Russia’s invasion of Ukraine has only intensified the policy dilemma facing major central banks given the additional inflationary pressures it creates and the potential risks to growth.
We have now witnessed the sad realisation of what NATO warned would happen: a full-scale invasion of Ukraine. Previously, markets had been talking themselves into the view that any incursion would be limited to the breakaway regions of Ukraine. Now they have to wrestle with the prospect that it will be much broader and more drawn out.
There are several questions that still need to be answered to determine the potential financial and market fallout. They include how far Ukraine will fight back, the level and extent of any sanctions imposed on Russia by NATO allies and how far the sanctions will feed into the energy channel, given that Europe is a major buyer of Russian gas.
Answers to these questions will emerge over the coming days, but what is already clear is that an environment of stagflation is increasingly likely to be maintained rather than to ease off over the coming months. Higher energy prices are likely to feed into other areas of the economy acting as a type of consumption tax, exacerbating the cost-of-living crisis already underway in the West, and potentially bringing recession nearer.
Market impact
The immediate impact on markets is the curtailing and, in some cases, effective halting of some Russian and Ukrainian securities trading by foreign investors. In due course, sanctions may move to the point of prohibiting Western capital movement in and out of Russia entirely, perhaps by excluding the country from the global international payments system SWIFT. This could have problematic consequences, however, as Russia would simply seek to transact using alternative systems.
At present, a SWIFT ban could be stored up as a potential major step, but because of the nature of the Europe/Russia energy relationship, we expect sanctions will typically be imposed on capital rather than commodities. Russia is a major producer of aluminium and fertiliser as well as oil and gas, and it will take time for supply chains to be reconfigured to other countries and sources, and in some cases the supply gap cannot be filled.
However, if the conflict is not contained to Ukraine, there could be tit-for-tat sanctions that could have a longer-term impact on both local and international markets. A united front on sanctions will be crucial. Putin will be closely monitoring whether NATO remains aligned in its response to the situation and will seek to exploit any fractures.
Central bank response
Central bank rhetoric has been deliberately hawkish since last year to get markets to tighten real financial conditions without the need for abruptly raising rates. We have consistently believed the Fed, for example, would have to tighten more slowly than indicated due to the high debt levels built up to cope with the impact of the pandemic. The Ukraine crisis only makes this more likely because although it has pushed energy prices even higher, it also presents risks to growth, particularly for Europe.
Central banks may find it hard to switch narratives aggressively if growth starts to weaken, and they won’t return to easing mode, so instead we expect them to continue trying to tighten policy, but at a snail’s pace in the hope of avoiding recession. Fiscal policy, meanwhile, is not in a favourable position to help due to the cost of the pandemic and to the domestic political challenges faced by many developed countries this year.
Allocation implications
While the conflict presents a range of threats to securities both within Russia and Ukraine and more broadly across the European continent, if it does remain contained then we could see other forces return to dominate sentiment in due course.
Going into 2022, we were already more cautious on risk assets, in particular in the US, where we expect a more complicated economic and political picture in the run up to the mid-terms. Instead we have looked towards areas of the world such as Japan (given its inflation position) and China (given its different policy pathway). We expect China to be patient and step back, watching closely to see how the Russia/Ukraine situation plays out.
Having tightened earlier in the cycle, the country is not caught in the prevailing policy dynamics of the West, and instead is moving towards stabilisation, and then perhaps stimulation, of the economy, which should be a tailwind for markets there. It could therefore provide greater diversification for investors concerned about events in Europe, particularly when the knee-jerk bid for the US dollar eases.
In this context, we expect capital to move towards China and Asia and other emerging economies that are less affected by the crisis and may prove to be beneficiaries if supply chains are redirected. Longer-term, we expect more countries to act to improve their resilience to future energy shocks, though the transition towards a lower-carbon energy mix will not be a smooth one and will differ country by country.
Conclusion
Markets have reacted sharply to the full-scale invasion of Ukraine but in the coming days we should have a better understanding of Russia’s territorial ambitions, the measures taken to impede them and the kind of risks to inflation and growth these present. Putin’s rhetoric may be primarily for a domestic and Ukrainian audience, but it needs to be watched carefully to see if this conflict and its fallout - human and economic - will be contained to Ukraine or whether other barriers will be tested.
