Preparing for the Impact of El Nino: Morgan Stanley's Prediction of an 'Inflation Storm' and its Effect on the Market

According to Ben Noll, a meteorologist at New Zealand's National Institute of Water and Atmospheric Research, the possibility of an El Niño phenomenon increased as the tentative value of the Southern Oscillation Index (SOI) dropped to -1.6, which is its lowest since 2015.

The SOI measures El Niño and La Niña phenomena in the atmosphere, where sustained negative values indicate El Niño and positive values indicate La Niña.

El Niño's impact on different countries can vary, with some experiencing direct and short-term effects while others facing longer-term implications for growth, inflation, and social stability. The severity of the impact depends on how ocean warming affects atmospheric temperature and rainfall patterns, leading to drought risks in Southeast Asia, Australia, Brazil, Colombia, Africa, Central America, and the Caribbean, and increased rainfall in the United States, Argentina, and the Andes if Morgan Stanley Senior Global Economist Rajeev Sibal'sweather models are accurate.

Sibal has predicted a 90% probability of El Niño continuing in the second half of 2023, significantly impacting global energy and food supplies. The two main risks associated with this phenomenon include high inflationand fiscal pressure.

The Science report "Persistent Effect of El Nino on global economic growth" highlights the enormous financial costs associated with past El Niño events, such as the 1997-98 event that reduced GDP by $5.7 trillion over five years. The current El Niño may have significant impacts due to high levels of energy stored in the ocean system, leading to record-high sea surface temperatures and more power for extreme weather events.

Significantly, unusual weather patterns due to El Niño can affect water flows and power generation for countries relying on hydropower. It can also cause energy outages by disrupting wind and solar energy generation.

Morgan Stanley analyzed past El Niño cycles and found that inflation is the primary impact, while economic growth is less affected than trade or inflation.

The rise in global food prices could lead to inflationary pressure, prompting central bankers to remain hawkish on interest rates for extended periods, affecting valuations.

The potential spill-overs from El Niño's impact on rising food prices could be significant. The European Central Bank recently suggested that a one percent increase in temperature during El Niño could lead to a six percent increase in food prices over 12 months. Bloomberg estimates that El Niño could add 3.9 percentage points to non-energy commodity prices and 3.5 percent to oil prices.

Sibal warned of inflation getting out of control if food or energy subsidies are not cut during price shocks and fiscal deficits widen. Broader economic imbalances may result from a second round of inflationary shocks.

Morgan Stanley concludes that El Niño's impact could make it more challenging to fight inflation, leading to a longer interest rate hike cycle by the Fed and affecting the monetary policies of many countries worldwide.

El Niño could lead to poorer crop yields, resulting in a lower supermarket supply and increasing prices.

The rice shortage since April this year is a testament to the potential impacts of El Niño on agriculture and food supply. Reports suggest that Pakistan's production has reduced by around one-third due to severe flooding, causing the worst rice deficit in 20 years. Meanwhile, China, the world's largest producer, is struggling with drought.

The impact on global inflation from "a large El Niio could spread beyond just food," according to JPMorgan.The bank's analysis of a WorldBank data set of commodity prices stretching back to the 196os found that El Nino events — typically occurring twice a decade -correlate with higher global rubber, timber, and zinc prices.

In Australia, El Nino tends to bring heavy rainfall to the western Pilbara region, home to vast iron ore reserves. Australia accounts for roughly 60 percent of the seaborne iron ore market, meaning higher prices in the event of weather-induced disruptions.

Extreme weather and hotter conditions significantly impact the agriculture and energy sectors. Drier conditions can lead to lower water levels, constraining hydroelectricity power generation for areas. The shortage of hydroelectric power could result in higher energy demand, particularly for crude oil and coal, due to difficulties in generating hydroelectricity. According to Charles Schwab, the 2016 El Niño coincided with a 13% market sell-off, with the materials and energy sectors leading.

While the insurers may benefit from extreme climate events, Morgan Stanley analyst Andrei Stadnik suggests that insurers such as Suncorp Group (ASX: SUN) would benefit from the warmer El Niño summer, given their better budget placement and greater exposure to Queensland. During an extended La Niña pattern, severe storms caused approximately $10.5 billion in damage over the past three years, making it an excellent opportunity for Australia's largest insurers to keep a lid on catastrophe costs. Morgan Stanley analyst Andrei Stadnik highlights that this change in weather conditions would benefit established players like Suncorp and IAG, with claims during El Niño periods being, on average, 40% lower than those during La Niña periods.

Moreover, Stadnik also pointed out that motor insurance could also benefit from El Niño's warmer weather conditions as drier roads lead to fewer accidents. Historical data shows that motor loss ratios may change by 2-3% due to changes in rainfall.