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Beyond the fog of war II: Three lessons from our webinar

Beyond the fog of war II: Three lessons from our webinar
Key takeaways
1
In our second Russia-Ukraine webinar, Invesco experts assessed three potential scenarios around the economics of war.
2
In the central scenario – which is a war of attrition – panelists assessed possible approaches to asset allocation.
3
The other key themes included the war’s impact on a globalised economy and its implications for the energy transition.

With Russia’s plan for a quick victory in Ukraine dashed, a prolonged war seems like the most likely scenario.  

In our second Russia-Ukraine webinar, Invesco experts assessed this scenario with others and discussed the economics of war. Here are some highlights from the discussion.  

“There are a multitude of possible scenarios here, so what I've tried to do is to group it into three broad areas,” said Paul Jackson, Invesco’s Global Head of Asset Allocation Research.  

Usually those high [energy] prices sow the seeds of their own destruction. Because you get the destruction of demand, either because you get recession or because we switch sources of energy

Paul Jackson, Global Head of Asset Allocation Research at Invesco

"If you think about the immediate economic impact, for me, it's what I would call moderately negative force a global economy, maybe 0.5% or 1% reduction in 2022 GDP, a moderate boost to inflation.”

Three possible war outcomes

 

Scenario 1: Business as usual

Scenario 2: War of attrition

Scenario 3: Prolonged war and energy crisis 

Description

Russia withdraws or overruns Ukraine by mid-2022

Ukrainian resistance prolongs the war into a multi-year affair

War is prolonged and Russia cuts energy supplies to Europe — 

Commodity prices

Down

Stable at elevated levels

Big increase 

Global GDP impact (2022)

Slight negative

Moderately negative

Significantly negative  

Recession risk

Low

Moderate

High 

Inflation impact (2022/3)

Slight boost

Moderate boost

Strong boost and then decline 

Stagflation risk

Low (high in Russia, Ukraine, Belarus)

Moderate (higher in countries close to the conflict)

Very high in Europe, moderate in US, low in China 

Notes: There is no guarantee that these views will come to pass. Source: Invesco Global Market Strategy Office

How do high energy prices sow the seeds of their own destruction? 

Europe's energy security has been in focus since the outbreak of war given Russia’s importance as an oil and gas supplier to EU states. 

In a real-world scenario that results in higher energy prices, Jackson said: “Usually those high prices sow the seeds of their own destruction. Because you get the destruction of demand, either because you get recession or because we switch sources of energy, we get more efficient in the way we use energy. And you get an increase in supply.” 

Germany is one of the more vulnerable members of the EU, said Stephanie Butcher, Invesco EMEA’s Henley-based chief investment officer. 

“In a way that is more helpful for the cohesion within Europe because there is more of a balance coming through and a sense of having to work more closely collectively to deal with energy pressures coming through here,” she said.  

At the same time, the pressure from the war on energy supply accelerates the environmental, social and governance (ESG) trend.  

“For Europe, perhaps the focus hasn't been so much about security of supply, which obviously right now is front and center. But the desire was already to move away from fossil fuels from an environmental perspective,” said Butcher.  

What does the war mean for globalisation? 

In setting the scene for the discussion, Kristina Hooper, Invesco’s chief global market strategist, looked at the “one-two punch” that the Covid-19 pandemic and Russia’s invasion of Ukraine present to a globalised economy.  

“I would argue that when we go back and look at this time frame, it will look like a blip, that it will be a period in which we experienced a shorter-term setback on the path towards greater progress, greater globalisation. I would anticipate that globalization comes back stronger than ever and that there's greater cooperation among many nations, if not all,” she said.  

"While in the short run politics might dominate the decisions that countries and companies make, usually over the longer term, it's economics that do that.” 

How could investors approach the current environment? 

In the central scenario of a war of attrition, Jackon said he would favour equities and investment grade fixed-income assets.  

There is also more inflation in the system, said Butcher.  

