Jeff Meli: Welcome to The Flip Side. My name is Jeff Meli. I’m the Head of Research at Barclays. I’m joined today by Ajay Rajadhyaksha, our newly appointed Global Chairman of Research. Thanks for joining me, Ajay.

Ajay Rajadhyaksha: Thank you for having me, Jeff.

Jeff Meli: Today we’re going to talk about the economic and market implications of the Russian invasion of Ukraine. Now, of course this has caused a tragic humanitarian crisis, which is ongoing. But we’re going to focus on the financial and economic effects and, specifically, whether the invasion and the subsequent wave of sanctions that have been imposed on Russia will cause a global recession.

Let’s start with financial markets, Ajay. Russia is a large emerging market economy that’s on the brink of default. Funding markets globally are showing signs of stress. There’s talk of large commodity trading firms being in trouble. And Russia’s effectively been ripped out of the global financial system.

I think we could see big spillover effects for financial markets. And actually this has happened before. Remember that back in 1998, when Russia defaulted on old Soviet Union debt following the dissolution of the USSR, there were massive disruptions to the fixed income market when a high-profile and highly leveraged hedge fund called Long Term Capital Management was forced to unwind.

Ajay Rajadhyaksha: I don’t think this is remotely similar, Jeff. Back in the ‘90’s, remember, there was significant financially linkages between Russia and the rest of the world. But over the last decade Russia has systematically reduced its external vulnerabilities. Public sector debt came down, banks became net creditors to the rest of the world instead of borrowers. The country’s firms reduced dollar debt.

But as a result, the country now owes a very small amount to the rest of the world. Our estimate in bonds is just over $100 billion in outstanding dollar bonds issued by all kinds of Russia entities. Now this sounds large, but in the global context it’s not. Just take one large US bank. J.P. Morgan’s long-term debt is several times as high.

Further, Russia runs a current account surplus, which means that the money spent on foreign goods is less than the money foreigners spend on Russian goods. Or more simply every month more dollars come in than go out. It seemed for the longest time like they were building fortress Russia, an economy with low vulnerabilities.

But, as a result, there’s barely been a ripple when Russia’s two largest banks shut down European operations.

Jeff Meli: Well, Ajay, that’s a nice argument, but market prices appear to suggest the investors disagree with you. So short term bank funding costs have jumped in the last couple weeks by a lot. You could look at, for example, the spread between LIBOR, which is a short-term funding rate that includes bank credit and the new SOFR or secured overnight financing rate, which is a short-term rate that does not include bank credit. Look at the gap between those two.

It used to be about five basis points, meaning banks borrowing five basis points more than SOFR. It’s increased to nearly 30 basis points. Longer term bank credit has weakened too. The spreads of the large banks are up 40 to 50 basis points year-to-date. Isn’t that a sign that there might be some more issues here?

Ajay Rajadhyaksha: Funding spreads are wider, yes. But they are still below the levels they reached in the second half of ’19. And look, risk premia and higher markets are skittish, but they should be, there is a war in Europe. The fact remains though, Jeff, that banks are very well positioned right now between excess reserves measured in the trillions which provide enormous liquidity and elevated levels of capital.

We really don’t see banks feeling any real stress. The bottom-line is that Russia is a fairly small economy, about one-tenth the size of China. It exports a lot of commodities but not much else. Stress in Russia will not cause a financial crisis.

Jeff Meli: Now we’ve been talking about the direct effects on financial markets. But there’s an indirect effect on financial markets too that comes through the sharp rise in energy costs over the past couple of weeks. Just to put some numbers on how much energy prices have risen; in the past two week alone the price of oil has gone up by 25 percent that by itself is a series hit to disposal incomes. But it comes on top of a steady rise in prices that began in early December.

Remember oil was below $70 a barrel in early December and it peaked at over $120 recently. We have seen similar increases in natural gas prices; to some extent here in the US but to an even greater extent in Europe. If western consumers have to pay more in energy they have less money to spend on other things.

And it’s not just oil and natural gas, Russia and Ukraine together produce a large share of the world’s wheat, barley, corn, fertilizers, a whole bunch of other commodities. Food prices are skyrocketing as we speak. And all of this comes at a pretty dangerous time for the global economy.

