The purpose of this blog is to highlight the possible impact of the war in Ukraine on the key points for an investment decision. In short, the conflict reinforces already existing trends. In addition, the global recovery scenario is still holding, but recession risks in Europe have increased.
The invasion of Ukraine and the market reaction to it underscores that, unlike in previous years, geopolitical events have now become a major factor influencing markets. See our 10 investment themes for this year. The change in the balance of power in a major European country by military means is another indication of the establishment of a multipolar world. The point is not just that there are more power centers, but that the systems are different.
The Western system, based on the rule of law and democracy, is no longer the dominant system. There are always military conflicts, but those with a lasting global significance have not existed for a long time. The relationship between Russia and the West is persistently troubled. Some speak of a new Cold War.
But the focus of geopolitical strategists has been on another for some time: the conflict between China, Taiwan and the United States. As a result, geopolitical risk premiums will be factored into investment decisions in the future.
De-globalization, Green Energy, ESG and Investment
There is also a growing trend toward de-globalization. The conflict between the US and China, among others, has already led to increased investment in the high-tech sector (chips) in each country’s own region. This affects the US, the EU, as well as China. The pandemic has pointed out that global supply chains are fragile, and security of supply of critical goods cannot be guaranteed in the event of a crisis.
The Ukraine crisis, in turn, reinforces the West’s economic disengagement with Russia and strongly underscores the issue of energy security. The motivation to develop alternative energy sources has arguably increased. This applies to both alternative supply routes and green energy production. As if climate change was not enough of a reason to invest heavily in green energy supply, now the issue of supply security is added to the mix. Furthermore, German Chancellor Scholz pointed out that defense spending will increase massively in Germany.
For Germany, this represents a 180-degree turnaround. All four themes (high tech, supply chains, energy, defense) have in common that private and government investment ratios are likely to increase in the trend. This implies higher economic growth and higher government budget deficits in the trend of the coming years compared to the baseline scenario.
Last but not least, the war in Ukraine underlines that the Environment, Social and Governance criteria are not only about combating climate change. The social and governance issues are equally relevant
Much is still in flux in the Ukraine crisis. What does President Putin want? The main thing seems to be to remove Ukraine from the West’s sphere of influence (prospects for joining the EU and NATO). In that case, a Russian-controlled government would be the ultimate goal. The question of whether Putin wants more, such as control over other Eastern European states, remains open. An escalation beyond the war in Ukraine represents an extreme risk. A more realistic risk lies in an unintended escalation, that is, a mistake.
The West has already responded with sanctions packages. For example, the EU has cited finance, energy (spare parts for production), transportation, export controls and visa policies. In a joint statement Saturday, the US, the U.K., Canada, France, Germany, Italy and the European Commission said they would prevent Russia’s central bank from using its international reserves to undermine broader sanctions.
This means that the Russian Central Bank cannot sell foreign currency reserves to buy rubles. It also means that income in euros and US dollars from the sale of commodities cannot be exchanged for rubles. The leaders also said they would exclude some Russian banks already affected by the sanctions from the Swift system, which would disconnect them from the international financial system and affect their ability to do business.
The Russian Central Bank responded with emergency measures: Raising key interest rates to 20% and capital controls. Restrictions on commodity exports have not been addressed. In the baseline scenario, Russia will continue to export raw materials and energy and will be able to be paid with the interbank financial telecommunications system SWIFT. However, revenues will remain frozen.
Four channels of impact
The extent of the sanctions will certainly have negative consequences for the economy in Russia, and there will also be collateral damage in the West. However, the greater negative consequences could come from four channels of impact that are not addressed by the sanctions. Previous crises show that the indirect effects are often greater than the direct effects:
1) Risk aversion could rise persistently. This affects consumers, companies as well as market participants.
2) If Russia is successful in its strategy, other authoritarian states might also be more inclined to enforce their own goals by means apart from negotiations.
3) If export restrictions in the energy sector are ultimately imposed on Russia, or if Russia reacts to the sanctions with counter-sanctions such as a restriction of energy supplies, a price shock in the commodity sector would increase the risk of stagflation.
4) The potential need for write-downs of Russian assets, possible payment defaults due to exclusion from the SWIFT system and interconnections in the financial sector could amplify the dampening effect on the economy in a risk scenario.
Global recovery scenario impaired, but still holding up
The direction of impact of the crisis on the economy is comparatively easy to estimate; the uncertainty lies in the extent to which:
1) Inflation rates will be higher compared to the original baseline scenario. This is because commodity prices (energy, metals, food) have continued to rise in recent days. The phase of high inflation rates will now last even longer. However, the expectation that inflation will fall in the medium term (next year) holds.
2) The resulting loss of purchasing power means lower economic growth than in the base scenario. However, the expectation for a continuation of the “recovery” phase of the economy on a global level holds as long as there is no commodity price shock. Private consumption in the service sector and hours worked are still well below the pre-pandemic trend. In Europe, however, the risks of recession have increased.
3) Central banks are being hampered in exiting the ultra-expansionary monetary policy stance. Central banks have already been confronted with the conflicting goals of fighting inflation vs. stability in the economic, financial and sovereign debt areas. Due to the surprisingly high inflation rates, there may be increased pass-through effects (companies may pass on costs) as well as rising inflation expectations. Central banks have so far responded with signals for earlier and faster key rate hikes. The Ukraine crisis has intensified this trade-off. Key rate hikes are still likely, but the risk for hikes to a restrictive interest rate level to cool the economy has decreased.
Global recovery scenario impaired, but it still holds
Long story short. First, as long as a recession can be avoided in the absence of a commodity price shock, the outlook for risk assets remains generally positive. Second, existing trends will be reinforced.
The themes, geopolitics, deglobalization and stagflation risk are putting pressure on valuations such as the price-earnings ratio because risk premiums are rising / have risen. At the same time, the topics of more green energy and higher investment rates have a supportive effect on long-term growth prospects.
Prognoses are no reliable indicator for future performance.