Morgan Stanley warns: El Niño will trigger an "inflation storm"

El Niño phenomenon is making a comeback, and Morgan Stanley warns of an inflation storm and fiscal risks.

On Tuesday, Ben Noll, a meteorologist at the National Institute of Water and Atmospheric Research in New Zealand, tweeted that the Southern Oscillation Index (SOI) for September is provisionally -1.6, the lowest value since 2015, indicating an increased likelihood of El Niño occurring.

The SOI is an atmospheric indicator that measures the El Niño and La Niña phenomena, with sustained negative values indicating El Niño and positive values indicating La Niña.

Regarding the upcoming El Niño, Morgan Stanley analyst Rajeev Sibal stated in a recent report that there is a 90% probability of a sustained El Niño in the second half of 2023. This will have an impact on global energy and food supply, with high inflation and fiscal pressure being the two major risks.

Especially for emerging markets, transitioning from the cooler La Niña to El Niño can have a significant impact on economies that are more vulnerable to fluctuations in energy and food prices and production. These economies often have limited fiscal buffers and are unable to withstand an inflation storm.

Morgan Stanley warns that El Niño will make the fight against inflation more challenging and may prolong the Federal Reserve's tightening cycle.

How does El Niño affect climate patterns?

Firstly, how does El Niño change weather patterns in the Pacific region and what impact does it have on global climates?

Sibal points out:

If weather models are accurate, it is expected that rainfall will increase in the United States, Argentina, and the Andes, while other regions such as Southeast Asia, Australia, Brazil, Colombia, Africa, Central America, and the Caribbean face the risk of drought.

Morgan Stanley emphasizes that the countries most affected by El Niño are in Latin America, with Peru, Chile, Ecuador, Costa Rica, and Panama being the most vulnerable. Additionally, in the Middle East, North Africa, and Africa, Kenya, Mozambique, and Egypt are also susceptible to its effects. Overall, agricultural stocks as a percentage of production are lower in Latin America and Africa compared to Asia.

Impact on energy and food supply

Secondly, the impact of El Niño on the economy is mainly reflected in energy and food supply, as the recent 2015 El Niño cycle caused global food price fluctuations and energy disruptions. According to a report by Dolphin Research, the El Niño phenomenon is most commonly associated with disruptions in food supply. The report states that crop production in Asia and Australia is at risk of drought, while most of Europe and large parts of North America are not significantly affected by this weather phenomenon. Meanwhile, South America and certain regions of the United States have above-average rainfall.

The following chart shows the regions most affected by crop production, with the current drought in Asia causing panic in the rice market. Sibal, an analyst at Dolphin Research, states that rice and palm oil production are concentrated in Asia, while a significant portion of global corn and soybean production comes from North and South America. During the El Niño period, there is a high risk of drought conditions in Asia, which means that rice supply in the region is facing downward risks. However, due to higher rainfall in the United States and certain regions of South America, soybean production in these areas may increase.

In addition to concerns about fluctuations in food prices, energy, especially green energy, is another worrisome aspect. The table below shows the countries most vulnerable to interruptions in hydroelectric power generation.

Dolphin Research points out that unusual weather patterns can affect water flow and power generation for countries that rely on hydroelectric power. Furthermore, the El Niño phenomenon can also disrupt wind and solar energy, leading to energy interruptions.

Finally, Dolphin Research analyzes the impact of El Niño from the perspectives of economic growth, trade, and inflation.

Based on an analysis of past El Niño cycles, Dolphin Research concludes that inflation is the main affected aspect, with economic growth being less affected than trade or inflation.

Regarding economic growth, Sibal points out that Australia, Ukraine, Thailand, Argentina, and Egypt are the most affected countries in terms of weather-related impacts. Additionally, during the previous El Niño cycle, the countries with the greatest economic fluctuations were Ukraine, Russia, Sri Lanka, Zambia, Egypt, Nigeria, Ethiopia, Argentina, Colombia, and Brazil.

As for the impact of climate risks on fiscal policy and credit, these are primarily concerns for poorer Latin American and African countries. Dolphin Research believes that Peru, Ecuador, Panama, Kenya, and Egypt will also be negatively affected, while Chile and Argentina have stronger disaster resilience. In addition, Sibal also warned of the risk of inflation getting out of control again:

"If subsidies for food or energy are not reduced during the period of price shocks and the fiscal deficit continues to expand, a second round of inflationary shocks may occur, causing more widespread imbalances in the economy."

According to the analysis report by Morgan Stanley, not only the Federal Reserve, but also the fate of global monetary policies may now be in the hands of the El Niño phenomenon. This climate phenomenon makes the fight against inflation even more difficult, and the Fed's interest rate hike cycle may last longer as a result.

Currently, the rising energy costs and the impact of the major strike in the automotive industry have put the Federal Reserve in a dilemma, according to Lindsey Piegza, Chief Economist at Stifel Financial Corp. She said:

"Energy costs are a major uncertainty that the Federal Reserve is currently facing. This could lead to a significant reversal in overall inflation and force the Fed to take more aggressive action than what investors are currently concerned about."