- The war in Ukraine, the most significant military event in Europe since World War II, continues to impact the global economy.
- The fallout is particularly evident in the energy and agricultural commodities markets.
- While it’s not a dominant consideration for the investment markets, the conflict remains a risk that bears watching.
Russia’s invasion of Ukraine and its subsequent global ramifications have been in the headlines since the war began on February 24th.
The war 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 in 1989 and the dissolution of the Soviet Union that followed. The economic fallout from the war has also likely been a contributing factor to 2022’s volatile investment environment.
The Ukraine-Russia conflict represents the most significant military event in Europe since World War II, but also raises a number of economic considerations. The U.S. and other countries imposed substantial economic sanctions on Russia, many western companies pulled operations out of Russia, and potential supply disruptions created threats to the global energy and agricultural markets.
As the war drags on with countless lives lost and significant destruction in its wake, the impact is being felt beyond the borders of Ukraine. Capital markets, government policymakers, central bankers and corporate leaders have all been forced to adapt to a unique variable on a scale not experienced in decades.
A difficult situation getting worse
Despite Russia’s broader military advantages, the two countries appear to be mired in what could be a long, drawn-out struggle. In September, Ukraine reclaimed significant territory, leading Russian President Vladimir Putin to take more drastic steps. This included annexing four eastern regions of Ukraine into Russian territory and drafting several hundred thousand Russian men into military service. Russia also stepped-up missile attacks across many parts of Ukraine.
“Inflation and the Fed’s response to it are still the primary considerations for investors. The Russia-Ukraine conflict is more of a ‘tail-risk’ event.”
- Tom Hainlin, national investment strategies for U.S. Bank
“Russia is struggling harder and harder against the backdrop of a supreme leader [Putin] who is bound and determined in his objective of taking military control over 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 have deceived himself about the level of effort that was required to potentially claim that victory.
“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 are holding firm in their support of Ukraine and defense of NATO nations, some of which border Ukraine (which is not part of NATO). NATO appears to be on the verge of adding two countries to its alliance that are in close proximity to Russia – Sweden and Finland. The U.S. and other NATO partners have delivered significant military equipment to Ukraine to aid in their fight against Russian troops. In addition, western nations continue to apply severe economic sanctions on Russia. A number of major corporations have closed or sold off operations in Russia as well.
“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 moved forward with a united view of the conflict.” Cohesion among western nations carried through in the implementation of economic sanctions and related measures implemented to date. A bigger question is how long the commitment of support for Ukraine will last.
While NATO countries have generally remained steadfast in their support, they have avoided sending troops to participate in the military engagement. The U.S. and other NATO countries have, to this point, limited their military involvement to providing significant weapons capabilities.
A lingering question since the start of the conflict is if the war could spread beyond Ukraine’s borders, eventually drawing NATO countries (including the U.S.) into the battle. Recent threatening statements by Russian President Putin further raised alarm. Bridges is particularly concerned about the potential use of tactical nuclear weapons, designed to cause significant damage to a limited area.
NATO has been public in its apprehension 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.” Putin recently said, “If the territorial integrity of our country is threatened, we will without doubt use all available means to protect Russia and our people – this is not a bluff.”1 It is not clear if attacks on the Ukrainian lands recently annexed by Russia fall under Putin’s definition of “territorial integrity,” but it does appear to increase the risk.
While the war, to this point, has been contained to Ukraine and its border area with Russia, the situation bears close watching. In the meantime, fighting continues with both sides suffering significant losses. There does not appear to be a ready path to ending the conflict.
Bridges believes Russia’s invasion of Ukraine heralds a new era, or second Cold War, that will differ distinctly from the previous three decades. In the new environment, economic weapons, much like those being imposed on Russia today, may be a primary form of combat, as both sides seek to avoid actual combat between the U.S. and Russia.2
Assessing the economic fallout
Given the inter-connected relationship between economies across the globe, emerging trepidation centers 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 “European nations reliant on Russia have tried filling up their reserves as quickly as possible to get ready for winter,” says Tom Hainlin, national investment strategist for U.S. Bank. “A key factor in how well their economies hold up is how cold winter will be in Europe, and whether it will stress the demand side for natural gas.”
Oil prices soared in the months immediately following the start of the war, but prices leveled off mid-year and then moderated. Prices rose again after the cartel of oil producing nations known as OPEC+ (which includes Russia and Saudi Arabia) announced a production cut, designed to limit supply and push oil prices higher. It seems likely that oil prices will remain subject to volatility in the near term.
Both Russia and Ukraine are major suppliers of wheat and other agricultural products to various parts of the world. This contributed to a rise in commodity prices that was felt worldwide, along with potential food shortages in parts of the world. By mid-summer, prices had dropped from their peaks. Concerns about the impact on the global food supply remain.
“In the U.S., we’re a bit more insulated from the economic fallout from the war compared to Europe and other parts of the world,” says Hainlin. Yet he says there is a greater risk for multi-national companies. “If Europe’s economy slows as a result of its energy insecurity, it will certainly have a negative impact on companies doing business in Europe.” Hainlin says similar economic risks exist for Japan, the United Kingdom and Australia, partly in terms of how the war may impact energy prices.
Investment considerations in a period of uncertainty
The conflict in Ukraine contributes a degree of 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. “Inflation and the Fed’s response to it are still the primary considerations for investors,” says Hainlin. “The Russia-Ukraine conflict is more of a ‘tail-risk’ event. If a resolution can be reached to end the war, that could trigger a market rally. If the situation escalates, that will clearly present a negative event risk that could have a detrimental effect on the markets, at least on the margins.”
Hainlin recommends that investors take a more defensive approach as they position their portfolios. “The Fed appears resolved to continue raising interest rates to stem the tide of higher inflation, so that lays the groundwork for a slower economy,” says Hainlin. “That could be reflected in a potential recession and lower earnings, which could continue to create challenges for stock prices.”
Be sure to talk to your financial professional about what steps may be most appropriate for your circumstances.
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