About the authors: Larry Hatheway and Alex Friedman are the co-founders of Jackson Hole Economics and the former chief economist and chief investment officer, respectively, of UBS.
It is never easy to discuss economic or financial issues in the context of war, death, human misery and destruction. Yet even in our horror, we are powerless to suspend reality. Human resilience relies on our ability to adapt and endure, even in the most mundane ways.
Nor can we pass moral judgment on the markets, whether in financial instruments or ordinary goods and services. Markets are not animated, even though they express human needs, desires and emotions. Markets are amoral. This is true even when they react to immoral brutality.
So what should investors consider as the potential short- and long-term implications of Russia’s invasion of Ukraine?
Let’s look at some of the more lasting implications first.
By launching an unprovoked attack on a sovereign European country and democracy, Russia is likely to face long-term diplomatic, commercial, financial and economic consequences. As long as Russia is ruled by Vladimir Putin or individuals with similar motives to his, it will be ostracized and cut off from the ability to engage in global markets for many goods and services, including most instruments of investment.
The notion of the BRICs – Brazil, Russia, India and China – as the age-old engines of global economic growth and returns on investment has long lost much of its cachet. Now, regardless of the outlook for the other three, Russia will be left out of any such investment thesis. Russian government debt and significant chunks of its corporate debt and equity securities have become off-limits to global investors. This is partly because of US and European sanctions, but also because fiduciary (“governance”) considerations will not allow many institutional and private investors to consider Russian securities as eligible financial assets. This fact will only change when Putin and his supporters are no longer in power.
The Russian invasion of Ukraine will also lead to a major rethinking of global security, including energy security. Russia is the world’s third-largest oil producer, Western Europe’s largest supplier of natural gas and one of the world’s leading suppliers of other raw materials. Ukraine is also one of the world’s three major breadbaskets, a major grain producer alongside North and South America. Assuming there is no quick resolution to the conflict, including a complete withdrawal of Russian forces, buyers of energy and other natural resources from Russia and Ukraine will have to diversify their suppliers.
The clearest example is in Western Europe, where energy policy is likely to move towards liquefied natural gas delivered from North America, the Middle East and Africa to reduce reliance on Russian pipeline supply. Debates will develop on the need to rethink nuclear fission energy and, ultimately, to explore the prospects of fusion. Wind, solar and energy conservation will also see renewed interest.
Investors, of course, also want short-term clarity and hate uncertainty. Until war is replaced by diplomacy, markets will remain vulnerable to bouts of volatility. At the end of last week, the markets rallied strongly, mainly on the belief that the sanctions will not have a negative impact on global economic activity.
That remains to be seen. Complacency is not justified.
It is an understatement to note that the situation is very dynamic. In the past 24 hours, a series of Western companies, including airlines, oil producers, technology companies and liquor distributors, have stopped doing business with Russia. If the conflict escalates, this laudable trend will surely accelerate, ultimately reducing a wide range of corporate profits.
With the withdrawal of Swift access and the ability of the Russian Central Bank to back its mined currency, a series of difficult outcomes will ensue. The Russian economy will be hampered, the ruble will plummet as the exchange rate soars, and there could be a run on Russian banks.
Investors’ baseline assumption should be that Russian energy exports will be disrupted, driving up prices for consumers and businesses around the world. Moreover, if an act of war were to disrupt the flow of natural gas through Ukraine to Western Europe, price spikes would be compounded by distribution disruptions that could even lead to a European recession, with serious consequences for US exporters.
The conflict-related spike in world oil prices is akin to a negative global shock to aggregate supply. It simultaneously increases inflation and harms growth.
This poses fundamental challenges for central banks.
Soaring energy prices will compound already steep price increases in food, transportation, commodity and industrial goods markets, where energy is an essential input. It seems likely that other prices, those captured in the core measures of inflation, will also follow higher. After all, the pandemic, global supply chain disruptions and accelerating demand have already triggered large increases in many wages and prices, making it easier to pass through higher energy prices and raw materials.
Yet those same price increases are likely to outpace wage gains. Now that U.S. consumers have brought their savings back to pre-pandemic levels, the risk is growing that falling purchasing power will slow consumption. This concern is greatest in Western Europe, where households and businesses also face the greatest security threat since World War II.
So, will central banks choose to fight inflation more vigorously or will they instead focus on potential challenges to global growth?
Recent comments from Fed officials indicate that an overwhelming majority of Federal Open Market Committee members are undeterred in their assessment that monetary policy needs to be tightened to curb inflation. Apparently, it will take a large negative shock – for example, a much larger drop in global stock markets and a corresponding reduction in investment and consumer spending – for the Federal Reserve to change course.
The calculation for the European Central Bank is more problematic. Unlike the energy self-sufficient United States, Europe depends on Russian natural gas. The ECB therefore needs to be more alert to potential weakness in consumer and business spending given the uncertainty. It must also be ready to react to a massive supply shock in the event of a disruption in Russian energy supplies.
The bottom line is that while the Fed is freer to focus on fighting inflation, the ECB needs to proceed with greater caution.
However, the two central banks share a common view of inflation expectations. If already high inflation, now compounded by soaring oil prices, results in a jump in long-term inflation expectations, the Fed and ECB will tighten aggressively. Fortunately, this is not the case now. Market metrics and surveys indicate that businesses, investors and households continue to expect inflation to decline over time. But watch this space carefully – few data points deserve more attention than inflation expectations.
All of which brings us to the investment implications of current events. History supports the idea that conflict-induced sell-offs are buying opportunities. In the terribly unfortunate parlance of Warren Buffett, investors should be ready to buy when there is blood in the streets.
But we strongly caution against making decisions based on concise statements. Even if, as we desperately hope, a ceasefire and peace can replace war in Ukraine, rallies in global stock markets are likely to be brief and muted. Here’s why.
First, market declines this year have been modest. A general correction, defined as a 10% decline in major equity indices, has yet to occur.
Second, equity valuations remain above long-term averages despite clear signs of slowing earnings growth, high inflation and greater willingness from various central banks to tighten monetary policy. Historical comparisons are therefore naïve. Few of these oft-cited episodes of conflict resemble today’s multi-faceted investment challenges. Markets could rebound if the war in Ukraine ends, but the rebound may not be impressive.
It is much more likely that risk-adjusted returns have peaked. Gains will be more modest and volatility higher. This outcome is likely regardless of how events in Ukraine unfold.
Finally, it should be emphasized that Russia’s invasion of Ukraine does not mean the end of global investment or emerging markets. Russia has never been a major driver of globalization, whether in trade or finance. Its place in the BRIC acronym has always been more for convenience (the BRICs seem stronger than the BICs). It was never fundamentally grounded. Asian economies and other dynamic emerging economies have historically been more important drivers of long-term global economic growth and investment returns. For most wallets, Russia’s demise will hardly be felt.
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