Investment Strategy

Is the Russia-Ukraine crisis enough to end the economic cycle?

Feb 25, 2022

Geopolitical events generally only have a market impact when commodities are affected. The impact of physical destruction, sanctions, and countersanctions on the energy trade will be the key things to watch.

Key points:

  • Geopolitical events generally only have a market impact when commodities are affected and this case is no different. The impact of physical destruction, sanctions, and countersanctions on the energy trade will be the key thing to watch.
  • How central banks respond to higher headline inflation, and now higher uncertainty around growth, is another key question. We think the Fed would still move even with the growth picture challenged.
  • Other than commodities, Russia and Ukraine’s economic and financial linkages with the global economy are minimal. Europe is more affected, and the U.S. is less exposed.
  • This adds a significant new source of uncertainty, especially given the delicate backdrop of Fed tightening and high inflation, but if the energy trade remains unaffected, global economic fundamentals will move back into the driving seat leaving us still cautiously optimistic.

On Thursday, Russia stormed Ukraine with an all-out assault that caught markets, world leaders, and experts off guard. After air and missile strikes, Russian troops launched attacks from multiple points leaving world leaders scrambling to respond. Shortly after the assault began, Biden and world leaders announced sanctions on banks, Russian leaders, but notably left energy and financial transactions off the table for now. Markets responded to the invasion in typical fashion with oil significantly higher, gold higher, and risk assets down, leaving investors wondering how this conflict will impact the global economy and – combined with the already uncertain backdrop from Fed tightening and high inflation – whether it will bring an end to this economic cycle.

In this note we briefly recap what has happened, what could happen next, and how it could impact markets and broader economic backdrop. The general rule of thumb is that geopolitical events rarely have a lasting market impact; however, historically the events that have had an impact were ones that impacted the global commodity trade – the Suez crisis and the ’73 oil embargo. Thus this conflict has the potential for a more lasting negative impact, but the key catalyst will be what happens with regards to the energy trade. 

Situation report. As of the time of writing on February 25, Russia has launched a full-scale invasion of Ukraine, in what could amount to the largest conflict in Europe since World War II. Russian attacks began on cities across the country with troops approaching the capital Kyiv. At the moment it is not clear what the ultimate aim is but it can’t be ruled out that these attacks could aim to overthrow the Kyiv government through military means. Furthermore, despite Putin’s claim to the contrary, it is possible that this will include occupation of some territory by Russian forces.

Why is Russia invading Ukraine? While no one can fully know Putin’s motivations, most experts see these actions as an attempt to forcefully bring Ukraine back into Russia’s sphere of influence where Russia can exert control over their domestic and foreign policy. Whether Russia intends to occupy Ukraine, change its government, change its constitution, control eastern regions or any combination of the above is still unknown, but the element of turning Ukraine into a buffer state under Russian control appears to be a key objective.

How is the world responding? The U.S. and world leaders responded with a package of sanctions that included adding Russia’s largest banks to the Specially Designated Nationals list; imposing new export restrictions on advanced technology, and broadening the scope of sanctions against oligarchs and families of the political elite. The EU and UK have responded with similar measures. The Nord Stream 2 pipeline is likely to be sidelined indefinitely. However, so far sanctions on commodities and financial transactions (SWIFT) have been off the table.

What is the impact of the invasion, sanctions, and countermeasures on the global economy? Oil and gas prices are rising significantly, reinforcing inflationary pressures and weighing on financial markets and global growth. Brent crude prices rose to nearly $100/barrel at time of writing and could remain high until significant alternative supplies become available (e.g., an Iran nuclear deal or more U.S. shale). Gas transiting Ukraine could be disrupted, affecting supplies to several central and eastern European countries, and raising gas prices in Europe. Climbing energy prices could push inflation even higher, but at the same time, could lead to more sluggish growth and dampened consumer spending. This could complicate the monetary policy outlook. While Western governments could exempt energy transactions from sanctions, the blizzard of new restrictions could lead traders to be cautious in handling Russian barrels.

Specifically, two potential sanctions that would have the largest global impact are sanctions on the energy trade and financial links (SWIFT). If SWIFT sanctions come into scope, this would essentially ban Russian corporates and financial intuitions from ruble convertibility and would likely have widespread impact on Russia’s economy and spill over to the rest of the world via disruptions to trade and financial transactions.

Notably, Russia produces ~12% of the world’s oil and ~17% of its natural gas supply. While the common refrain is that geopolitical events rarely have a lasting impact on markets, much will depend on how the commodity trade is impacted. This will be the key factor determining whether this is a short market blip or a longer-lasting correction. Until now, Western governments have refrained from sanctioning energy trade because of the collateral damage to their own economies, and Putin has refrained from using energy as a countermeasure because it represents the key source of trade and revenue for the Russian economy. It’s not just oil and gas – Russia is also a significant exporter of palladium, and Ukraine is a significant exporter of agricultural commodities. Sanctions or disruptions could impact wider sectors from fuel cells to electronics.

