Russia/Ukraine: Transformational, not transitory

Global geopolitical backdrop

The Russia/Ukraine war is a geopolitical crisis of the highest order, one whose global implications will be felt for months and perhaps years. There’s simply no going back to the world that existed before the February 24 outbreak. Geopolitical risk and, in particular, a world increasingly shaped by “great-power” competition is the new normal, in my view.

Given the unpredictable nature of geopolitics, I think the set of possible outcomes is wide — from “frozen” conflict to a broader war with NATO, regime change in Moscow or Kyiv, and maybe even the use of weapons of mass destruction. As of this writing, my base case for the foreseeable future remains a frozen conflict and a still-sovereign, though effectively partitioned, Ukraine.

Assuming that proves correct, and if oil and gas prices stay relatively stable (admittedly a big “if”), I think markets can begin to look past the most dire worst-case scenarios. It may take several weeks or longer to reach that point, with multiple cease-fires and eventually an unstable peace agreement, but probably not before we’ve seen more civilian deaths and infrastructure damage, as both sides remain incentivized to achieve military gains ahead of any peace deal. I also expect additional NATO supplies and other Western aid to flow into Ukraine, further prolonging the conflict. And Western leaders will likely face continued pressure to ratchet up anti-Russia sanctions amid ongoing reports of civilian atrocities.

As a result, I believe the risk of spillover to NATO countries remains on the table, as do other potential surprises for markets to digest. So again, I think we should be prepared for a variety of possible paths from here; but in any case, make no mistake that we’re likely headed for a world of persistent geopolitical frictions between NATO countries and Russia for years to come (or as long as President Putin remains in power). It’s a potentially dangerous moment for global security and stability that could reverberate far beyond the borders of Ukraine.

On the upside, this new geopolitical environment may produce the longer-term benefits of a stronger, more unified, and maybe enlarged NATO, as well as a renewed commitment to defense spending in Europe (as we’ve seen with Germany) and elsewhere. War has a way of clarifying government priorities, so I believe a top priority for many countries will now be their national defense and security. Energy security will also be a new and enhanced strategic focus in Europe and globally.

Finally, however the crisis might unfold from here, I think Russia’s aggression is likely to sharpen the division of the world order into two large ideological camps, which may lead to greater policy focus globally on strategic sectors that are deemed central to great-power competition.

What it all means for Europe

In one line, I think Russia/Ukraine is a transformational crisis in two important senses, first in bringing out a sea change in how we should think about Europe in the medium to longer term, which markets don’t seem to have priced in yet. Secondly, from a more global perspective, I see this conflict as just the next big step in a broader process of deglobalisation that was already well underway prior to February 24. I think that’s going to mean structurally higher global inflation going forward, which, in turn, could fundamentally alter the roles of many of the world’s major central banks.

Here, I’ll focus primarily on what the crisis means for Europe. First, the resulting spike in energy prices has put a firm squeeze on European consumers’ real incomes, probably in the neighborhood of 2% (depending on the country and partially offset by government fiscal stimuli in some countries). In effect, if energy prices stay where they are today, Europe’s inflation might rise by 2% to a peak of around 7% — which would likely lower economic growth and real GDPs quite a bit. In fact, I think there’s a distinct risk of a technical recession across much of Europe later this year. It could even be a deep recession if the next stage is one of escalation through energy rationing (whether by the European Union or from Russia “shutting off the pipes”), potentially knocking 4% – 6% off of GDP. In a scenario like that, I doubt the European Central Bank (ECB) and Europe’s national central banks would be inclined to exit their easy monetary policies anytime soon. So it’s very easy to have a negative outlook on Europe right now.

On the other hand, if the base case is one where the war becomes a frozen conflict with no energy rationing (and that’s a key factor in all of this), then I think one of the big legacies of this crisis for Europe could be the onset of more activist fiscal policies (on top of what was already enacted to combat the COVID crisis in recent years) over one-, three-, five- and 10-year time horizons to address longer-term issues of defence spending and energy investment. Potentially coming at a time when Europe’s unemployment rate is at a historic low, increased levels of fiscal spending by governments would likely drive even higher inflation across the region, in stark contrast to the relatively tame inflation it’s experienced for most of the past 20 years. I don’t think European bond yields are anywhere near pricing in that kind of a seismic shift in the inflationary regime — not yet anyway.

