Russian invasion of Ukraine: Looking through the newsflow

Gillian Edgeworth - Macro Strategist

Putin has signalled that he wishes to replace the current Ukrainian government with a pro-Russian administration. This implies ongoing military conflict until the Ukrainian government steps down and much of Eastern Ukraine is secured. Even if Russia succeeds in this, we would expect persistent pockets of resistance. 

What does the escalation of sanctions look like from here? Below is a rough guide. My conviction in the first set of steps is high. Beyond that, the potential costs to the West increase, but I believe these countries’ willingness to absorb these costs is much higher than in the past.

1. Immediate next steps: 

At the time of writing, the UK and the US have already announced additional sanctions, with the EU and others to follow shortly. The US sanctions involve the following: 

• Four major banks added to the Specially Designated Nationals (SDN) list prohibiting all transactions;
• Thirteen entities with new sanctions imposed on primary and secondary trading of new issues;
• A ban on technological exports to Russia by the US, the EU, and some countries in Asia; and
• Sanctions on more Putin allies and family members.

Our legal team is working through the details of these items as we speak.

2. If Russia takes Kyiv and other cities east of the Dnieper:

• State-owned enterprises (SOEs) in the real economy outside the energy sector added to sectoral/specially designated nationals (SDN) sanctions list; and 
• Initial sanctions on energy and oil exports problematic but possible.

3. If Ukrainian resistance continues as a Russia-friendly government is installed: 

• Further sanctions limiting energy and oil exports; and
• Addition of Russian Ministry of Finance/Central Bank of Russia to sanctions list. (Though possible, this would be among the last measures likely to be taken, as it would further increase the probability that Russia doesn’t service its US$462 billion of external debt outstanding.) 

John Butler - Macro Strategist

How will central banks react?

There is no urgency for the European Central Bank (ECB) to clarify its position on rates as no one expects an imminent rate hike. But I think this will make the ECB even more uncomfortable at this stage with open-ended quantitative easing (QE). I therefore expect it to shift to some form of rolling assessment of QE that enables it to react when it has more clarity, with June as the likely re-assessment date. However, this is a fluid situation.

The impact could be greater for those central banks expected to hike imminently. Notably, the Bank of England has a difficult balance to strike, with inflation already high and about to lurch even higher. While I still expect further rate increases, the pace could be more cautious than the market currently assumes. 

The bigger picture

The relationship between central banks and growth has changed. During the past 15 years, any negative shock to growth or spike in uncertainty has been a reason to add more liquidity, as the central banks saw little risk of inflation. This time, inflation is higher at the outset, so there is a debate about whether this shock will be inflationary or deflationary over the medium term. If inflation expectations get dislodged, central banks will have to keep hiking into weaker growth. On balance, however, I think central banks fear recession more than inflation. So, while they remain in tightening mode for now, they are unlikely to tighten as aggressively as expected before this shock, even with higher inflation. 

The key point is that risk assets no longer enjoy the same level of “insurance” from central banks as in recent decades. Instead, central banks may become a source or even a compounder of volatility.

Implications for the EU and the euro area

For most of my career since 1999, I have taken a structurally negative view of the euro area because of its unwillingness to resolve the flaws within the currency union. Every time growth slowed, these flaws risked being exposed. And the only outcome was more and more QE from the ECB. The risk is that this invasion of Ukraine puts the spotlight back onto the outstanding fragilities within the system: from the lack of security (the EU’s dependence on the US) to the weakness of its border controls (migration flows) and its dependence on external energy (in particular, Russian gas).

There must now be a high chance of a wave of refugees from the Ukraine to Poland, Romania, Hungary and possibly euro-area countries. We know the strains this put on European countries in the recent past and how fragmented their response was. This could have negative implications for the region’s politics. For example, immigration could suddenly become a big issue heading into the French election this April.

One possible silver lining to this cloud is that I think there is a higher chance now that this emergency is used to unify the region and define why it exists. The medium-term scenario is that the conflict becomes another reason to accelerate fiscal spending on renewable forms of energy, to remove the euro area’s dependence on Russia. But it could also spark more fiscal spending on everything from rearmament to income subsidies to offset higher energy costs. 

Over the past year, my views have changed to become the most bullish I have ever been on the structural outlook for the single currency, motivated by the shift in German politics. My sense is that the German attitude has changed to allow Germany itself to inflate and to be open to explicit burden sharing across the region. That significantly increases the probability that the region is heading towards a sustainable currency union (and one that is no longer unable to create inflation).

So I think this shock potentially changes things. The past 10 years have been characterised by institutional paralysis within the euro area, with fiscal austerity offset by huge liquidity from the ECB. This meant negative rates, low yields and tight spreads. But this event could force clarity on which tail wins — unification or fragmentation. Unity would mean more fiscal spending, an ability to create inflation and more burden sharing across the region. The implications would not be clear for spreads, but yields would be higher.  For now, we may have to work through a period of volatility and put the spotlight back on the fragilities within the euro area before these medium-term implications play out.