We’re more or less through the recovery from the initial economic downturn linked to COVID. And, not only are we through that, the fiscal stimulus that helped boost that recovery is now in the rearview mirror. We’re facing the highest inflation we’ve had in decades, which Central Banks need to contend with with no stimulus in sight, policy actually about to get tighter. I think that all of this increase in energy prices could actually tip the global economy into recession.

Ajay Rajadhyaksha: I agreed that the real place to worry about Russia and Ukraine is the energy impact. And I do think there are real risks of a modest recession in some major economies, but not the US and not large EM economies either.

Jeff Meli: Well, Ajay, I noticed that you avoided mentioning Europe as a place where we’re not likely to see increased recession risks. Actually that’s the part of the world where I think the recession risks are the greatest.

Europe has two things working against it. First, it imports a huge amount of energy, including a substantial portion from Russia.

Ajay Rajadhyaksha: That – look that part is true. Europe does get about 40 percent of its total natural gas consumption from Russia and it is particularly important for heating gas.

Jeff Meli: Yes, so and the shock to the energy cost in Europe has been really large, much more than we’ve experienced here in the US Gas, petrol I guess, at the pump in the UK is already up 25 percent from just a few weeks ago. Natural gas futures prices have almost doubled in Europe.

Moreover, Europe has had low potential growth to start with. They have less of a buffer than the US and other economies have. They never really fully recovered from COVID before getting hit with this new shock. And they have a big refugee crisis that’s playing out.

Ajay Rajadhyaksha: I agree that the risks of a recession have risen. I also agree that that is more so in Europe than elsewhere. But there are a few major offsets here, Jeff. First, services consumption still has room to recover in Europe. Remember European households are between 8 to 10 percent of excess savings over and above what they would have saved if COVID hadn’t happened, simply because they spent far less on services than normal in both ’20 and ’21.

Jeff Meli: Yes, but aren’t those savings concentrated in specific households with high income and high wealth? Those are people who generally speaking have a lower propensity to consume those savings.

Ajay Rajadhyaksha: That is true too. But the number is still so large. It at least puts a floor under European consumption falling too much. Also the Euro area’s fiscal stimulus was less front loaded than the US, which means some government spending will support growth this year.

Germany especially will also get a boost from auto production picking up last year. Fewer cars were produces simply because parts were not available. And finally, I think European governments will shield consumers to an extent from energy costs. Absorb some of it themselves.

So, yes, we took down EU growth by 170 basis points for 2022 after the war started. But we still have Europe growing a little above trend in 2022.

Jeff Meli: You know I worry, Ajay, that risks here are all to the downside on our forecast. Just recently the US imposed a ban on Russian oil. What if Europe feels like they have to do that same thing and not just for Russian oil, but also for natural gas? That could leave Europeans having to actually ration energy. There’s almost no place else that they can get it.

And then I think a recession becomes almost a certainty.

Ajay Rajadhyaksha: Europe is critically dependent on Russian energy, no question. And if there is abrupt shutdown of Russia energy exports into Europe, for whatever reason, we will get demand restriction, the chances of a recession will rise sharply. But that is why Europe have ruled out any such move, Jeff.

And the Russians, on their side, well they need to hard dollars so they are unlikely to cut off energy exports either.

Jeff Meli: All right now what about large emerging market economies? Just 10 years ag,o in 2012, there were food riots in emerging market economies sparked by the Arab Spring. Now we look at Russia and Ukraine, you could I think feasibly describe them as like the world’s bread basket. There are certain countries, particularly emerging market countries that are very dependent on wheat and other grain imports from Russia and Ukraine.

Look where wheat prices are.

Ajay Rajadhyaksha: That is a fair point. One difference though is that in this cycle many emerging economies don’t have remotely the kind of fiscal and monetary stimulus that the west put in place over the last two years.

In addition, many of them started tightening well before the Fed, which means that their starting point on inflation is quite reasonable. Look at the largest one, China, their CPI is below 2 percent. Their central bank is easing policy to support growth. Indian inflation is between 5 to 6 percent, which is again very manageable for an emerging economy.

Food prices will bite, but this is not 2012.

Jeff Meli: Let’s turn to the US then. I mean look, oil prices are effectively global, which means that we feel it here too. For example, gas prices are multiyear highs. Gas prices actually are a big deal for the US consumer, we drive a lot. It ends up being reflected in measures like consumer confidence which track gas prices very closely.

Isn’t this price going to weigh on our recovery?

