Just as the world started to emerge from two years of heightened uncertainty and disruption during the COVID-19 pandemic, it faces another global crisis—this time geopolitical—with Russia’s invasion of Ukraine. Although these two shocks seem disparate, they share one common theme: an inflationary impact on the global economy.
Before war broke out in Europe, central banks had been widely expected to remove monetary accommodation during 2022. The COVID-19-induced recession and subsequent recovery have been the sharpest in the modern era, and with tighter labor markets and elevated inflation, policymakers started signaling more urgency to raise rates.
Complications from Conflict in Europe
The Ukraine conflict and resulting economic sanctions have quickly escalated well beyond early expectations. Because Russia and Ukraine account for a significant share of global energy and agricultural commodity exports, by early March the Bloomberg Commodity Index had risen more than 30% from 2020 year-end levels and oil prices 60%.
Economic links between Russia and the European Union (EU) and US are being severed, with the Russian economy likely heading into a deep recession. Meanwhile, a growing number of EU and US corporations are shuttering their Russia operations.
The spike in commodity prices and the stresses of effectively disconnecting the world's eleventh largest economy (3% of global gross domestic product) from much of the developed world complicates central banks’ plans to reduce policy accommodation. The commodity supply shock will boost inflation and dent real consumer spending power, while the sharp impairment in the value of Russian assets could create financial risks that may not have fully played out yet.
Uncertainty About the Ultimate Geopolitical Impact
The economic recovery has been strong so far, and inflation concerns are elevated, so the Fed appears on track to start raising rates this month (after the date of this publication), even though near-term rate-hike expectations have declined. Europe’s policymakers have room to be more patient with rate hikes, given the possible greater hit to economic growth from the Ukraine conflict and somewhat lower starting inflation than in the US. The European Central Bank, however, did announce plans to accelerate its tapering, which was a surprise.
There’s still a lot of uncertainty about the eventual economic fallout from the war, both near-term and long-term. The scope of sanctions and potential mitigation measures are still evolving. The duration of sanctions is unclear, although these measures have historically been long-lived. To the extent that sanctions aren’t global, at least some portion of Russian flows are likely to find their way to other destinations.
More broadly, economic relations between the US, Europe, China and Russia a year from now could be very different from those prevailing over the past decade. Given these risks, central banks may be compelled to follow a nuanced, data-driven approach as long as geopolitical risks persist—but this approach will likely be challenged by higher-for-longer inflation.
Strong Growth Backdrop Pre-Ukraine War…
A key question for asset allocation is whether equity performance—a key growth driver in multi-asset portfolios—can withstand a period of rising interest rates. Historically, rate hikes have tended to coincide with strong economic backdrops, with equities and other risk assets performing well during these episodes, on average.
In other words, rising rates didn’t necessarily derail economic growth nor equity returns (Display). For the six months following initial rate hikes, equity performance trailed cash in only three of 10 historical episodes. Performance was similarly robust during hiking cycles, with below-average returns aligning with recessions and steep hiking paths.