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Ukraine Crisis – The Economic Perspective
30 March 2022

Written by Ivan Fletcher

The outpouring of grief for the atrocities committed by Russia on the people of Ukraine has been significant and can be quite traumatic to watch or contemplate.  Sadly the outbreak of war is not an uncommon theme in the world we live in.  Coming on the back of a 2 year period where the world has endured the human and economic impact of a pandemic is naturally a cause of worry to us all.   The purpose of this article is to look at the situation from an economic and market perspective.  You may be pleasantly surprised what history shows us.

The Back Drop   

  • From a financial market perspective, the Russian invasion of Ukraine came at a challenging time with persistently high inflation pushing the main developed central banks to tighten monetary policies.
  • The US had already priced in a sharper rise in US cash rate, which triggered a correction in major equity indices before the Russian invasion.   Geopolitical tensions now adds another element of uncertainty to already volatile markets.

Economic Impacts / Risk 

  • The direct economic impact is relatively small as GDP of both countries (Russia & Ukraine) is relatively small, but there is indirect impact thru commodity markets as we have felt through the petrol bowser.  On the flip side, Australia benefits from some higher commodity prices  (for example – a surge in thermal coal prices in particular has been supporting our terms of trade).
  • The biggest Economic risk is the increase in inflation resulting in USA federal reserve in particular accelerating their raising of Interest Rates.

The Western Response  – Economic  Sanctions

  • The responses from the Western democracies has been stronger than expected with western governments escalating economic sanctions.
  • Sanctions against the Russian central bank are likely to be even more devastating.  Russia has accumulated a massive foreign currency reserve of around USD 630 billion and its sovereign wealth fund holds another 175 billion USD, with 50% of reserves held in Western currencies, mainly Euro. The Russian central bank has  increased interest rates from 9.5% to 20% to prevent a bank run.
  • The Western democracies have not yet utilised its most potent weapon – sanctions on Russian energy exports due to self interest as Russia accounts for close to 20% of EU’s gas sources. While a gas ban is off the table so far with European officials, policy makers are rushing to reduce their reliance on Moscow.

Impacts on Financial Markets

  • The Russian invasion of Ukraine surprised financial markets, despite weeks of warning from western intelligence agencies of an imminent invasion. Investors seemingly largely misunderstood and assumed Putin to be a rational risk taker who was using the threat of military action to extract further concessions from Ukraine.
  • Developed market bond yields had risen sharply on the back of increased expectations of more aggressive interest rate tightening by central banks. However market sentiment on bonds shifted somewhat after the Russian invasion of Ukraine.
  • Energy prices rose sharply after the Russian invasion of Ukraine, including oil prices, something we are all feeling at the bowser.
  • Equity markets have been volatile with most equity indices delivering negative returns. The degree of Equity market impacts have has been a function of proximity to Russia and Ukraine, with the impacts on share prices since war actually broke out being stronger in  Europe than USA and
  • There has been a significant pull back in the higher priced American indexes such as the S&P 500 and the Nasdaq of at least 10%, but this was before war broke out (with the last S&P peak dated 3/1/22  at 4796.56) .

What Lies Ahead ?

There are of course several scenarios that can play out.  The most significant and obvious question is   “How will the Russian invasion of Ukraine develop and conclude?”

  • According to Colonial First State Senior Investment manager (George Lin) – The invasion has not significantly changed the US inflation dynamic with slowing but still reasonably strong economic growth in 2022.  With higher inflation, the Federal Reserve still needs to and will tighten monetary policy.  However the target rate may be lower  or the Federal Reserve may decide to get there more slowly.
  • Energy markets may actually end up doing part of the Federal Reserve’s job in demand management, allowing it to adopt a more cautious approach in terms of the speed of the monetary policy tightening.
  • The supply of Russian energy to the Western democracies will likely come under question, either due to Russia using its energy export as a weapon or the main European countries bowing to public opinions and turning off Russia’ energy supply.  
  • A significant disruption to Russian gas supply to western Europe has the potential to push their economy into recession.  The US is better positioned due to its domestic gas and oil production.

What Should Investors Do ?

Firstly, some historical perspective –  Historically, the impact on markets of war outbreak has been shallow and short  with an  average decline of 7% and corrections lasting no more than a few months.

  • In this case, the All Ords index (accumulation) had dropped by 10.5% to a low of 7092.6 by 27 January and the US S&P 500 had reached a correction point of 13% by 23 February.  Both indices have actually risen since the physical  outbreak of war (24 February).
  • Equities are expected to recover as the outcome of conflict becomes clearer or valuation levels become more attractive.
  • However it is very difficult to predict what will happen over the shorter term of 3-6 months as there is unlikely to be enough cushion in current prices to protect further downside in the event that conditions do weaken further.  
  • Investors should not get overly bearish or panic even if uncertainty is high.
  • Don’t try and time the bottom of market and be prepared to ride out downside.
  • It is important in these times to stick to your long term strategies. Remember the Share markets fell 35% in 6 weeks in March 2020 and recovered within the next 6 months.

Sources

Colonial First State –  Monthly Wrap by George Lin (21/3/22)

Macquarie Bank  (YouTube video 17/3/22) by Jason Todd (Head of wealth management Investment Strategy) and Ric Deverell (Had of Global Macroeconomics)





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