The Global Economic Consequences Of The Invasion Of Ukraine
The invasion of Ukraine is above all else a human tragedy, but it is also a failure of the current international system with significant implications for economies.
Even as tensions rose at the start of this year, few predicted a full-scale invasion of Ukraine nor such an extensive economic response from the West with sanctions targeting a host of Russian institutions most notably the Russian Central Bank.
Although the humanitarian crisis is front of mind, investors do need to analyse what this means for them and their clients.
Delegates debated the macro-economic implications at the recent WM Nexus Impact Investment Forum in London with Miquel Burquet, partner and portfolio manager at Marlowe Capital, and Abrdn emerging market economist Edward Glossop.
How much pain will Russia feel?
Burquet said his view is that the Russian economy is not going to collapse.
“In the end, the Russian economy is a straightforward commodities producer. Sanctions would hurt a more sophisticated, services-centered economy such as the UK or the Netherlands. But an economy which is far simpler is more difficult to hurt.
“The debt level is quite low, around 17% of GDP. They have these huge reserves, half of them are frozen, but you still have the other half, so worst case is they will get hurt, but bounce back.”
Glossop said sanctions may put some political pressure on President Putin and his inner circle.
Yet he noted that sanctions do not necessarily lead to internal forces toppling the leader even when they lose access to some of the funds used to pay political patronage – citing Venezuela as an example.
He said abrdn has seven scenarios to help frame its thinking which ranged from a broad diplomatic outcome through to a Russian regrouping and doubling down of military aggression.
Impact on the West
Unsurprisingly, both speakers agreed that the channel through which the crisis was transmitting on the West was commodity prices and thus higher inflation which is putting pressure on central banks.
Burquet saw three scenarios – a very unlikely soft landing, a set of interest rate rises leading to a recession and some rises but with Fed pulling back as the ‘House of Cards’ started to shake.
He tended to the second or the third where the US “might have to live with high inflation and high interest rates for a number of years”.
He said Europe faced a similar scenario, but with a greater risk of stagflation.
Glossop added: “Ordinarily speaking, central banks would look through such a shock and focus on demand-side impacts such as the tightening financial conditions that we have already seen.”
But, he said, context is everything. Inflation was already very high for example at a 40-year high in the US.
“The US Federal Reserve and other central banks are well behind the curve, and do not have the luxury of looking through the shock and are set to hike interest rates quite substantially this year,” Glossop added.
Fed Chief Jerome Powell has a goal of a soft landing but, he added it is easier to discuss a soft landing than to engineer one as history shows.
Marlowe Capital has just published a comparison between the tightening in 2022 and the Volker shock in the late 70s and early 80s.
It brought two recessions with many sectors suffering, though it did eventually see control asserted over inflation providing the basis for the subsequent 80s rebound.
Burquet added: “They managed to control high inflation at that time, with interest rate tightening. The problem is that right now, this financial system is far more complex. They start tightening, and then some of the bubbles that have been created around technology for example [may start to burst] and that may force them to stop the tightening.”
He noted that during the 70s crisis, the destruction of inflation adjusted value was greater than during the Great Depression.
Glossop felt it was less likely that the Fed – given its pivot to a hawkish stance since around November last year – would tolerate or acquiesce in persistent high inflation.
He added: “The Fed doesn't target financial conditions; it targets inflation.”
Is China free to take a different path?
Glossop said there is a view in some circles that China is the one economy that could chart a different course.
“The People’s Bank of China is the one central bank that can decouple from the Fed and global monetary conditions, so if the Fed is tightening, if the ECB is tightening, the PBOC in China can ease monetary policy, and that can help to continue to boost equity markets,” he said.
He sees two challenges to the view that China easing could boost markets – the current zero Covid strategy and its impact on growth and the difficult balancing act in China of maintaining a strong pace of growth while also reducing perverse incentives and moral hazards in the property sector.
What of the ESG approach?
Glossop said that abrdn will no longer be investing t be investing in Russia and Belarus for the foreseeable future on ESG grounds
“We did substantially reduce exposure to Russia and Ukraine around the start of December, when there was an intense buildup on the border, not necessarily because we thought that conflict would definitely happen, but because there was substantial risk.”
There was some debate about taking ESG approach during the crisis – it does tend to bring a focus on companies with stronger balance sheets and more resilience. There is also likely to be ongoing client demand to avoid Russia.
The crisis has also brought a greater focus on supply chains – but for now it also a matter of whether supply is actually available at all.
“Russia and Ukraine are massive producers of certain goods and components that are critical to the global economy such as palladium, xenon gas and even wheat where Russia and Ukraine are big exporters of these things. So, it's only going to exacerbate the supply chain difficulties and shortages that we've seen over the past couple of years,” Glossop added.
Real estate depending on money in the market and central banks
Delegates also asked the panel to consider the prospects for real estate. Burquet said: “My view is it will depend on what happens with the amount of money in the market. In addition, countries want to reduce the balance sheets of the central banks. That will be a very, very tricky game to do with inflation, and combined with interest rates. Just looking at these factors, it is unlikely that real estate prices keep going up as they have done in the past. That's the only thing I can say.”
Glossop said: “If the Fed and other central banks are trying to get ahead of the curve by increasing nominal interest rates above inflation, and neutral rates, which is what we expect, then that is less good for real estate. Not to say it's bad, but I just don't think there’s a particularly bullish case.”
Emerging markets – commodity exporters/importers a clear dividing line
The panellists said, unsurprisingly that current conditions are not great for emerging markets, though with a divide between energy and commodity importers and supplier regions such as Latin America and EMEA.
Glossop noted that most emerging markets started the tightening cycle earlier and will reach peak inflation earlier which could signal local currency bond market rallies.
High oil prices are likely to add a percentage point or so to inflation in the US and elsewhere, but it was important to watch Saudi Arabia and other OPEC members.
Glossop added: “When do they expand supply to try and try and bring prices back down? Because in the past, Saudi has been comfortable with oil prices at $60 a barrel. That is good for their macro. They can run sustainable budget and current account balances. And then in the US, it squeezes the high-cost producers, so it's good for Saudi and other low-cost producers, they can expand market share. So prices at over $100 may not be sustained for too long.”
Burquet added: “For developed markets, we think that the most politically stable and macro economically stable area is North America. It is subject to these short-term uncertainties but the upside cycle that started after the 2008/9 crisis is still there, although modified by this high inflationary environment.”
What happens next?
As for developments in the crisis itself, Glossop said that currently the EU is essentially handing over a few billion dollars every single month, to Putin to finance his war via gas payments.
So, it is possible there will be more pressure for an EU gas embargo , which would then bring more pressure to bear on European economies.
The best case scenario remains a diplomatic solution, perhaps an agreed neutrality or Finlandisation as was the case during the Cold War. Yet it remains difficult to see this yet, given Putin's past form of using military as a foreign policy tool so it is not a base case.
As for the chance of Putin being ousted, neither felt it likely with Burquet noting a recent study comparing China and Russia, which showed that in marked contrast to Xi, with wide constituencies to please, there are very few people Putin needs to keep onside; therefore a cheap monetary policy and the potential for bubbles formation is more likely to arise in China than in Russia.
It is clear from the discussion that you can analyse the global impacts of both the invasion and the economic response. The uncertainly comes from the conflict and its hoped-for resolution which remains much harder to predict.
The above discussion took place at the recent Impact Investing Forum hosted by WM Nexus. If you would like further information on the Forum, or to discuss further any of the issues covered with any of the participants, please contact Alina Legendi at email@example.com.
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