It is a well-known fact that geopolitical events have no lasting impact on financial markets. However, Russian president Vladimir Putin’s decision to wage war on Ukraine has forced institutional investors to reassess their strategies. While stock market indices tend to recover fairly soon after the initial shock of a geopolitical event, the conflict between Russia and Ukraine has potentially wide-ranging consequences beyond a sudden spike in volatility.
The outbreak of the conflict has raised uncertainty to levels not seen in decades, both in terms of security and over the likely trajectory of the global economy. There is a sense of urgency in the industry to make sense of the new geopolitical and economic scenario, as investors try to deal with the practical and moral implications of Russia’s invasion.
“We have entered a new era, having witnessed an event that in geopolitical terms is as seismic as the fall of the Berlin Wall or 9/11. In this new chapter, a new Cold War may well become the nature of the relations between Russia and the West. As a result of this state of heightened tensions, it seems sensible to think that a kind of geopolitical risk premium will be embedded in markets,” says Mark Dowding, chief investment officer at BlueBay Asset Management.
It may be difficult to quantify this geopolitical risk premium, but Dowding points to higher spreads and higher volatility, as measured by the VIX index, as potentially permanent features of this new regime.
Higher inflation takes its toll
The downsizing of Russia’s exports of energy, fertilisers and other commodities as a result of Western sanctions is widely recognised as a driver of long-term inflationary pressures. This has many powerful implications, particularly for the European economy.
John Llewellyn, partner and co-founder of Llewellyn Consulting, the independent macroeconomic advisory firm, points out that a ban on Russian oil and gas exports would add 1% to global headline inflation alone.
“Because Europe is a net energy importer and is chronically over-reliant on Russian oil and gas, because of higher prices its national income is bound to fall relative to its GDP, which means Europe gets harder hit than the United States, despite the two economies being of roughly the same size,” says Llewellyn.
Guillermo Felices, global investment strategist at PGIM Fixed Income, also highlights the changing outlook for global economic growth. “The consequences of the conflict are clearly inflationary, as can be seen by the reaction of the energy and commodity markets. But until the outbreak of the conflict, the prospects for growth were positive. Now we are in a very different environment, where growth could suffer, particularly in Europe and if the conflict persists.”
The channels through which a protracted conflict could affect economic growth are several, according to Felices. One is imports, which become more expensive as commodity prices rise. The second is consumers’ purchasing power, which is already under pressure. Third, sentiment effects could weigh not just on corporate investment, but also on financial conditions. “I think these drivers are pretty strong, and will definitely affect growth especially in Europe if the war continues,” he adds.
The complicated outlook of uncertainty, protracted inflationary pressure and potentially lower growth puts Western central banks in an extremely difficult position, according to Llewellyn.
He says: “Over the past decades, central banks always had the intrinsically impossible task of controlling both growth and inflation using only interest rates, but they managed anyway because the inflationary pressures were not that great.
“After the [COVID] pandemic, they hoped that the post-pandemic inflation surge would be transitory, which was perhaps a sensible assumption, and it looked like they would get away again with controlling inflation without killing the recovery. But now they are facing, at the same time, a huge and protracted rise in inflation, with workers demanding wage increases, and pressure on growth due to the conflict. They are between a rock and a hard place.”