply – we think by around 1-1.5 percentage points. But it would also hit activity hard. The European Central Bank (ECB) has revised up its inflation forecasts but has not factored in a major hit to growth. Yet we think it could shave up to 3 percentage points off growth.

    Ripple effect

    Such a hit to the euro area would ripple out to the global economy given Europe’s substantial international trade links. We believe the impact could be even more severe under the supply disruption scenario: a January 2022 ECB study suggests a 10% reduction in gas supplies could reduce GDP by 0.7 percentage points. If Russian gas were no longer available to the EU in the 2022/23 winter and no ready substitute available, the direct impact on GDP could be just under 3% of GDP – on top of the existing estimated hit, clearly pushing the euro area into recession.

    Fossil fuel demand shift

    As well as shaping the macro picture, the drive for energy security will clearly reshape energy demand and supply.  Europe will have an acute need for more fossil fuels from outside Russia to meet its energy demands and achieve its ambitious plans to reduce its reliance on Russia. We expect production elsewhere to be ramped up. But global oil, natural gas and coal markets will likely remain tight in our base case scenario – and Europe’s energy cost burden will remain highly elevated.

    A more divergent transition

    We will see higher fossil fuel output outside Russia and sustained high energy prices. We could also see carbon emissions edge up as the EU burns more coal and oil to make up for less Russian gas. But this isn’t a sign that the transition to clean energy is being derailed, in our view. The world needs fossil fuels to meet current energy demands because of how economies are wired. But ultimately, the total demand for fossil fuels is key, not where they’re produced. The increase in non-Russian supply must be viewed against Russian production assets becoming effectively stranded. We are set to see a shift in where fossil fuels are produced, not a surge in the total amount of fossil fuels consumed.

    The drive in Europe for greater energy security should spur the development of clean energy. Tight fossil fuel markets, with sustained high prices, act like a carbon tax on consumers. Europe is now spending about 9% of its GDP on energy – the highest share since 1981. See the chart. And the green energy premium – the extra typically paid for choosing renewables over traditional energy – has been eroded. Even before the shock drove up fuel prices to record highs, the cost of wind and solar energy had reached parity with existing coal and gas-fired power and was far below the cost of fossil fuel power generated by building new infrastructure, according to a Lazard analysis from October 2021. Now that fuel prices are even higher, renewables have become even more competitive despite higher steel, aluminum, polysilicon and copper prices – all materials needed to build renewable power capacity.

    Spending more on energy
    Energy burden as a share of GDP, 1970-2022

     This chart shows that Europe is now spending about 9% of its GDP on energy – the highest share since 1981. This is nearly twice as much as the U.S. energy burden.

    Sources: BlackRock Investment Institute and BP Statistical Review of World Energy 2021, with data from Haver Analytics, March 2022. Notes: The chart shows the cost of oil, gas and coal consumption in the European Union and U.S. as a share of GDP. We use regional energy prices and divide by GDP in U.S. dollars. Data for 2022 are based on IMF’s latest GDP forecasts and the year-to-date average of daily commodities prices.

    Fast-forwarding to renewables

    This should all spur the energy transition toward renewables and electrification in Europe, in our view. We believe this would be the case across all three scenarios. Yet in the U.S., we don’t expect the same motivation to hasten the transition. The burden of higher energy costs on U.S. consumers – though very real – will be much smaller than for EU consumers: between the start of the year and early March, natural gas prices in the EU rose by three times as much as in the U.S. The share of GDP the U.S. spends on energy is a fraction of that in the EU. Because the U.S. is also a net exporter of primary energy, its trade balance will improve if it scales up oil and gas production. Gains for energy companies will offset some of the hit to consumers, meaning that the U.S. will face more difficulty in balancing competing interests. At the same time, geopolitical events may reduce political attention on the energy transition.

    The current investment perspective

    By spurring the transition in Europe but less so elsewhere, the drive for energy security means the transition will now be more divergent. But we think it could be reinforced overall. Markets are reflecting this view: while traditional energy stocks are doing well in the short term due to greater demand for non-Russian output, clean energy stocks are also outperforming global benchmarks. From an investment perspective, the effective stranding of Russian fossil fuel supply has created investment needs in both traditional energy and renewables.

     

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    Philip Hildebrand
    Vice Chairman, BlackRock
    Jean Boivin
    Head, BlackRock Investment Institute
    Alex Brazier
    Deputy Head, BlackRock Investment Institute
    Elga Bartsch
    Head of Macro Research, BlackRock Investment Institute
    Eric Van Nostrand
    Head of Research for Sustainable Investments, BlackRock Sustainable Investing
    Christopher Weber
    Head of Climate Research, BlackRock Sustainable Investing