Scenarios for the Russia-Ukraine conflict

Scenarios for the Russia-Ukraine conflict

Military parade in a Ukrainian town.

Geopolitical events often follow a very similar pattern. First, the conflict consumes the headlines of the press. First the general one and then it leaves its place to the most sensationalist. With the first headlines, investors show some panic causing a period of volatility in the market (January-February).

As the media pressure decreases, so does the volatility, although, although the conflict is still present, it is no longer the media epicenter. Finally, as long as the fundamentals of the economy are not greatly affected, financial markets return relatively quickly to what they were focusing on before the fire alarm sounded.

Currently, that epicenter is inflation, and the effect, the reaction function of the US central bank.

According to a Northern Trust AM study looking at all the geopolitical events over the past 70 years and how financial markets responded, both in terms of the duration and size of the loss, as well as the length of time it took to recover previous levels, on average, markets lose about 4% and offset those losses in just over a month.

The current geopolitical event is occurring at the time of another pressing question for markets: the timing and extent of the Federal Reserve’s monetary policy tightening. As such, it’s a bit difficult to separate the two debates, but overall, global equity markets are down 8.6% (US equity market down 10.5%) on point, bouncing 5.7% on average (6.6%). Both are currently down 5.2% and 7.6% respectively so far this year. Apparently this market weakness can be seen as an opportunity.

From here what can happen with Russia-Ukraine? Outlining scenarios and assigning probabilities is always a useful tool with uncertain events such as geopolitical tensions and risks. Next, I describe the three most likely scenarios, which would be the best assumption about the probability of each scenario and the impacts on growth and inflation fundamentals. The probabilities of course are totally fictitious and are only intended to expose my conviction in their degree of compliance.

1/ full invasion: Russia invades with the intention of taking full control of Ukraine (10% chance).

Impact on growth: Negative for emerging and developed Europe. Trade would be negatively affected and, depending on the sanctions regime that is put in place, European financial institutions would be at risk of capital impairment of Russian and Ukrainian assets. Higher energy prices would also hurt economic growth, and uncertainty about energy supply would also be a hindrance (double whammy).

Impact on inflation: Energy prices rise and secondary effects are likely to arise clashing with ECB expectations and what the market is pricing.

two/ partial invasion: Russia consolidates its de facto control of the Donbass region, and perhaps elsewhere, but does not intend to take full control of the country. By doing so, she sends a signal to the Western world of how seriously she takes their safety (40% chance).

Impact on growth: Negative but moderate, and not a game changer for developed Europe depending on the sanctions regime.

Impact on inflation: Negative in the short term, but could fade relatively quickly if the situation stabilizes and energy markets continue to function. Energy prices would take time to normalize, but the end of winter would help offset the price x volume effect.

3/ no invasion: Russia withdraws a large part of its troops (although it is also likely to maintain a very significant presence for a longer time) but obtains enough diplomatic concessions to refrain from invading (50% chance).

Impact on growth: positive but moderate and mainly due to lower energy prices.

Impact on inflation: Positive through lower energy prices, which will shorten the time for headline inflation to return to target.

Making it clear that in no case is there an invitation to make decisions derived from an eventual investment, the most plausible scenario should be the one with the highest probability. Markets will therefore remain focused on monetary policy factors rather than geopolitical issues although it should not be forgotten that, as I mentioned a few months ago in the hot topics for this year, while inflation and China concentrated attention, a silent killer could alter the order of risk: geopolitics.

Military parade in a Ukrainian town.


Leave a Reply

Your email address will not be published.