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A personal thought piece by Andrew Milligan

The potential impact to markets from the situation in Ukraine

Andrew Milligan is an independent economist and investment consultant. He is a Board Adviser and an Associate supporting Devlin Mambo, although this note is written in a personal capacity.

There is a mass of news, information, speculation and considered analysis about the situation in Ukraine, with significant uncertainty about exit routes or eventual outcomes. The following quote from the Financial Times is useful: in relation to Ukraine: either little changes or everything does, i.e. in a year’s time, either this war will have changed little about markets, or changed everything.

I will begin with some high-level conclusions before examining certain areas in detail. The invasion has “triggered a set of geopolitical shifts that are astonishing in their scale and rapidity. The world is not the same today as it was last week,” as Richard Fontaine observed. Even if the conflict does not spread beyond Ukraine’s borders, its economic effects will appear – the only question is how bad they are. It remains possible that this war is eventually seen as a major turning point in the relationship between democratic and autocratic societies. The speed of the turnaround in EU foreign policy making is profound. In that sense it will aggravate existing trends, rolling back globalisation, enhancing a bi-polar world order (US & EU vs Russia and China), and reinforcing high levels of uncertainty facing investors. There may be unintended consequences for the global financial system of the decision to shut down access to the US dollar system for the world’s second largest energy producer at a time when energy markets are already under stress.

On a more positive note the war will also spur major investment in renewables as an insurance policy against future shocks to fossil fuel supplies. From an ESG point of view, more investors will begin to examine their portfolios for potential stranded assets, as Russian equities and bonds have quickly become un-investable.  Lastly, in terms of strategic asset allocation, it should remind investors that even when they assign an outcome a low probability, they should not stop examining the potential consequences of such an event appearing.

What is priced into the asset prices of the major markets?

The degree of daily market volatility makes it difficult to answer this question. Although Russian asset prices have collapsed, and the Russian economy is likely to enter recession, it is the case that Russia is only about 2% of the world economy, smaller than such countries as Canada or Korea. Investors have only priced out one of the 5-6 interest rate increases expected in the USA this year. The explanation is that economic fundamentals have not yet changed much; there is not yet enough global weakness to stop a Fed worried about inflation. In addition, real bond yields have declined noticeably, hence supporting equity market valuations. Markets do expect medium-term disruption in various sectors, but not yet a broader disaster. Hence the flight to safe haven assets, such as US dollar or Yen looks measured. On the downside, to quote Benjamin Graham “in the short run, the stock market is a voting machine”. Neither the dramatic market moves nor periods of relative calm in recent days tell us much about what lies further down the line, either for companies or for the wider economy.

Scenario Analysis

A useful approach in such situations is to carry out scenario analysis. The most likely outcome is Russian military control over the whole country leading to regime change. A range of other outcomes are possible (this list is by no means exhaustive and tail risks have multiplied).

  1. Ukraine collapses – the political and military will to defend the country quickly disappears
  2. Drawn out contest – the Ukraine turns into an Afghanistan/ Chechnya type situation for Putin as Russian forces get bogged down
  3. Energy shock - Putin deploys his energy weapon, so Western Europe faces not only sharply higher energy price but also energy rationing
  4. Europe gives way – the pain from lost exports and surging energy costs becomes too high
  5. Putin forced out – a financial crisis creates sufficient opposition from the oligarchs to force Putin to stand down.
  6. Extreme scenarios would include cyber-attacks on critical Western infrastructure, or a wide-reaching international conflict in eastern Europe, even the use of nuclear weapons.

Uncertainties abound. At one extreme there could be a chaotic outcome lasting years, as in e.g. Syria, at another extreme there could be peace within a few days. Will energy and food prices surge or collapse? Obviously, Russia could switch off European access to gas supplies (Europe gets nearly 40% of its natural gas and 25% of its oil from Russia). Conversely, although overall OPEC spare capacity is limited the US might seek assistance from Saudi Arabia to boost production. Calm or cold weather patterns this spring and even next winter might be key. In addition, Ukraine and Russia account for over 20% of global wheat exports. A final uncertainty is the success of the Western sanctions. Some analysts argue that the effects will be very serious, akin to the stranglehold on Iran, whilst others argue that Russia has a strong balance sheet position reflecting little external debt and strong foreign exchange reserves.

Political analysts have been wrong-footed several times

The first surprise was that Putin did invade, the second was such an aggressive, unified Western response. Massive retaliatory sanctions are being rolled out (e.g. removing access to SWIFT and Russian foreign exchange reserves). The European response has proved more forceful and robust than Putin or analysts would have expected, demonstrated by the EU shipping weapons including even fighter aircraft to the Ukraine. A third surprise is that domestic and foreign policy has changed so quickly in some countries, notably Germany which is boosting defence spending and weapons exports whilst rapidly building LNG terminals and potentially extending nuclear and coal plants life-spans. Another example would be the decision by Switzerland breaking its traditional neutrality to place sanctions on Russian bank accounts.

Economic implications

The world economy was generally in a good place at the start of the crisis. After winter lockdowns, business activity was improving into Q1. US and EU manufacturing and services PMIs are running about 57-59, i.e. consistent with solid growth as companies rebuild inventories. Whilst companies are upbeat, households in many economies are already suffering from the surge in inflation, e.g. warnings that UK households could suffer the biggest annual decline in living standards since the 1950s. Consumer confidence had declined this year in most large economies, a reflection of how people view the state of their personal finances. Fiscal policy may have to help take the strain.

Looking ahead, Russia's invasion will simultaneously worsen inflation pressures and damage growth prospects throughout the global economy. Early estimates of the impact of the trade and energy shocks on Europe suggest its GDP growth will be 0.75%-1.0% lower. That makes it a stagflationary shock which central banks will find it difficult to adjust to – hence only modest changes in interest rate expectations. A further major negative supply side shock is not difficult to envisage, say due to sanctions or cyberattacks. The adverse financial consequences for companies are only starting to appear such as e.g. BP, Equinor and Shell all divesting assets at a loss, or aircraft leasing losses, or firms such as Apple, Ford, Boeing, and BMW announcing they are halting or seeking to exit their Russian operations, or the losses from sales by the Norwegian sovereign wealth fund etc.


Key signposts for investors might include:

  • Sanctions. How far will western sanctions go, what are the Russian counter measures? 
  • Energy.  Where do oil and gas prices go? Is there a risk of physical disruption?
  • Supply chains.  What is the impact on other key commodities, such as wheat or palladium?  
  • Economic impact.  What are the effects on aggregate supply, demand and inflation? 
  • Macro policy. What will be the impact on monetary and fiscal policy?  How do central banks and finance ministries consider the downside risks to growth in developed markets and upside risks to inflation? 

Turning to other major issues, the next few sets of employment reports will help determine Fed and MPC policy making. Markets still expect US and UK rate increases later in March. The latest inflation data have been sufficiently worrying, for example in terms of the breadth of inflationary pressures, so Fed governors such as Powell have warned of a steady pace of rate increases. ECB signals that it will delay moving from QE to QT would be an example. The Chinese government’s next work report, due about 5 March, will also give clues about the main direction of government policies especially on stable growth.

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