How Russia's invasion of Ukraine created a new inflationary regime

Conflict has set off a structural deterioration that could play out over decades, says investment strategist

How Russia's invasion of Ukraine created a new inflationary regime

Nearly 200 days after it started, the conflict between Russia and Ukraine is continuing to rage, and its humanitarian and economic toll only grows by the day. Aside from the damage to the Ukrainian and Russian economies, the war is creating a tailwind to inflation across the world – and Jeffrey Schulze doesn’t expect it to end anytime soon.

“The good news is that oil has almost done a full round trip back to where it was prior to the invasion,” said the director and investment strategist at ClearBridge Investments, specialist investment manager of Franklin Templeton in a recent interview with Wealth Professional. “However, crack spreads – better known as refinery margins – have started to move down, but they're not quite to where they were heading into February when the invasion happened. That means gasoline prices may not fully revert back to where they were, which could continue to be a tailwind to inflation.”

The ongoing conflict between Russia and Ukraine, Schulze says, means there will be a continued geopolitical premium embedded in prices across global energy markets, further contributing to elevated global inflation. That’s on top of the chronic relative tightness in the energy markets, with limited spare capacity to satisfy the world’s thirst for oil. In the United Arab Emirates, he says spare capacity is around 1 million barrels a day, compared to 100 million barrels per day in current global oil demand.

On the brighter side, Schulze says a lot of the Russian oil that used to flow to Europe, but has been blocked due to sanctions, is now finding its way into China and India. That has eased the upward pressure on global oil prices somewhat, he says, but that still doesn’t fix the growing cracks in the global economic picture.

“Until we can get a resolution to that conflict, you're going to continue to have that geopolitical premium embedded into energy markets and it's going to keep inflation a little bit higher,” he says. “There’s definitely the potential for higher structural inflation across the global economy as the Russia-Ukraine conflict continues to drag on.”

The more profound implications, according to Schulze, become clear when one thinks about globalization’s historical role in driving down inflation. Since China joined the World Trade Organization in the late 1990s, increased trade between nations has created a supply-side downward push on prices.

Today, both Russia and China, which has long had a tense relationship with the West, are under greater scrutiny than ever. As geopolitical tensions cause those relationships to fray, there’s increased incentive for countries to onshore production of key products, or import them from allies who are not necessarily able to produce them at the lowest cost.

“The CHIPS Act was passed in the US in July, which is going to bring a lot of US semiconductor manufacturing back home, and not necessarily in the most efficient way or the lowest price possible,” Schulze says. “At the end of the day, I do think that the simmering tension between the West, China and Russia will lead to a period of deglobalization and higher inflation.”

For what it’s worth, investors won’t be feeling that burn anytime soon. Schulze expects the move toward a more regionalized world of trade to happen over the course of decades rather than years.

“Although you may see some higher structural inflation in the global economy, this is not going to be something that sets off inflation to a similar degree as in the 1970s,” he says. “It’s going to be more of a slow burn rather than a sharp transition.”