Cold versus hot war?

While the risks of conflict between Russia and NATO have increased, for now a new form of cold war appears more likely. From a macroeconomic perspective, I think such a new cold war would accelerate deglobalisation, which is one of our core themes, as countries will value self-dependence in their supply chains and energy sources. 

I think that will mean big investment, financed through fiscal expansion. One of our themes is that inflation will be determined more domestically than globally. I expect current events to accelerate that shift back to domestic rather than global output gaps. It would also mean that country relative stories will become more important again as central banks are likely to keep their inflation targets but allow greater deviations. The cycle could become more volatile and institutions less secure, which would have to be reflected in higher risk premia in markets.

Nick Samouilhan, CFA - Multi-Asset Strategist
Adam Berger, CFA - Multi-Asset Strategist

First, these actions uproot many of the standing assumptions about the global security, political and economic order and will of course lead to strategic changes — this is a watershed event.

• Greater cohesion in Western policy, enhancements to security arrangements (especially within NATO) and energy supply reform in Europe are just some of the dynamics we expect to be caused or accelerated by this geopolitical shock.
• Second, as these changes will take time to play out, we believe it is important to focus on what is going to matter more in the shorter term.
• Third, provided the conflict does not escalate, the framework within which to examine its impact from an allocation perspective is to answer the key question of whether real growth declines as a result (making rate hikes less likely) or remains durable (in which case rate normalisation will continue).

The immediate market implications are complicated and hard to predict given that the incursion is ongoing and it’s not clear what the ultimate objective is or what the outcome will be. But, while events in recent days have escalated much further than expected, this crisis has been brewing for some time (and certainly has been the focus of the market in the last fortnight), so some of this will already be priced in. We focus on three aspects:

• First, the progression of the hostilities. Sadly, markets have in the past quickly become desensitised to localised conflicts, especially if they are contained and end quickly. However, further escalation or a protracted conflict that makes the outcome unknown will weigh on markets, at least temporarily.
• Second, like many geopolitical events, there is an impact on energy  markets and hence on inflation-sensitive assets. It’s not clear whether this will be sustained, as it remains uncertain whether either side will want to restrict the flow of Russian energy to Europe.
• Third, the response from the West  in the short term will likely remain centred on personal and corporate sanctions, so the implications for specific companies in portfolios will need to be examined.

Looking beyond the very near term, the key driver for markets will be the impact on the outlook for global growth, inflation and interest rates — all of which are related and were the main focus of markets before recent events. Before the conflict, markets were pricing in a series of rate hikes on the back of strong economic growth and elevated inflation, with markets hoping for a normalisation of rates that would lead to a moderation in inflation without causing a recession. While that soft landing was the hope, the risk of a policy mistake was real. This conflict complicates the outlook and increases that risk. Higher energy prices, along with higher prices for a range of other important commodity exports that will now come under sanction or restriction, will worsen the inflation outlook, particularly if these are used as weapons of war. At the same time, these higher energy prices will join elevated inflationary pressures to create downside risks to economic growth due to lower real consumption. So we are potentially facing a challenging time of higher inflation and lower growth, which in turn makes the rate outlook difficult. There are also second-order effects, adding further uncertainty to the economic outlook. For example, we could see a growing likelihood of further fiscal spending in the US and Europe, especially if focused around energy independence and transition.

Within these parameters, we (for now) think a moderately pro-risk portfolio stance may be warranted, overweighting equities and underweighting duration. Given our time frame of 12 – 18 months and based on what we currently know, that stance seems appropriate even in light of recent events. However, if the outlook for growth were to change, we would need to revisit it. That said, unless the escalating conflict in Ukraine triggers a return to a stagflationary regime similar to the 1970s — which is not our base-case scenario — equity markets may now already have factored in the risks of central banks failing to prevent a shorter-term recession. If that scenario is correct, there is a case to be made for long-term investors to maintain their equity positions and even cautiously start leaning into the headwind. But the time frame matters greatly. We cannot exclude further and more pronounced sell-offs in the near term as the conflict sadly continues to escalate. Areas we think warrant particularly close scrutiny include:

• Energy prices — Energy could potentially be used as a weapon of war. Such a scenario would favour a tilt to commodities as an inflation hedge and a modest reduction in equities given the duration impact. Overall, we think it would still be important to maintain a modest duration underweight.
• Sanctions — Could their impact be significant enough to slow growth or create a recession? If so, central banks may have to step in, and governments may have to provide fiscal support. However, absent that stabiliser or if it comes late, we could see a hard landing and further steep declines in equity markets. The European banking sector remains at the epicentre of these developments and will be a good indicator of the future direction.
• Central banks — Watch the commentary and actions. Will these events slow the tightening pace of monetary policies? If so, will that heighten the intermediate (roughly three-year) risks of rising inflation? As with sanctions, this implies further downside to equities if central banks struggle to balance everything. Conversely, there is potentially an upside if they handle the situation well.