Russia’s invasion of Ukraine is not only about politics. If Vladimir Putin is victorious he will tighten his grip over the world’s commodity markets. Ukraine is not only a large producer of grain and sunflower oil, but the Donbas region hosts abundant lithium resources, a key ingredient in the manufacture of electric vehicles.
While it remains to be seen whether Putin’s gamble will pay off, the war between two huge commodity producers has sent ripples through global markets. Russia and Ukraine account for almost a quarter of global wheat imports and 20% of vegetable fats. Russia is also a key exporter of nickel, coal, lead, aluminium and, of course, natural gas.
It did not take long for the cost of the war to feed through to the global commodity markets. Natural gas prices in Europe surged by 50% in March, as did the average global cost of wheat, while fertiliser prices in the US leapt by close to 40%, according to the Institute of International Finance (IIF).
The consequences will be severe, particularly for countries heavily dependent on Russian and Ukrainian grains, predicts Elina Ribakova, the IIF’s deputy chief economist. “With world food prices at multi-decade highs, we worry about global food security,” she says, believing that the war poses a threat to this year’s harvests in Russia and Ukraine.
At first glance, it appears that the UK is only marginally affected by the war. Trade with Russia accounts for 1% of the UK’s global transactions and it buys 13% of its energy from Putin, while Germany relies on a third of its fuel from Russia.
But the impact on Britain’s economy has been more severe than anticipated. By April, inflation reached a 30-year high of 7% and rising commodity prices have been named as a key culprit by Jon Cunliffe, the Bank of England’s deputy governor for financial stability.
“We have already started to see some of the effects on commodity prices, including for energy and food,” he said in a speech in April. “Global oil prices have increased by 11% and UK wholesale gas prices have increased by 40% since the invasion,” he told the audience at the European Economics & Financial Centre.
This is also a concern for Evan Guppy, head of liability-driven investment (LDI) at the Pension Protection Fund (PPF). “The outlook for inflation has materially deteriorated since the start of the year as a result of further sharp increases in the cost of basic commodities, in particular energy commodities.
“These increases have started to feed into consumer prices and will continue to do so in the coming months as businesses pass those higher costs on to consumers.
“The war in Ukraine is a big part of the reason for these increases, with Russia and Ukraine important commodity exporters of, for example, oil, gas and wheat,” Guppy adds.
“Headline inflation in the UK will move sharply higher in the next couple of months with the large increase in the energy price cap in April the main driver.”
Not about the money
But a closer look at the market reveals a more nuanced outlook. First, it is not so much a shortage of commodities that is driving such turbulence. Globally, the net production of wheat, grain and cereal is expected to be in line with last year’s figures as other countries have increased their harvests, says UN
agency the Food & Agriculture Organisation.
While the regulation of metal and energy output is more difficult to adjust, the defining challenge of the crisis seems to be price volatility and distribution rather than price rises.
This was picked up by Cunliffe in his speech. “Prices have been extremely volatile, reflecting uncertainty about the course of the war and imposition of sanctions. Had I given this speech at the start of the last Monetary Policy Committee round, the increases would have been 22% and 116%, respectively. Had I given it two weeks later, when the decision was announced, they would have been 10% and 17%.”
This is largely due to the impact of derivative markets on day to-day pricing. The prices of commodities have been influenced by speculation about future prices, in a way no other asset class has. The first futures contracts for commodities were found in ancient Mesopotamia in around 4500 BC in the
form of clay tokens while modern commodity trading in the US and Europe goes back at least 150 years. As such, commodity prices have always been influenced by traders’ perception of supply, rather than the actual availability of those commodities.
Commodity markets were already heated prior to the first bullet being fired in Ukraine, with a surge in demand for timber, for instance, causing exchanges such as the Intercontinental Exchange to lift their margin rates for trading gas futures.
For example, margin costs for trading brent crude oil have more than doubled during the past year, which in turn has dried up market liquidity and led to an increase in short squeezes. This decline in futures trades affects the physical commodity markets. Firms that trade physical commodities use futures to manage risk. This has created a paradoxical situation where farmers banking on increased demand for wheat are unable to sell their goods because commodity trading firms have reduced shipments due to the lack of liquidity in the futures market.
Does all this mean that commodities will continue to drive up inflation? Not necessarily, argues George Calhoun, professor at Stevens Institute of Technology. “The relationship between the prices of raw commodities and those of finished goods is weak and is getting weaker. In the 1960s up until the 1980s, the correlation of steel to car prices was 53% and it’s been a negative 11% since the 1990s. The percentage of the cost of a box of Kellogg’s cornflakes that actually is contributed by corn is between 2% and 4%,” he says.
“The value in consumer goods today is not coming from commodities, it is coming from technology, it is coming from software, design, brands, equity and other intangible assets,” he adds.
There is data available to back up his claim. During the past 10 years, commodity prices of timber, steel and gas have shown a negative correlation to the consumer price index (CPI) index.
However, this is a trend that is particularly pronounced in developed markets. Price levels in emerging markets are much more susceptible to commodity price rallies. For example, food accounts for a quarter of the Turkish and Brazilian CPI indexes, 36% in Russia and 40% in India, according to CaixaBank.
Nevertheless, when it comes to developed markets, Calhoun is convinced that long-term deflationary trends, such as demographic changes and the growing share of technology in production, will prevail.
In the long run
Does this mean that institutional investors, who are in it for the long run, should ditch inflationary concerns? For most institutional investors, managing the portfolio impact of rising price levels remains a key concern.
And while inflation indices such as the CPI or retail price (RPI) index have come under fire for their inaccuracy to reflect the cost of living across the country, they still make an impact on the calculation of pension scheme liabilities.
The PPF’s Evan Guppy believes inflation is here to stay, at least for the medium term. “The derivatives market is currently pricing that RPI inflation will peak at around 11% in May. In contrast to earlier in the year, it now looks as though the energy price cap could rise again in October meaning that headline inflation will be slower to fall from that level and will remain at elevated levels until we get into 2023.”
This is also a growing concern for Brian Kilpatrick, chief investment officer of HSBC’s pension scheme. “I am very, very worried about inflation. Our defined benefit assets are well hedged against inflation and interest rate risks,” he says. “That means inflation does not really impact our funding levels.
“It does, of course, impact members when inflation is higher than in the past. But the biggest impact will be on the value of assets in defined benefit and defined contribution more broadly.
“While equities tend to perform well in a moderate inflationary environment, the big worry is stagflation and defaults coming out of this environment,” Kilpatrick adds.
Paradoxically, while commodities have been seen as a traditional inflation hedge, demand for commodity funds has been limited. Over the past month, commodity ETFs across Europe continued to book net outflows, according to Lipper’s monthly ETF report.
While commodity hedge funds have benefited from riding the wave of volatility, pension fund investors show little appetite to invest in the asset class with the volatility making them unappealing. “We have been in a lot of discussions with our trustees about the outlook of the inflationary environment and what it means for the assets we are invested in,” Kilpatrick says. “That is one of the reasons why we are thinking about investing in illiquids because they tend to be one of the assets that provide inflation-linked cashflows.”