The pivotal role of China

I believe the Russia/Ukraine conflict has brought us to a crucial moment in China’s relations with the developed world. Notably, I think the crisis is going to accelerate some of the big global trends that were already underway — more disruptions in the flow of global trade; the possibility of greater divergences between China and other nations; the potential for economic sanctions to expand beyond Russia; and higher likelihoods of negative geopolitical tail risk events and outcomes. The potential economic repercussions of increased divergence from China are significant given the sheer size of China’s economy and markets and how intertwined they’ve become with some other nations. For instance, China is currently the largest global provider of capital for countries that overborrow and overconsume — the US chief among them.

Speaking of the US, Washington’s relations with Beijing were already on a declining trajectory even before this crisis, and look unlikely to improve anytime soon. I think China would like to remain as neutral as possible, balancing its vital economic and national security interests in managing relations with both Russia and the US. However, from a geostrategic standpoint, trying to maintain neutrality is a difficult task. I suspect China would be inclined to maintain the status quo in its relations with Russia, a world power as well as a neighboring country. Also, China’s economic ties with Russia are deep, complex and important, meaning (among other things) that it could feel some secondary effects from the US sanctions against Russia.

Equally important is China’s relationship with the European Union (EU) and its individual member states, which (much like its relationship with the US) was already stressed prior to the Russia/Ukraine crisis due to some shifts in Europe’s political landscape, as well as many European countries’ greater emphasis in recent years on global human rights. Even some of the smaller EU states have had strained relations with China — Lithuania, for example, with which China has been in the midst of a heated trade dispute. So, the China-Europe dynamic will also bear close watching in the period ahead.

Inside commodities markets

The commodities markets have been in the crosshairs of the Russia/Ukraine crisis because both countries are major global exporters of critical commodities. Energy commodities (oil and gas) have been top of mind for many investors given these markets’ centrality to global inflation, growth, and monetary policies. But Russia and Ukraine also export significant amounts of other key commodities: nickel, steel, and other metals, along with agricultural staple commodities like wheat and corn.

I’d be hard pressed to find a historical precedent where a geopolitical event involving two commodity exporters of such size and breadth is impacting global markets to the same degree as Russia/Ukraine. For a little perspective, Russia is the world’s second-largest oil exporter. It contributes about a third of Europe’s total natural gas supplies. In aggregate, it’s the second-largest global exporter (behind the US) on a gross basis and the largest on a net basis. Ukraine is important in its own right, especially as an exporter of wheat and corn. (Much of Ukraine’s total global exports are concentrated in grains, whereas Russia’s are broader-based.) In fact, if you combine Ukraine’s exports of wheat and corn with Russia’s, they comprise about 25% of world exports of those two commodities.

And this tragic episode is occurring at a time when global commodity markets were already very tight. The structural supply-demand backdrop has rarely been more favorable for prices, with aggregate inventory levels across almost all commodity groups the lowest they’ve been since probably the 1980s. What typically happens when supplies are that tight and unresponsive is that commodity prices skyrocket, making us much more dependent on demand for commodities that people want or need having to be “destroyed” by the elevated prices. And the price levels that might trigger said demand destruction are often dramatically higher than what we’d call a “normal” price for any given commodity.

So, it’s no surprise that we’ve seen near-term volatility in the commodities markets since the conflict began earlier this year. Looking ahead, challenges may persist. On the supply side, Russia may struggle with its production, especially as it loses external financing, and could even opt to impose export bans on some commodities. Longer term, onshoring a country’s supply chains can be an expensive solution (i.e., inflationary) because it essentially means moving away from a very low-cost producer (for example, oil and metals production in Russia is among the cheapest in the world) toward reliance on much higher-cost domestic supply chains to produce those same commodities. And finally, there are still financial obstacles in the medium and long term to investing substantial capital in the energy transition. Time will tell.