Ukraine escalation is a wake-up call: PGIM Fixed Income

Below, PGIM Fixed Income economists and energy specialists discuss implications of the unfolding events in Ukraine.

Katharine Neiss, chief European economist at PGIM Fixed Income

The implications are very different for the euro area than the US. For Europe, the events of recent days represent a clear negative supply shock to the region, pushing down on economic activity and up on inflation, creating a dilemma for policymakers.

The are several channels through which recent tensions reverberate across the region with energy and the attendant hit to confidence high on the list. Additional negative effects come through trade and financial links, though the macro impact of these is limited in comparison.

Although the escalation is a common shock, it is important to note that its impact is asymmetric across the region, with large euro area countries such as Germany and Italy most exposed given the greater reliance on Russian energy, relative to France, for example.

Clearly, such a negative shock puts the ECB in a difficult situation, with the prospect of higher and sustained energy price rises feeding through to inflation whilst simultaneously squeezing households and firms. Shocks with an asymmetric regional impact also raise the prospect of euro area fragmentation, with concerns economies such as Italy may be unable to finance debt levels.  The potential for euro fragmentation risk further challenges the ECB.

Given the fluid and challenging backdrop, we expect the ECB to keep its options open, and reinforce its relatively dovish stance, as announced back in December, of a gradual tapering in asset purchases over the course of this year. Recent events also offer the ECB an opportunity to take back control of the inflation narrative – higher than expected inflation outturns are clearly due to an external shock and are outside of the control of the central bank. Such verbal intervention could reassure markets. In addition, we expect the ECB to utilise in real time the flexibility it adopted during the pandemic to ensure favourable financing conditions and prevent sovereign bond spreads from widening.

Ellen Gaske, lead economist, G10 economies at PGIM Fixed Income

At this point, the Fed is likely still on course for lift-off at its March meeting, but market expectations have now fallen back close to our forecast of an initial 25bp hike. We still anticipate a total of four 25bp rate hikes this year, along with a commencement of quantitative tightening in the third quarter of the year. However, we now see roughly symmetrical two-sided risks around our Fed funds forecast.

First, if higher energy prices persist and dampen consumer spending on other goods and services, a slower-than-expected real growth rate of the economy could limit the amount of Fed tightening this year, while also keeping longer-term inflation expectations in check.

Second, if longer-term inflation expectations become untethered amidst high energy prices and the broad-based inflation pressures of the past year, then there is a risk the Fed could step up its tightening pace beyond the moderate path we are anticipating.

Dave Winans, credit analyst, US investment grade energy at PGIM Fixed Income

The events in Ukraine are a wakeup call for realistic energy policy in Europe and the US. The world’s second largest gas field straddles Pennsylvania and West Virginia, but extracting the gas has been problematic given the difficulty of establishing new US pipelines. The irony here is that due to the run up in crude prices, Gazprom is making more money now than it did before the invasion took place.

Gary Stromberg, US high yield energy credit analyst at PGIM Fixed Income

The US is at 100% capacity for its natural gas exports, so while gas prices in Europe are up 40-50%, we cannot ‘help’ by exporting more. Getting new export terminals approved and built is a multi-year process. That being said, we remain constructive on natural gas prices over the medium term, given supply discipline and increasing demand. We continue to think natural gas will be a critical bridge in the energy transition.

For oil, we are waiting to see if the US releases more barrels from the Strategic Petroleum Reserve, and we may also see Iranian exports ramp up if an Iranian deal gets done. It is clear to me a geopolitical risk premium of at least $10/bbl will provide support over the near term, however, oil above $100/bbl will impact demand, so we are watching for demand destruction and its impact on longer term oil prices.

For our high yield producers, we expect companies to more aggressively hedge both oil and gas, with 2023 strip prices above $80/bbl and $4.00/mmbtu providing very attractive margins for E&P companies. We expect minimal defaults in the next several years given current commodity prices.

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