“Some areas of equity markets manage quite well in an inflationary environment. What will really determine the extent to which the equity markets too can stay at these sorts of levels and where they move from here is going to be earnings delivery,” she said.  

Butcher said that the crisis underscores the need for balance within a portfolio.  

"It’s about having more balance within portfolios than has been the case in the previous decade and ensuring that portfolios have the right sort of mix across assets and sectors.” 

The economics of war also provides a reminder of the importance of having exposure to alternatives.  

“We've advocated for a long time the importance of diversification both across and within equities, fixed income and having an alternative strategy in there,” said Hooper. 

Q&A session

Due to time constraints the panel were unable to answer all questions live. Here is a selection of answers that the panellists provided after the webinar:

European inflation is currently lower than that of the US and we would expect that to continue to be the case, with the European economy impacted more negatively by the war than the US. However, were Russia to cut Europe’s energy supplies, the corresponding loss of production could boost European inflation (due to lack of supply) and that could cause Europe to have higher inflation than the US. 

That seems to be the intention of the ECB and markets appear to be pricing-in multiple hikes. The ECB will be focused on higher rates of inflation but will also be expecting that (and other effects from the war) to weaken the economy and thereby reduce inflation over the medium term. The ECB is likely to raise rates this year – but perhaps only once or twice.

Although opinion polls suggest the gap has closed, it is likely that Emmanuel Macron will win the election. But if Le Pen were to win, though condemning the war in Ukraine, she would be less likely than Macron to play a leading role in the isolation of Russia, while being more willing to normalise relations with Russia once the war is over.  

No.  Europe gets more than 20% of its energy from Russia and taking that to zero would be a multi-year process. Even the EU’s target to reduce gas purchases from Russia by two-thirds this year seems ambitious. 

Never say never...and many investors think that gold provides mitigation against inflation. Gold also tends to do well in times of recession because bond yields fall. However, a geopolitical risk premium is already in the price and it is surprising that gold hasn’t weakened more in the face of rising real treasury yields. At these prices, there could be more downside than upside. 

Compared to historical norms, yes. However, that doesn’t mean they can’t go higher in the short term, depending on developments in Ukraine. But history suggests that prices don’t remain this high for very long. 

That depends on what is meant by “durably”. Over the long term (i.e. decades), there is a strong headwind to inflation – lower population growth. In the short term, the inflation impulse coming from commodity prices is easing (the year-on-year gains are lower than a year ago), so we expect headline inflation to come back towards core by the end of the year in many places. However, core inflation is now higher than we have seen for some time and looks as though it will remain above the commonly used 2% central bank target over the coming years (certainly to end-2023 and perhaps beyond). If we are wrong and core inflation remains at current levels for longer, we would expect bond yields to move significantly higher. The effect on equities will depend on the nature of the inflation but as it generalises (away from being purely cost-push), inflation could turn into a positive (profits will rise if selling prices rise at the same rate as costs).  

Certainly not. The US dollar has benefitted from its perceived safe-haven status and some other US assets may have outperformed over the last month or so (but not all). History suggests that geopolitical risk premia do not last very long, so we would expect a reversal of many so-called safe-haven trades over the coming months. Further, US equity indices benefitted over recent decades from the heavy weighting in growth stocks (as bond yields declined) and this is now reversing. Finally, the recent crisis shows the strength of diversification. We never know where the next emergency will occur and the US has been the source of some big shocks in the past.  

We are always worried about inflation, as it is the one part of the economic cycle when economically sensitive assets (equities and real estate, say) have tended to underperform. Volatility also tends to rise during recessions. On balance we believe we are still in the early stages of a new cycle but, as ever, there are signals that contradict that view. In particular, US unemployment is close to historical lows and inflation has risen sharply. Those are data points we would expect to see at the end of the cycle, along with inversion of the yield curve (which is now visible in parts of the US yield curve). The US Federal Reserve is usually at the end of a tightening cycle when those symptoms are present but it has barely started this tightening cycle. If recession comes, it most likely won’t be caused by the Fed. 

Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.