First, Russia is likely to face long-term adverse diplomatic, trade, financial and economic consequences based on its actions. This was a choice that does not enjoy widespread domestic support in Russia. Many Russians and Ukrainians are literally kinsfolk, and this path took the population by surprise. The shock is particularly acute for the middle-class Russians with aspirations for their families—they now face the prospect of international isolation and diminishing opportunity. The notion of Brazil, Russia, India, and China (BRICS) as the secular drives of global economic growth and investment returns had already lost much of its cache. Now, irrespective of the outlooks for the other three, Russia will almost certainly be excluded from any such investment designation so long as its expansionist policies remain a threat to regional, European, and global stability. Russian government debt and significant corporate securities will likely be severely restricted for global investors, both on account of US and European sanctions, but also because fiduciary considerations (governance) will not permit a return to the status quo. For investors, the lesson is clear—do not underestimate the likelihood of policy direction diverging from economic logic.
Second, a significant re-think of global security will need to be contemplated, particularly energy security. Russia is the third largest producer of oil in the world, the largest provider of natural gas to western Europe, and a leading supplier of other commodities. Ukraine is also one of the world’s three “bread baskets,” a major grains producer alongside North and South America. Nations that have relied on energy, food and other raw materials from Russia and Ukraine will now begin to diversify their suppliers. For example, the European continent relies on Russia for approximately 40% of its current natural gas requirements. Liquified natural gas is likely to be a significant alternative, and countries like the United States and Qatar would help fill the gap of reduced reliance on Russian supply. This shift looks to have already begun, as natural gas flows from Russia to Europe declined by 30% in first half of 2021 and 40% in the second half of 2021 relative to the same periods in 2020. Of course, the near term also matters for investors. Investors dislike uncertainty and until such time as warfare is replaced by diplomacy, markets will remain vulnerable to bouts of volatility.
Two factors will dominate the cyclical impacts on asset prices stemming from the conflict: its implications for inflation and growth. Those outcomes will, in turn, determine the response of central banks and the direction of interest rates.
In the near term, rising energy, food, and other commodity prices will push up headline inflation rates. Core measures of inflation—which exclude more volatile food and energy prices and are preferred measures for the Federal Reserve (Fed)— will likely follow higher. The pandemic, global supply chain disruptions, fiscal and monetary policy, and surging demand in 2021 have already unleashed strong gains in wages and prices, which make passing along higher energy and commodity prices more likely.
Recent comments by Fed officials indicate that they remain undeterred in their assessment that monetary policy needs to be tightened to slow inflation and prevent a persistent overshoot. It would likely take a significant adverse shock, such as a much larger decline in world equity markets and a corresponding reduction in investment and consumer spending, for the Fed to change its current assessment of monetary policy.
The challenge for the European Central Bank (ECB) is potentially much greater. Europe, as noted above, is reliant on Russian energy and to any disruption that might unfold due to conflict or sanctions. Accordingly, the ECB is not in the same position as the Fed. It must be more concerned about potential adverse demand shocks owing to uncertainty, as well as a potential adverse supply shock should energy supplies be disrupted. While the Fed, for now, can remain focused on inflation-fighting, the ECB almost certainly will proceed with greater caution.
Still, both central banks have their eyes focused on one common variable—inflation expectations. Market-based and consumer survey-based measures continue to expect inflation to average between 2.1% and 3.1% over the next five years. While this is still higher than the 30-year average for the actual Consumer Price Index of roughly 2%, it is much lower than the most report of 7.5%.4 If the conflict and sanctions produce not only higher commodity prices but a shift upward in inflation expectations, both central banks (and others) will be forced to hike rates faster at the potential cost of sharply lower growth or even recession.
Which brings us to the near-term investment implications. History is kind to the idea that conflict-induced selloffs are buying opportunities. We are not so sure. Even if a ceasefire and peace can replace war in Ukraine, a recovery in equities may not be sustained as above-average valuations, slowing earnings, and the triple specters of inflation, monetary policy tightening, and geopolitical uncertainty remain. Historical comparisons that suggest that the advent of conflict results in a buying opportunity are not always to be relied upon as the underlying conditions may be different. Those earlier episodes were not presented with today’s unique fundamental challenges
Markets, in short, may enjoy a temporary respite on the hoped-for end of hostilities, but relief is unlikely to be long-lasting. Returns are fundamentally falling for other reasons, and volatility is apt to be more elevated. Rising interest rates and slowing earnings growth all but ensure that outcome, irrespective of what happens to geopolitical risk.
The medium-term implications for investors remain much as we’ve highlighted them before. As returns decline and volatility increases, diversification becomes paramount in our view. New opportunities also emerge. Over time, for example, higher interest rates might offer investors opportunities to re-engage certain fixed income markets for income as well as safety.
Finally, Russia’s invasion of Ukraine does not signal the end of global investing. Russia was never a major driver of globalization, whether in trade or finance. Asia and other emerging markets were always more important and remain viable long-term options. The strategic and climate-change drivers for massive investment if energy supply and distribution may have become even more important, for Europe, Asia, and many other parts of the world. The “R” in BRIC may be moving from upper to lower case, but the world and its capital markets will continue to offer investment opportunities.
Asset Class Implications
- Western sanctions are escalated and geopolitical uncertainty increases.
- Macro Implications: Lower demand as energy prices increase, and higher inflation expectations. Both pose challenges for policymakers as interest rate tightening cycles appear imminent.
- Multi-Asset Implications: Geopolitical outcomes have varied over history. The risk is that we move into a higher inflation/lower growth environment, which can be challenging for risk assets
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