Financial markets are faced with many uncertainties because of the Ukraine war, geopolitical tensions, higher inflation and deteriorating growth prospects. Here are a few possible scenarios.
Russia’s invasion of Ukraine has not gone to plan and the country is also labouring under unprecedented economic sanctions. Western governments continue to supply the Ukrainian army with weapons, making things progressively difficult for the Russian army – add to that the fact that the Ukrainians have far more motivation to fight. Hence Russia will only be able to seize a limited part of Ukraine. At the same time, the Ukrainian army will ultimately prove too small to defeat the Russian army.
We draw two conclusions from this:
The war in Ukraine is likely to become a protracted conflict – perhaps occasionally interrupted by a temporary ceasefire – with Moscow attacks targeting civilian casualties as has very often happened in Russia’s recent wars.
The West will lend increasing support to Ukraine, while Russian propaganda against the West will intensify accordingly. This could lead to Moscow taking an increasingly aggressive military stance against the West with the view that the more the West is provoked in this way, the better. Indeed, any military action by the West will be framed as an attack on Russia. Moscow will increasingly need this, because developments in the Ukraine war remain disappointing for Russia so far.
Chart 1: Military expenditure as a share of GDP
Source: Refinitiv Datastream/ECR Research.
Stockholm International Peace Research Institute (SIPRI).
Expensive bloc formation
It remains to be seen what economic consequences this will have:
The war in Ukraine will yield too few victories for the Russian rulers meaning that the democratic West will therefore be increasingly portrayed as a major enemy. Consequently, defence spending in the West will have to be ramped up considerably for many years to come.
It would be irresponsible if the West remained highly dependent on imports of Russian commodities. Alternative sources will have to be tapped for this. This will also cost vast amounts of money.
There is a possibility that China will head in the same direction as Russia, which could reverse the economic intertwining between China and the West to a certain extent as more Western companies will opt to bring production closer to home – rather than manufacture in China. The result is that the world will be increasingly divided into two blocs – one around the US and one around China, with limited trade between the two blocs. In this case, the West will lose many of its inexpensive production facilities, resulting in more expensive imports and products.
The fight against climate change is another major factor. Governments need to play a key role, costing large amounts of money.
In summary, for the time being, we expect a climate of massive violence stemming from the war, increasingly far-reaching sanctions from the West and persistently high commodity prices (or at least commodity prices that will be considerably higher than they would otherwise have been – they could fall back in the event of declining economic growth). At the same time, we expect persistently high public deficits.
A shift in monetary policy
This brings us to the next point. As long as inflation stayed low, central banks were able to buy vast amounts of bonds with surplus money created for this purpose. However, inflation has since risen to high levels, which is why this can no longer be done without losing the confidence of bond investors. Central banks will therefore have to terminate this policy.
This policy has been pursued for many years, and this has resulted in enormous amounts of surplus money. This money has stayed with the banks or assets have been bought with it (shares, bonds, property to name a few). This money could still end up in the real economy, certainly if inflation and public deficits stay high. In order to retain the confidence of the bond market, it will be necessary to remove a large proportion of this surplus money from the system – by having the central bank sell the previously purchased bonds and/or by not replacing expiring bonds with new ones.
In short, the supply/demand ratio for bonds and money creation by central banks will change drastically. Rather than buying bonds, central banks will sell them and rather than creating money, they will extract money from the system. This will result in additional upward pressure on interest rates – especially on long-term interest rates if public deficits stay high.
A reservoir of negative forces
Recent US economic data has been fairly strong. This is probably due to large-scale fiscal and monetary stimulus schemes that were implemented in response to the corona crisis. However, forces that have a negative impact on economic growth are becoming stronger (incidentally, Europe has had weaker data for some time):
Elsewhere expect a loss of consumer purchasing power and a decline in confidence in the future due to the Ukraine war and high inflation.
The Fed has to hit the monetary brakes. The American political situation is increasingly moving towards a fiscal policy where deficits will not be raised any time soon. This will therefore not support economic growth to any great extent. Most inventories are back to normal, and more stockpiling is unlikely to significantly boost economic growth.
Chart 2: US consumer confidence regarding the near future has dropped sharply as inflation worries mount
Source: Refinitiv Datastream/ECR Research
Consumers are unlikely to borrow more in the current uncertain situation. We see more and more stagnation in global trade due to ever-increasing sanctions against Russia and mounting problems for many emerging markets. We fear that all this will culminate in US economic growth falling back to around 1% before long, while economic growth in Europe will be on the brink of recession. In this light, we expect the following:
Long-term interest rates are likely to consolidate before too long (we expect this to be a temporary decline in the context of a long-term uptrend in interest rates). We will see a shift in the expectation that central banks will quickly raise their rates and switch from buying bonds to selling bonds. This will still happen, but to a lesser extent and more gradually than is generally expected at this point. Commodity prices will consolidate, and they could even decline after a while. Share prices will come under more downward pressure.
We still expect central banks to intervene as soon as the economy threatens to lapse into a recession. Once inflation clearly falls back as a result of this, central banks will hit the monetary gas again. Public deficits might also be raised in this case hitting the fight against inflation.