Ajay Rajadhyaksha: See the thing is the US is not an energy importer anymore so, yes, US consumers will pay more. But most of that money goes right back to other parts of the US economy. But it is used for more investment, hiring, et cetera.

It’s not a perfect one-for-one, but the impact of the oil hit to the US is far, far less than for Europe. We expect only a 30 basis point hit to full year GDP growth in the US from the rise in energy costs. This is not the 1970’s, Jeff.

Jeff Meli: Well it is true, Ajay, that the US is now longer an energy importer. But I think there are two constraints keeping that from having the same sort of benefits we’ve historically seen when energy prices go up. The first is that US energy companies have been displaying a remarkable amount of capital discipline. They’re not investing during this boom in part because they’re investors are tired of getting left hung out to dry during the inevitable bust.

And second, the Biden administration has put increasing constraints on the domestic energy industry in terms of what they can produce and where they can produce it. That also might keep the normal cycle of investment and job growth from happening.

Ajay Rajadhyaksha: So look, Jeff, my point is that that money from rising oil prices still largely stays within the US economy. And it does come back to the economy. If nothing else, it comes back through things like higher dividend payouts.

The fact is I also think these constraints you are talking about, maybe they matter at the margin, but they don’t change the overall picture. Which is that the United States is far less vulnerable economically to rising oil prices than it was a decade or two decades ago.

Jeff Meli: You know it’s also funny, Ajay, that you mentioned the ‘70’s because there’s something else that’s different about the US from the rest of the world right now. That’s also sort of akin to what was happening in the ‘70’s and that’s that our inflation picture is far worse.

US inflation and especially services inflation, which is stickier, is much higher than it is in Europe. And now with energy costs skyrocketing the inflation picture is actually going to get worse. That means the Fed cannot back away from tightening interest rates even if consumers are hurting.

Now for years and years the equity markets, and also the economy, have counted on the so-called Fed put, that’s when the US Federal Reserve kind of comes to the rescue during times of economic stress by cutting interest rates. But that put is missing.

Ajay Rajadhyaksha: Yes, the Fed does face a challenging outlook. But that’s why we think they will hike five times this year even as growth is slowing down. And in terms of the impact on the economy, what matters more is not how quickly the Fed hikes, but where the Fed stops.

Markets have stuck to their belief that this cycle will end with roughly a 2 percent Fed funds rate and we generally agree. That has not changed since the war started.

Jeff Meli: Well look, Ajay, my point is that we don’t have buffer. Let’s look at the COVID experience. The recession in the US was pretty sharp, but also pretty short, because we benefitted from enormous fiscal and monetary policy stimulus. We had unprecedented spending, the Fed reacted immediately and very aggressively with rate cuts and asset purchases.

All of that staved off the worst of the downside associate with COVID. But now we have capacity for neither type of stimulus, both because of sort of budgetary issues in DC, plus the inflation picture constraining the Federal Reserve.

It was one thing to suggest the Fed could engineer what we call a quote-unquote “soft landing”, which means they get to hike rates without causing a recession. So we thought that was possible before when the global economy was surging. Global growth was over 6 percent last year. But now I’m not so sure it is possible.

An accident, i.e. a recession, seems like a much more likely outcome in the midst of a hiking cycle given all of the volatility that’s happening globally.

Ajay Rajadhyaksha: I would say that you need to acknowledge that a lot of tightening has already happened. The Fed looks at tightening as more than just front-end interest rates. Financial conditions like credit spreads already are wider. Equity markets are down 10 to 15 percent from their highs. I think markets have priced a lot in, both related to Russia and the Fed.

And look, once again, and I know I keep harping on this, but US household balance sheets are in really good shape, Jeff. The jobs report showed that the labor market is recovering strongly. The US jobless rate is 3.8 percent, we have averaged almost 600,000 jobs a month for the last three months.

This economy has too much momentum, too much going for it to go straight into a recession. The risks have risen, yes. But the Russia/Ukraine war is not going to cause a US or a global recession.

Jeff Meli: Well I hope you’re right, Ajay. And I’m sure we all hope that there’s a cessation of hostility soon. We will see how things play out over the next couple of months and quarters. For now, clients who want to understand the economic impacts of the Russia/Ukraine war can look at our latest Global Macro Thoughts Weekly entitled “The World Faces a Supply Shock” available on Barclays Live.