- Not only is the war in Ukraine the most significant military event in Europe since World War II, it also represents a potential turning point for the global economy.
- Given the inter-connected relationship between economies across the globe, there are emerging concerns centered around what the potential impact could be on the U.S. and world economies.
- Continuing high inflation, rising interest rates, and now the Russia-Ukraine conflict and resulting global economic impact are all variables to watch carefully as you consider how best to position your investments.
Russia’s invasion of Ukraine and the global ramifications that followed have dominated the headlines in the early months of 2022. The conflict began on February 24th and is seen by some as a key inflection point in the geopolitical landscape, marking a move out of the post-Cold War era that’s existed since the fall of the Berlin Wall and dissolution of the Soviet Union.
The war in Ukraine is the most significant military event in Europe since World War II, but also represents a potential turning point for the global economy. Significant economic sanctions were imposed on Russia, many western companies pulled operations out of Russia, and a potential supply disruption threatened the global energy markets. As the world witnesses tragic scenes of bombed-out buildings, decimated cities and fleeing civilians in each day’s news updates, the war is having far-reaching consequences beyond Ukraine’s borders. Capital markets, government policymakers, central bankers and corporate leaders have all been forced to adapt to a unique variable on a scale that has not been experienced in decades.
Following is some perspective on the war, what may lie ahead in the conflict, and its potential impact on the broader economy and the capital markets.
A difficult situation getting worse
Although destruction has occurred on a massive scale in parts of Ukraine, it is not indicative of Russian military success. “Russia is struggling harder and harder against the backdrop of a supreme leader [Russian president Vladimir Putin] who is bound and determined in his objective of taking military control over the entirety of Ukraine,” says David Bridges, senior geopolitical and security advisor at Fidelity Management and Research Company. Bridges, who had a 25-year career as an operations officer at the CIA, including significant time in the former Soviet Union and Eastern Europe, says Putin may be deceiving himself about the level of effort that will be required to potentially claim that victory.
As a result, it’s likely that the war will continue for an extended time period. “We’re in the early days of the conflict,” says Bridges. “This is not something that will be resolved by early summer. This is going to be with us for a while.” He notes that both the Russian and Ukrainian sides seem to be dug in and prepared to continue the battle despite the level of damage and number of casualties that have already occurred.
“I don’t believe Putin is looking for an ‘off ramp,’” says Bridges. “He’s convinced that he can prevail, and that all he needs to do is push harder.” Notably, Bridges says Putin is emboldened by a belief that he can “stare the west down. He believes he can find a chink in the alliance that he can de-couple European NATO (North Atlantic Treaty Organization) countries from the U.S.”
What could cause the war to spread
To this point, the nations of the NATO alliance have held firm in their support of Ukraine and defense of NATO nations, some of which border Ukraine (which is not part of NATO). In addition, western nations have implemented severe economic sanctions on Russia. A number of major corporations have closed operations in Russia as well. Economic measures represent one of the primary ways in which the West is trying to counter the Russian military offensive, at least to this point.
“We’ve seen a uniting of nations that may have had a cooler relationship before,” says Kevin MacMillan, head of state and federal government relations at U.S. Bank. “NATO leaders have moved forward with a united view of the conflict.” Cohesion among western nations carried through in the implementation of economic sanctions and similar measures that have been announced.
“We’re in the early days of the conflict. This is not something that will be resolved by early summer. This is going to be with us for a while.”
While NATO countries have been steadfast in their Ukrainian support, they have thus far shown a reluctance to become directly involved in a military engagement. Nevertheless, there are reasons to be concerned that the intensity of the war will escalate. Could the war spread beyond Ukraine’s borders, eventually drawing NATO countries (including the U.S.) into the battle? Bridges sees four possible routes to broader escalation:
- An attack in NATO territory. Poland, a neighbor of Ukraine and a NATO member, serves as an origination site for supplies coming from western nations to Ukraine. “Russia talks about attacking supply lines. If it did this, some of its strikes could occur in NATO territory,” says Bridges, which would likely trigger a NATO response.
