War in Europe: investor fears stoked by risks of Russian-Ukraine conflict

A Russian invasion of Ukraine has been on the cards for some time. But one that wasn’t considered a high probability, with only a boost in energy and gold prices of late signs of investors nervousness about the potentially economic and financial consequences of such an event. The balance of probabilities shifted on Friday after the US warned an invasion could be imminent, and occur before the end of the Beijing Winter Olympics – something that was recently considered unlikely due to Russian fears of attracting the ire of China-- as Russian forces amass along the Ukrainian border.

How have investors reacted to the prospect of an invasion?

The developments – really, another potential supply shock for the global economy – rattled investors. Stocks were dumped, pushing the S&P500 down by another 1.9%, though stocks that benefit from increased military spending surged. Safety was sought in long-dated Treasuries, pushing the US10 Y back to 1.9%. Gold flew on fears of a Russia isolated further from the global financial system. Energy prices pushed to new highs on supply fears. And sold Euro was sold on risks to Eurozone growth, with bought the Dollar bought as well as the Yen as yields fell.

What impact would a conflict have on global markets?

The biggest issue here is whether bomb’s are drop and troops are run through Kyiv and the rest of Ukraine. For market participants, the impacts are the potential economic sanctions and disruptions to energy production that’s posing the biggest risk. Of course, this is why we saw oil prices crack new 7-year highs – WTI is trading around $US93 per barrel right now – and gold spike 1.7%. Should an invasion occur, US sanctions will come down on Russia, which would see assets frozen and, more painfully, Russia locked out of swift. The result from there would probably be a halt to gas imports into Europe, not to mention the likely cessation of Nord Stream II, strangling an already vulnerable Euro gas market, and pushing up broader energy prices. There would also be the growth effects – war, even if the conflict remains largely isolated to Ukraine, is no good for growth, but another supply shock that could disrupt existing pressures on global supply.

Monetary policy expectations unchanged with inflation risks heightened

Although a risk to the economic outlook, amidst persistent fears of tighter global monetary policy, the situation in Ukraine does little to change the arithmetic. If anything, it might make it worse. That’s because although there will be inevitable growth implications from an invasion, and some sort of war, this event would be another supply-shock, and have inflationary consequences for the global economy. Obviously, the key element is energy prices, the increase in which would put further upward pressure on inflation globally, and compel central bankers to tighter policy more aggressively. The dynamic was probably communicated through the yield curve on Friday night. Although long-dated rates fell, the short-end was less affected, suggesting limited change to policy expectations. The 10-2 spread tightened marginally to 43 basis points, as the trend lower there continues to stoke recessionary concerns.

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