The Economic Headwinds of War
Russia’s unprovoked war with Ukraine has already had wide-ranging impacts on the global economy. What’s an investor to do?Download PDF
- The U.S. and West have rallied behind Ukraine on the heels of Russia’s invasion.
- The swift and harsh economic sanctions have already severely hobbled Russia.
- Those same sanctions are causing disruption and volatility in global markets.
- Looking at other similar historical periods, we believe that investors might consider a stay-the-course strategy with a diversified portfolio.
On Feb. 24, 2022, Russia invaded Ukraine from the north, east and south, as President Putin planned to topple the democratically elected Ukrainian government and replace it with a pro-Russia government. While there are some similarities to the 2014 takeover of Crimea, this unprovoked attack may have been a miscalculation on Putin’s behalf.
Putin’s strategy was based on Russia’s military outpowering Ukrainian forces, his belief that NATO would not send troops, and that European countries would hesitate to impose harsh sanctions due to its dependence on Russian oil and gas. Uncomfortable with NATO’s expansion into Eastern Europe, Putin planned to quickly overthrow Ukraine’s government and endure the sanctions through Russia’s stockpile of foreign-exchange reserves that it had accumulated over the past several years.
The Crimea annexation taught him that there may be little resistance to a Russian invasion, thinking this time would yield similar results. However, Ukrainians are fiercely resisting Putin’s takeover and gaining overwhelming support from rest of the world, including Russian citizens. Although Russia could still conquer Ukraine, maintaining control seems unlikely.
Swift and Harsh Sanctions
The U.S. and the rest of the West responded to Moscow’s invasion by swiftly imposing sanctions to thwart Putin’s aggression. The first wave targeted Russian politicians and business leaders by freezing assets and banning travel. Major Russian banks were also cut off from the global-banking system, and exports of sensitive materials (such as semiconductors) to Russia were also suspended.
Soon thereafter, the U.S. and several of its partners took measures to block Russia’s access to the Society for Worldwide Interbank Financial Telecommunications (SWIFT) international banking payment system, which is the main secure-messaging system that banks use to make rapid cross-border payments. It is considered the Gmail of global banking.
Removing Russian banks from SWIFT disconnects them from the international-financial system, hindering their ability to operate globally and effectively blocking Russian exports and imports. The sanctions will deny the Russian central bank from accessing its foreign exchange reserves, preventing it from defending the Russian ruble from free fall. This has already caused a major economic shock to Russia’s economy.
In terms of military support, the European Union has pledged to finance the purchase and delivery of weapons. Even Germany has shifted its stance to provide military aid, despite being heavily dependent on energy from Russia.
Global Economic Impact
Ukraine remains a significant exporter of metals and grains, while Russia also exports oil and gas. Outside Ukraine and Russia, Europe is the most exposed to the disruption, as Russia supplies Europe with 40% of its gas and about a quarter of its oil. The rest of the world will feel the economic impact through higher commodity prices, which would further boost inflation and hinder growth.
The decision to block Russian banks from SWIFT may lead to missed payments and overdrafts within the international banking system. This may spur major central banks to supply the market with dollars, which means the Federal Reserve (Fed) may have to expand its balance sheet again right before it had planned to end its bond purchases. Furthermore, the Fed and other major central banks may become less hawkish on interest-rate hikes. At this point, a 50-basis-point hike (one basis point equals 0.01%) in March is highly unlikely because of this conflict.
Uncertainty remains whether the Russian invasion draws NATO forces into the military conflict, which could prolong this war. So far, Russia and Ukraine have agreed to continue talks aimed at ending the war. A delegation led by Ukraine's defense minister recently began cease-fire talks with Russian officials. Negotiators said they made some progress but failed to agree on a cease-fire. Instead, Russia intensified its assault that included civilian deaths. After the initial talks, negotiators agreed to meet again, which may be a narrow window for Putin to prevent a long-lasting conflict.
Historical Insights for Investors
Market volatility is expected to remain high and continue in the near-term. When the U.S. stock market opened after the invasion, it initially plunged about 3%, which was reminiscent of September 11 and the 2003 Iraq invasion. On average, the market impact of these geopolitical events is a one-day loss of around 1%. Total drawdown from such geopolitical events averages nearly 5%, taking only about 20 days to bottom and about 40 days to recover. However, when the U.S. entered into World War II after the bombing of Pearl Harbor, it took over 140 days to bottom and more than 300 days to fully recover.
We believe that the lesson is not to panic sell amid such geopolitical events and to stay diversified, which may help investors navigate through the short-term volatility. Moreover, in our opinion, the risk of stagflation may support the case for portfolio diversification to address the heightened volatility and uncertainty.
A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.
Pacific Life Fund Advisors LLC is the manager of the Pacific Funds Portfolio Optimization Funds. The views in this commentary are as of March 1, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.
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