- Offensive cyber tactics aimed at disrupting government and corporate technology systems in the West. “It is entirely reasonable to assume that the Russian counterpunch (utilizing cyber-attacks) aims to do financial damage to the West,” says Bridges.
- The use of tactical nuclear weapons, designed to cause significant damage to a limited area. NATO has been public in its concern about Russia’s use of nuclear arms. According to Bridges, “Putin will be increasingly inclined to use other capabilities in his arsenal as his conventional capabilities continue to fall short of the mark.” Similarly, President Joe Biden has indicated that if Russia uses chemical weapons in the war, the U.S. would respond. “The nature of the response would depend on the nature of the use,” said the president.1
- The flow of refugees overwhelms other countries in Europe. “We may see Russia attempt to drive civilians in increasing numbers to swamp these countries’ ability to handle the flow of refugees,” says Bridges.
Any of these scenarios could lead to an expansion of the conflict, raising concerns for everybody from world leaders to those directly involved in the fighting to consumers and investors.
Bridges considers the war to be the start of a new period of history. The Cold War began after World War II and ran until the fall of the Soviet Union in 1991. The post-Cold War period has been marked by mostly improved relations between the U.S. and its NATO allies and Russia. Bridges believes Russia’s invasion of Ukraine heralds a new era, or second Cold War, that will be distinctly different from the previous three decades. In the new environment, economic weapons, much like those being imposed on Russia today, may be the primary form of combat as opposed to a shooting war between the U.S. and Russia.2
Assessing the economic fallout
Given the inter-connected relationship between economies across the globe, emerging concerns center around the potential impact on the U.S. and world economies. Energy is a key part of the equation, given that Russia provides approximately 10% of the world’s oil output. The impact is far greater in Europe. For example, Russia supplies about one-third of European natural gas and about one-quarter of its crude oil imports.3
“The war has thrust some tenable European assumptions into the bright light of day,” says Bridges. “The chief one being the reliance on cheap Russian energy flows on one hand, and on the other, a deep reliance on security provided by the U.S. taxpayer to cover Europe’s own defense expenditure shortfalls.” A number of European nations are now committed to raising their defense spending levels given the threat now posed by Russia.
The U.S. is much less dependent on Russian oil and has curtailed its importation. However, given Russia’s prominent role as a global energy provider, energy prices quickly soared after the war began. The price of a barrel of oil rose from $92.24 on February 23 to as high as $124 within two weeks. The change is reflected at the gas pumps and contributes to the high inflation trend that’s been in place for over a year. The latest price jump came at a time when energy prices were already elevated.
Other commodity prices will also be a concern, as both Russia and Ukraine are major suppliers of wheat and other agricultural products to various parts of the world. Higher commodity prices could have an impact on inflation, the rate of economic growth and the performance of capital markets.
Investment considerations in a period of uncertainty
The conflict in Ukraine adds greater uncertainty to a market that, prior to the outbreak of hostilities, was focused on concerns about inflation and a major shift in monetary policy by the Federal Reserve. “We came into 2022 with a ‘glass half full’ point of view, but we’re taking a more balanced perspective today,” says Eric Freedman, chief investment officer at U.S. Bank. He notes that the Federal Reserve has indicated its willingness to aggressively raise interest rates in an effort to slow the pace of economic growth and ultimately, temper the inflation threat.
Freedman describes the investment environment in the early months of 2022 as “choppy” and says there are challenges that could emerge for risk assets such as stocks. “If the Fed continues to reverse multiple years of monetary policy by raising rates, but we lack clarity around fiscal policy (federal government spending) as we head into a slowing economy, it could be problematic for risk assets.” He also points out that markets are concerned about elevated energy prices, which could offset other steps being taken to solidify the economy and reduce inflation.
The continued trend of high inflation, rising interest rates, and the Russia-Ukraine conflict and resulting global economic impact are all variables to watch carefully as you consider how best to position investments. Be sure to talk to your financial professional about what steps may be most appropriate for your circumstances.
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