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I had recently posted that we were undergoing a “regime change” of sorts where market liquidity could be tighter, real interest rates higher, inflation higher and more persistent, and the rotation from growth assets to their value counterparts more enduring. Little did I (or probably anyone) know that today I would be writing about war and its likely economic and market fallouts!
First and foremost, I’d be very remiss if I didn’t acknowledge that we are witnessing an unfolding tragedy of epic proportions. The extent of the human suffering that will inevitably result from Russia’s unprovoked invasion of Ukraine (indeed, that already has) is deeply saddening, to say the least. And the global impact of the crisis does not end there — far from it, in fact.
The fluidity and frenetic pace of the newsflow are extremely important here and create an ever-changing, highly uncertain backdrop — from developments on the conflict itself, to further sanctions and financial restrictions being imposed on Russia by the West. Recognizing that these types of risks are very difficult to analyze, I want to highlight five things that I think investors should keep a close eye on over the coming weeks:
1. Geopolitics — Best-case scenario would be if there were immediate negotiations between President Zelensky and President Putin in Belarus, followed by a swift settlement and ceasefire. No one can get into Putin’s head of course (nor would I want to try), but unfortunately I think this is a low-probability outcome. After all, Putin’s overriding goal is to replace the Ukrainian government. The unnerving threat of nuclear weapons and the additional troops now assembled along Ukraine’s borders signal escalation more than de-escalation.
One big question here is: Where does China stand on what’s taking place to its west? The country is attempting to balance its key alliance with Russia with declaring its principle of national sovereignty. The US not only hopes it can “pry” China away from any allegiance to Russia, but also that the US response to the Russian invasion suggests to China the potentially dire consequences of attacking Taiwan. In any case, China’s current association with Russia is a negative for investors, in my view.
2. Sanctions — The West has been largely unified and galvanized by Russia’s blatant aggression, resulting in a bevy of severe economic and other sanctions against Russia, Putin personally, and the Russian oligarchs. Corporations and banks have been affected as well, limiting Russia’s access to global financial market infrastructure and preventing its central bank from accessing its foreign currency reserves. These retaliatory measures by the West are much harsher and more decisive than those elicited by Russia’s invasions of Georgia in 2008 and Crimea in 2014. They are intended to “break the back” of Putin and his coterie and to essentially neuter the Russian economy.
So far, the sanctions have excluded any steps to curtail oil and gas exports from Russia, as Western officials naturally want to hurt Russia’s economy without causing collateral damage to US and European consumers. Here are some of the numbers to bear in mind that may have global repercussions, which could be longer lasting than the conflict itself (Figure 1):
3. Inflation — We don’t know the extent to which global supply chains will be disrupted and some commodity shortages potentially exacerbated by the various sanctions (and by how Russia might respond to them). However, my sense is that they are unlikely to improve. Thus, I think we should assume a base case of higher inflation at least over the next few months.
January’s US Consumer Price Index (CPI) print was 7.5%,2 while the US Federal Reserve’s (Fed’s) preferred Personal Consumption Expenditures (PCE) Price Index registered 6.1% annually over the past year.3 While recent market consensus has been that inflation will likely head lower in the second half of 2022, our Global Macro Team estimates that the latest rises in oil and gas prices could add as much as 1.5 percentage points (ppts) to global inflation and subtract around .75 ppts from global growth.
4. Central banks — The heightened uncertainty will likely inject a healthy dose of caution into global central banks’ efforts to fight inflation in the months ahead. The 50-basis point (bp) rate hike that had been widely anticipated going into the Fed’s next meeting (in March) now appears unlikely, as does the expectation of further rate hikes coming out of every subsequent Fed meeting this year. The hawkish rhetoric we’ve been hearing from the European Central Bank (ECB) is also likely to be tamped down now.
The Fed, in particular, now faces a more complicated challenge than before: how to rein in inflation without tipping the US economy into recession. Striking that delicate balance may require the Fed to adopt a less hawkish policy stance, which could be a marginal positive for capital markets. On the other hand, the Fed has to make sure inflation expectations don’t become unanchored, which would force a more aggressive course of action.
5. Fiscal policy — To some degree, the conflict may be a catalyst for more fiscal stimulus in Europe, if not elsewhere as well. Higher oil and gas prices will be hitting Western consumers at an inopportune time for some of these fragile economies that are just beginning to heal from the pandemic-induced slowdown. In the US, the crisis may even give some renewed “oomph” to President Biden’s Build Back Better legislation.
1 Source: Eurostat, as of December 2020.
2 Source: US Bureau of Labor Statistics, January 2022.
3 Source: US Bureau of Economic Analysis, January 2022.