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Natasha Brook-Walters, Director, Investment Strategy

 

Following Russian President Vladimir Putin’s decision to launch a full-scale assault on Ukraine, markets swiftly moved into risk-off mode before recovering. Commodity prices, notably oil and gas, shot up. The immediate response from the US, the European Union (EU), the UK, and other members of the Western Alliance has been a toughening of sanctions.

The situation is highly fluid and the eventual outcome is impossible to predict. While we had considered this scenario, how it develops from here will be critical. We're focused on shifts in probabilities and what reactions from Western governments and central banks could mean for longer-term asset implications. In the meantime, we wanted to share with you two Wellington perspectives that the multi-asset team found helpful in our latest discussion.

 

Potential Scenarios

Gillian Edgeworth, Macro Strategist

 

Putin has signaled that he wishes to replace the current Ukrainian government with a pro-Russian administration. This implies ongoing military conflict until the Ukrainian government steps down and much of Eastern Ukraine is secured. Even if Russia succeeds in this, we would expect persistent pockets of resistance.

What does the escalation of sanctions look like from here? Below is a rough guide. My conviction in the first set of steps is high. Beyond that, the potential costs to the West increase, but I believe these countries’ willingness to absorb these costs is much higher than in the past.

1. Immediate Next Steps:

At the time of writing, the UK and the US have already announced additional sanctions, with the EU and others to follow shortly. The US sanctions involve the following:

  • Four major banks added to the Specially Designated Nationals (SDN) list prohibiting all transactions;
  • Thirteen entities with new sanctions imposed on primary and secondary trading of new issues;
  • A ban on technological exports to Russia by the US, the EU, and some countries in Asia; and
  • Sanctions on more Putin allies and family members.

Our legal team is working through the details of these items as we speak.

2. If Russia Takes Kyiv and Other Cities East of the Dnieper River:

  • State-owned enterprises (SOEs) in the real economy outside the energy sector added to sectoral/specially designated nationals (SDN) sanctions list; and
  • Initial sanctions on energy and oil exports problematic but possible.

3. If Ukrainian Resistance Continues as a Russia-Friendly Government Is Installed:

  • Further sanctions limiting energy and oil exports; and
  • The addition of Russian Ministry of Finance/Central Bank of Russia to sanctions list. (Though possible, this would be among the last measures likely to be taken, as it would further increase the probability that Russia doesn’t service its US$462 billion of external debt outstanding.)

 

This escalation could have a significant adverse impact on European economies, with the global economy and central banks facing a double whammy of higher inflation and lower growth.

 

Three Macro Implications

John Butler, Macro Strategist

Immediate Context

The current escalation could have a significant adverse impact on European economies in particular, with the global economy and central banks facing a double whammy of higher inflation and lower growth. The impact of gas and oil prices so far could already add 1%–1.5% to inflation and could lower growth by 0.75%. The aggressive ratcheting up of sanctions is likely to have an additional blowback on to the European economies, while consumer and business confidence may be dented by the fear of war.

How Will Central Banks React?

There is no urgency for the European Central Bank (ECB) to clarify its position on rates as no one expects an imminent rate hike. But I think this will make the ECB even more uncomfortable at this stage with open-ended quantitative easing (QE). I therefore expect it to shift to some form of rolling assessment of QE that enables it to react when it has more clarity, with June as the likely re-assessment date. However, this is a fluid situation.

The impact could be greater for those central banks expected to hike imminently. Notably, the Bank of England has a difficult balance to strike, with inflation already high and about to lurch even higher. While I still expect further rate increases, the pace could be more cautious than the market currently assumes.

The Bigger Picture

The relationship between central banks and growth has changed. During the past 15 years, any negative shock to growth or spike in uncertainty has been a reason to add more liquidity, as the central banks saw little risk of inflation. This time, inflation is higher at the outset, so there is a debate about whether this shock will be inflationary or deflationary over the medium term. If inflation expectations get dislodged, central banks will have to keep hiking into weaker growth. On balance, however, I think central banks fear recession more than inflation. So, while they remain in tightening mode for now, they are unlikely to tighten as aggressively as expected before this shock, even with higher inflation.

The key point is that risk assets1 no longer enjoy the same level of insurance from central banks as in recent decades. Instead, central banks may become a source or even a compounder of volatility.

Implications for the EU and the Euro Area

For most of my career since 1999, I have taken a structurally negative view of the euro area because of its unwillingness to resolve the flaws within the currency union. Every time growth slowed, these flaws risked being exposed. And the only outcome was more and more QE from the ECB.

One risk is that this invasion of the Ukraine puts the spotlight back onto the outstanding fragilities within the Euro system. 

The risk is that this invasion of the Ukraine puts the spotlight back onto the outstanding fragilities within the system: from the lack of security (its dependence on the US) to the weakness of its border controls (migration flows) and its dependence on external energy (in particular, Russian gas).

There's now a high chance for a wave of refugees from the Ukraine to Poland, Romania, Hungary and possibly other euro-area countries. We know the strains this put on European countries in the recent past and how fragmented their response was. This could have negative implications for the region’s politics. For example, immigration could suddenly become a big issue heading into the French election this April.

One possible silver lining to this cloud is that I think there is a higher chance now that this emergency is used to unify the region and define why it exists. The medium-term scenario is that the conflict becomes another reason to accelerate fiscal spending on renewable forms of energy, to remove the euro area’s dependence on Russia. But it could also spark more fiscal spending on everything from rearmament to income subsidies to offset higher energy costs.

Over the past year, my views have changed to become the most bullish I have ever been on the structural outlook for the single currency, motivated by the shift in German politics. My sense is that the German attitude has changed to allow Germany itself to inflate and to be open to explicit burden-sharing across the region. That significantly increases the probability that the region is heading toward a sustainable currency union (and one that could now create inflation).

So I think this shock potentially changes things. The past 10 years have been characterized by institutional paralysis within the euro area, with fiscal austerity offset by huge liquidity from the ECB. This meant negative rates, low yields, and tight spreads.2 But this event could force clarity on which tail wins—unification or fragmentation. Unity would mean more fiscal spending, an ability to create inflation and more burden sharing across the region. The potential implications would not be clear for spreads, but yields would be higher.

For now, we may have to work through a period of volatility and put the spotlight back on the fragilities within the euro area before these medium-term implications play out.

Cold vs. Hot War?

While the risks of conflict between Russia and NATO have increased, for now a new form of cold war appears more likely. From a macroeconomic perspective, I think this would accelerate deglobalization, which is one of our core themes, as countries will value self-dependence in their supply chains and energy sources.

I think that could mean big investment, financed through fiscal expansion. One of our themes is that inflation will be determined more domestically than globally. I expect current events to accelerate that shift back to domestic rather than global output gaps. It could also mean that country-relative stories will become more important again as central banks are likely to keep their inflation targets but allow greater deviations. The cycle could become more volatile and institutions less secure, which would have to be reflected in higher risk premia in markets.

 

For more information on how geopolitical events can impact your investments, talk to your financial professional.

1 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.

2 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.

Important Risks: Investing involves risk, including the possible loss of principal. ● Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets or in a particular geographic region or country.

The views expressed here are those of the authors. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams, and different fund sub-advisers, may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds. 

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From our sub-adviser, Wellington Management
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Director, Investment Strategy
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Macro Strategist
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