Post Market Wrap | Europe to feel economic brunt of war on Ukraine

This Post Market Wrap is presented by KOSEC – Kodari Securities

• Economic impact on Australia appears neutral at worst
• Australian exports at record high of $49.2B in January 
• Strong employment growth boosting Australian economy
• Domestic inflation likely to peak in June 2022 according to RBA
• Australian equity market to remain resilient, despite potential for higher interest rates.

Impact of Ukraine/Russia conflict on trading in 2022

The impact of the war in Ukraine is likely to be felt most severely in Western Europe (notably Germany), more than anywhere in else in the world, except for Russia, where crippling economic sanctions are yet to fully bite. 

Europe is heavily dependent on Russian natural gas and oil for its energy consumption. Sanctions imposed on Russian energy exports have pushed global oil and gas prices materially higher for European consumers. Significantly higher energy prices have an immediate dampening effect on consumption but can also be inflationary. The extent to which European consumption falls because of higher energy prices, will determine the response by European Central Banks to the threat of higher inflation. Lower economic growth rates may do the work of Central Banks and reduce the need for monetary tightening through higher European Central Bank interest rates. This appears to be the case for now.

The economic impact of the conflict is neutral or perversely slightly positive for the US, China and Australia. This is because the US and Australia have negligible export exposure to Russia and Ukraine, while the US is a net exporter of energy. Australia’s major export partner is China which accounts for about 35 percent of Australian exports, after Japan at about 12 percent, followed by South Korea and the US each at about 6 percent. Russia and Ukraine account for just  0.2 percent of Australian exports.  China, Japan, and South Korea are not directly impacted by the war on Ukraine. 

China’s position to date in the Ukrainian crisis is one of inaction, despite it being impacted by higher energy and commodity prices. Just how long China will not involve itself in the crisis may be determined by the severity of the impact of higher commodity prices on its economy. Should the economic impact on the Chinese economy become severe, China may be able to exert political influence on Russia to end the war on Ukraine, or at least moderate the level of human devastation.   

Implications for Australia 

Australian exports hit a record high in January 2022 of $49.2 billion.

The war on Ukraine has boosted demand and prices for our major exports, especially Liquid Natural Gas (LNG), coal, nickel, copper, lithium and gold, as well as agricultural exports of wheat, wool and beef. 

LNG prices are linked to the price of oil with a 4-month lag, implying higher LNG prices are on the way for Australian exporters like Woodside Petroleum and Santos. Similarly, Russia is the world’s largest wheat exporter ahead of Australia, being the fourth largest exporter, meaning Australia is now a significant beneficiary of higher wheat prices. Recent rains are likely to support higher wheat production in Australia over the coming 2 years. This follows current production levels already at a level 32 percent higher than the 10-year average.

These developments support a strong growth outlook for the Australian economy. This has obvious implications for Australian interest rates. The RBA has flagged the potential for higher interest rates in response to higher inflation. The RBA estimates inflation to reach 3.25 percent by June this year, before settling at 2.75 percent out to June 2024. This inflation trajectory signals higher interest rates in Australia. However, the crisis in Ukraine and resultant higher energy prices may see a slightly less aggressive tightening than would otherwise be necessary. The outlook is complicated by strong domestic employment and wages growth, brought about by strong exports. 

Image: File

The Australian equity market sold off in late January and is down approximately 3.8 percent year-to-date, although it has since recovered from the January low. Global markets more generally have been hit harder and are down about 10 percent from their recent peak. It appears that for now the impact of the crisis in Ukraine, and the likely rise in interest rates on the back of higher inflationary expectations, are already factored into equity markets. 

In Australia, the sell-off has been muted by record exports and the persistently strong economic growth outlook which is maintaining near-full employment levels and encouraging higher wages. 

The evidence suggests that it will take more than a few interest rate rises to panic the Australian market into a prolonged sell-off. 

This Post Market Wrap is presented by Kodari Securities, written by Michael Kodari, CEO at KOSEC.