Russia Invades Ukraine

We see Russia’s invasion of Ukraine as a significant and surprising escalation of the conflict. We now know what we are contending with: the start of a protracted stand-off between Russia and the West. We deplore the human toll and tragedy all this may bring. The key macro impact in the short run is higher inflation via rising energy prices, in our view, complicating central banks efforts to curb price pressures.

The invasion appears to target regime change in Kyiv and will likely trigger punishing sanctions by the U.S. and its allies. This may include cutting off Russia’s main banks from the world’s financial system and restricting key technology exports. We could also see Western arms and materials supporting any Ukrainian insurgency – and Russian cyberattacks and disinformation.

Risk assets have fallen sharply, with U.S. and European equities hitting new lows for the year. Government bond yields have declined but not as much as might be implied by the equity selloff. This shows their diminished appeal as diversifiers in the inflationary environment. Russian assets have been hit hard on the prospect of more sanctions.

The key macro impact from this event, in our view, is fast-rising energy prices. This will exacerbate supply-driven inflation - while delaying and raising its peak. We think central banks will need to normalize policy to pre-Covid settings to curb inflation, and they will find it tough to respond to any slowdown in growth: policy rates are headed higher. 

Central banks ultimately won’t go beyond normalization to rein in inflation, in our view, because of high costs to growth and employment. In other words, we think central banks will live with inflation. They may face less political pressure to contain inflation as the conflict becomes an easy culprit for higher prices. We believe this will allow central banks move more cautiously as they raise rates, especially the European Central Bank. Our conclusion: The invasion has reduced the risk that policymakers slam on the brakes – or that markets think they will.

Investment implication: The key to watch is the interplay of energy prices and inflation expectations. We dialed down risk-taking this year because we saw a risk of confusion amid a confluence of unique events: the economic restart, spiking energy prices and new central bank frameworks. This confusion has played out: Market expectations of rate hikes have become overly hawkish, in our view. We were prepared to take advantage of market dislocation, but are holding off on making changes to our tactical views until the interplay dynamics become clearer. For now, we keep favoring equities over bonds at lower risk levels than last year.