For other regions, particularly Asia, export controls could restrict trade with Russia. These would likely appear similar to those in place on Huawei in that the U.S. would control sales to Russia of any products made with U.S. software or equipment. For example, any firm in China or Germany which uses U.S. equipment, software or intellectual property to make products destined for Russia would have to seek a license from the U.S. Commerce Department. Broad sanctions of this type would make business difficult for exporters around the globe, and would put Chinese firms in an especially tough spot. China is Russia’s largest trading partner, and Chinese firms, notably in electronics, export plenty of products made with U.S. inputs. The potential expansion of sanctions-related risks to many more Chinese firms is one reason that Beijing should be concerned about the conflict in Ukraine.

Potential Russian countermeasures:  Putin could also respond with measures that impact oil and gas supplies. However, his options are limited; the only way he can hope to inflict enough economic pain on Western countries to undermine their opposition to his actions is by restricting Russia’s energy exports. Although Putin gave reassurances that he will maintain uninterrupted supplies of Russian gas to global markets, it’s far from certain how he’ll respond.

Russia has already been restricting the flow of natural gas it sends to the EU, with volumes down by more than a third compared with pre-pandemic levels. The risk now is that Putin further reduces Russia’s gas exports to Europe, and potentially dials back Russia’s crude oil exports. The objective would be to create energy shortages in the EU, while pushing up global oil prices to a point where the rise in U.S. retail gasoline prices—now at a seven-and-a-half year high of US$3.60 a gallon—begins to inflict political pain in Washington. The common objection is that Putin is unlikely to cut off gas supplies because he needs the revenue. But US$640bn of foreign reserves, up from US$350bn in 2015, gives Russia a sizable cushion to weather any pain. In any case, Russia demonstrated in 2014-15 its capacity to absorb economic hardship without triggering domestic political upheavals. In the short term, Russia needs its energy export revenues a lot less than Western Europe needs its energy exports.

Market outlook and how we can invest from here

Risk assets are coming under pressure, with the most acute damage experienced in Russian markets. As of Thursday’s close, MSCI Russia has tumbled -40% for the week. The ruble is in the range of the weakest it’s been in years (having breached 87 rubles per $1 USD. The S&P 500 sold off initially but reversed course to close at 4,288. Brent crude prices are the highest they’ve been since 2014 (over $100/barrel after the initial news, now trading around $97). Spot gas prices in Europe climbed 25% to record highs. Haven assets are rallying, as gold prices topped $1900/oz for the first time since June last year. The market risk is greatest in Europe. Given the region’s reliance on Russia for energy supplies, a worst-case scenario escalation could bring a slowdown in growth and consumer spending by way of higher headline inflation. That said, higher commodity prices actually tend to be a tailwind for Stoxx 600 earnings. We’re not changing our year-end index outlooks for Europe, and expect the relative valuation gap between the Stoxx 600 and S&P 500 to narrow from 26% to a more average ~20% by year-end. In the U.S., we see limited long-term corporate earnings risk as well.

Whether you’re looking for an opportunistic trade or a hedge, Energy may be the place to find it. Various structured notes that offer exposure to underlying assets that may be beneficiaries of the ongoing tensions, and so do top energy producers. JPM analysis suggests crude prices could spike to $125-150 given the escalations1.

In currencies, the upside for USD against JPY looks less compelling with visibility on geopolitics low in the near-term and already significant tightening priced in for the Fed. The GBP could be weaker against CHF. The UK is one of the largest energy importers in G10, leaving it vulnerable to an even more negative terms of trade shock; there is already more hikes priced for the BoE than we think will materialize this year, leaving rate differentials vulnerable to compressing; and CHF is a broadly defensive, safe-haven currency that benefits in environments like today’s. Gold is showing why it deserves a role in portfolios, but we think this rally offers the opportunity to reduce overweights given how stretched current prices are relative to real rates.

EQUITY MARKET MOVES AROUND GEOPOLTICAL EVENTS

Sources: Bloomberg Finance L.P. as of February 21, 2022. Note: Shaded events occurred around recessions.

Over time, politics, economics, and markets are likely to find a new equilibrium. For instance, Russia could see a situation with more territory, but a weaker economy hamstringed by sanctions and the ongoing costs of war. Energy markets may find calm as Russian exports are diverted to other importers and other producers step-up, allowing central banks to refocus on fundamentals. Whatever the path may be, we expect the world to heal from the damage—but there would be pain felt along the way. Furthermore, economic fundamentals tend to dominate over time and here the backdrop of healthy growth, Fed tightening, higher inflation, and COVID effects will have a bigger impact than this conflict.

Thus, don’t overreact with the “sell” button. While markets may stay volatile until investors get more clarity, we continue to believe that other dynamics (inflation, central bank policy) would be more significant performance drivers in the year ahead. On the whole, we’re urging investors to review intra-asset class exposures and upgrade quality where possible as the cycle continues to progress. Otherwise, our conviction in diversified portfolios’ ability to deliver solid returns from here remains intact. 

1 J.P. Morgan Investment Bank as of February 2022

All market and economic data as of February 25, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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  • The MSCI Russia Index is designed to measure the performance of the large and mid cap segments of the Russian market.
  • The Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Annuities are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Equal Housing Lender Icon Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.