Market & Economic Outlook
Russia’s Invasion of Ukraine: Market and Economic Implications
The geopolitical Russian brown bear has awoken from hibernation with a misguided and tragic attempt to reassert Russian global influence in a post-USSR world, slow NATO expansion, and ultimately oppose democracy. The world’s holiday from Europe’s long, dark history of conflict has ended abruptly with the first invasion of a European sovereign nation since World War II. In addition to the tragic humanitarian toll, Russia’s invasion of Ukraine has shaken market complacency at a particularly vulnerable time and has likely put an end to the post-Cold War era. As such, while the situation remains fluid and is rapidly evolving, the conflict will have humanitarian, political, economic, and financial market implications to a varying degree.
The Why, How, and Where Things Head from Here
Since Russia’s annexation of Crimea in 2014, a full invasion of Ukraine has likely been in the works with Vladimir Putin waiting for what he believed was the right moment. The invasion has been one of both military force as well as cyber attacks. Speculated objectives for the invasion include the following:
Western countries, including the United States, have reacted to the military incursion by imposing severe economic sanctions on Russia, many of its companies, oligarchs, and political and military leaders. Economic sanctions have progressively escalated on a united front among many countries along with military supplies to assist the Ukrainian forces. Potentially the most severe sanctions thus far have been the targeted withdrawal of various Russian financial institutions from the SWIFT interbank network as well as restrictive measures on Russia’s central bank. These measures could severely cripple the Russian financial system. NATO military forces have yet to engage in the fighting in order to prevent a severe global escalation.
Should Russia overthrow the Ukrainian government, a pro-Russian puppet government is likely to be installed as opposed to a full occupation of Ukraine. If this occurs, economic sanctions will likely continue to escalate, essentially further isolating Russia from the rest of the Western world. While most market pundits believe this Russian intrusion will not move beyond Ukraine, there is a non-zero probability Russia invades other countries and in particular a NATO ally. Although unlikely, such an escalation would result in U.S. military action and have broad and far-reaching implications well beyond what is currently factored into financial markets.
Implications for Inflation, Economic Growth, and Financial Stability
Most acutely, the economic pain from the conflict will be felt from a supply disruption of critical natural resources. Russia is the third largest global oil producer, accounting for over 10 percent of global production, and one of the largest global producers of natural gas supplying over 40 percent of European natural gas needs. Combined, Russia and Ukraine account for 25 percent of global wheat exports and Russia is the world’s largest exporter of fertilizers and palladium. In addition, 90 percent of the neon used for lasers in U.S. semiconductor manufacturing comes from Ukraine. As a result, the conflict will likely drive prices for these and other resources higher for the foreseeable future, which will only add fuel to the global inflation fire started by the historic stimulus unleashed to fight the economic pain of the pandemic.
Within Europe, the significant reliance upon Russian oil and gas as well as Russian and Ukrainian agricultural products is expected to significantly squeeze consumer real purchasing power and weigh on confidence. Some economists estimate a 0.3 to 0.4 percent hit to European GDP growth. In turn this could result in stagflation in Europe.
Less directly reliant on Russian and Ukrainian exports, the economic growth drag in the U.S. is expected to be minor. In general, higher energy prices squeeze consumer real purchasing power and weigh on business and consumer confidence. Further, growth contagion from a more pronounced economic downturn in Europe as well as a wealth effect hit from a decline in financial assets could weigh on U.S. economic growth.
Over time, should the conflict remain unresolved, the substitution effect and demand destruction could ease inflation pressures, although this is often at the expense of economic growth.
The significant economic sanctions imposed by the West are likely to result in a severe recession for the Russian economy. The Russian Ruble, stock market, and sovereign debt prices have plummeted while Russian interest rates for local currency sovereign debt have skyrocketed to over 15 percent for 10-year bonds. More troubling for the Russian economy, the removal of various financial institutions from the SWIFT network and increasing global restrictions on the Russian central bank may cause a Russian bank run and could ultimately result in a collapse of their banking system. The large foreign reserves, declining reliance upon imports from western countries, and alliance with China may allow Russia to survive for a prolonged period under heavy global sanctions. However, the restrictions on conducting transactions with the Russian Central Bank are estimated to have frozen roughly 40 percent of their reserve balance.
Implications for Central Bank Policy Actions
Global central banks are likely to be more careful and cautious in tightening monetary policy with increased geopolitical risks, but hikes are still very much in play in much of the world. The rise in geopolitical tensions increases downside risks to the economic outlook, which will likely cause central banks to be less hawkish than they otherwise would have been. However, the Russia invasion of Ukraine risks sustained higher commodity prices which can impact both inflation and discretionary consumer spending. The global central bank response will likely be determined by which one of these factors dominate and by underlying domestic economic conditions. In the short term, central banks may need to inject overnight liquidity into foreign markets and institute foreign swap lines to prevent liquidity issues resulting from the SWIFT sanctions.
Implications for U.S. Interest Rates
In the short term, the conflict will likely result in higher near-term inflation expectations and lower real interest rates given a potential flight to quality into U.S. Treasuries as well as a potential delay in the removal of global monetary policy accommodation. The decline in real rates will likely exceed the increase in inflation expectations, thereby resulting in lower nominal U.S. Treasury interest rates.
Longer term, the conflict should not derail the move toward modestly higher U.S. Treasury interest rates and a flatter U.S. Treasury yield curve. However, the potential dampening effect on economic growth as a result of the conflict could inhibit or slow the move higher in long maturity U.S. Treasury interest rates.
Implications for Corporate Earnings
Although the effect on corporate earnings is very industry-dependent, should the conflict result in a significantly slower growth environment in the U.S., that could weigh on the earnings from most industries. In the near term we believe the following industries may benefit or suffer from the conflict:
Implications for the Equity and Credit Markets
The conflict has shaken up the complacency the markets have become used to over the past year. The resulting increase in inflation, economic and consumer headwinds, escalating geopolitical uncertainty, and potential for a financial market accident in Russia could weigh on equity prices and corporate bond credit spreads in the near term.
While there may not be an exact historic parallel for the events that are occurring today in Ukraine, history has shown a strong U.S. equity market resilience following major geopolitical events. Since 1940, the S&P 500 index has been higher 58 percent of the time three months following a major geopolitical event and higher 75 percent of the time twelve months following a major geopolitical event.
Potential Geopolitical Side Effects
The Russian invasion of Ukraine could influence other geopolitically sensitive situations and influence new secular forces, raising a host of questions, such as:
The holiday from Europe’s checkered history of conflict has ended with Vladimir Putin testing the resolve of the Western world in a hostile attempt to reestablish Russian global influence. To Putin’s detriment, he greatly underestimated the united global response against his tyranny. As a result, his actions will cause severe economic pain to the Russian economy while also exerting varying degrees of economic and market headwinds globally. Although history has shown a strong U.S. financial market resilience to major geopolitical events, U.S. military involvement with nuclear escalation is the extremely unlikely but uncharted downside scenario. With failure for Putin resulting in a potentially political deathblow, we can expect drastic measures to continue.
In general, the current geopolitical environment combined with the gradual removal of global central bank policy accommodation, elevated inflation, decelerating economic growth, and elevated valuations leaves us in a defensive posture. However, investors can still come out ahead in a defensive environment by focusing on asset allocation, robust industry and issuer selection, and portfolio diversity.
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