Economic Fundamentals Matter Most, but War in Ukraine Poses Risks

This article is provided by ITR Economics in partnership with Sheet Metal & Roofing.

Please note: At ITR Economics, we confine our analysis to the economic impact of events. That does not mean we assign primacy to the economics, and it does not diminish our personal anguish over the pain, suffering, and loss of life resulting from Russia's invasion of Ukraine.

Our analysis will develop in the coming weeks as we gain clarity regarding the length and breadth of the conflict and related sanctions. The situation is rapidly changing, and there are many unknowns; we encourage you to follow us on social media and to read our blog for additional near-term updates.

We have not changed our macroeconomic outlook, as there are too many unknowns at this juncture, the length and breadth of the conflict being one of the more important variables. We are closely monitoring consumer activity, as consumers are the backbone of the US economy. Commodity price spikes are pushing up on already elevated inflation, which could negatively affect consumer discretionary spending. The impact of the war will vary by market – the defense and oil and gas markets, for example, may benefit, while markets that rely on European buyers could face headwinds.

Energy and Commodity Prices

The US is the largest petroleum producer in the world and was a net exporter by a slim margin in 2020 and 2021. Russia and Saudi Arabia are next in terms of production volume but have a larger role in global exports. The US has historically purchased some, but not much, petroleum from Russia, whereas European countries have significant exposure to and dependence on Russian petroleum.

Following the invasion of Ukraine and the early financial sanctions on Russia, US and European Union buyers became wary of buying from Russia. The EU, which is more dependent on Russia than the US, has increased financial sanctions but has not banned oil imports from Russia. The US does have an import ban on Russian oil. The conflict has resulted in spiking energy prices in Europe and, to a lesser but still noticeable extent, the US. Consumers are facing elevated gasoline prices and have limited ability to scale back their consumption of gasoline. This inelasticity means higher prices could cut into consumers’ discretionary spending – as noted above, this is something we are keeping a close eye on.

Additionally, we are seeing rising prices for other commodities such as nickel, aluminum, wheat, and more.

And on top of higher prices, businesses could face exacerbated supply chain disruptions if their inputs pass through Russia or Europe.

Monetary Policy – Inflation and Interest Rates

The US Consumer Price Index in February was 7.9% higher than one year prior. This elevated inflation reading predates the recent spike in oil and other commodity prices caused by the war in Ukraine. Inflation eats into consumer purchasing power, and volatile pricing trends pose a risk to the economy as they impact businesses and consumers’ ability to plan. The Federal Reserve recently ended quantitative easing and is expected to raise the Federal Funds Rate in March to reign in inflation. However, raising rates is a contractionary monetary policy, and the Federal Reserve may be hesitant to pump the breaks given recent geopolitical events. To determine its policy, the Federal Reserve will need to balance the downside risks associated with the international conflict against the negatives of elevated inflation. For now, rates are still quite low, but we expect a trajectory of overall rise ahead. If you are looking to invest in efficiencies and in your competitive advantage, consider doing so soon, while rates are still low.

The Preexisting Financial Cushion    

Although economic ripples from the war in Ukraine and related sanctions are reaching the US, we have the benefit of a solid financial position from which to face them. Jobs are plentiful, and consumers have savings to draw upon. Corporate profits were at record highs in late 2021. These preexisting trends provide a buffer for the US economy while it moves along the back side of the business cycle.

Economic Fundamentals Reign

Although we are in uncertain times, we encourage you to lead with confidence. Look for opportunities both to profit and to assist your community during this time. In the long run, economic fundamentals are the determining factor. When the situation in Ukraine stabilizes, commodity prices and markets will normalize. Economic fundamentals suggest slowing growth, rather than recession, this cycle, but the economy can be more susceptible to negative pressures on the back side of the business cycle, and a protracted conflict or direct US involvement could put the economy at risk for a recession. Be aware of that risk, but remember that the longer-term macroeconomic trajectory is for growth. Investing in efficiencies and your competitive advantages while interest rates are low will pay dividends in the long run.