Article

Markets then and now: What’s changed after a year of war in Ukraine and rampant inflation?

Russia-Ukraine conflict: what’s the impact on Europe?
James Rutland Lyndon Man Sudip Hazra Elizabeth Gillam Michael O’Shea Arnab Das Bjoern Wolber
Fund Manager Co-Head of Global IG Credit Director of ESG research Head of EU Government Relations and Public Policy Senior Public Policy Manager EMEA Global Market Strategist Head of EMEA Investment Analysis
Key takeaways
1

In our analysis, Invesco experts offer key insights into the changing risks facing markets and offer their views on what this means for fixed income and equities.

2

The outbreak of conflict on 24 February 2022 exacerbated inflationary pressures. And in hindsight it seems clear that central banks reacted too slowly.

3

Geopolitical and energy risks, though still present, have receded. The focus has largely shifted to monetary policy and whether central banks can curb inflation and avoid recession.

On the first anniversary of Russia’s invasion of Ukraine, the outlook for the global economy is much changed. Geopolitical and energy risks, though still present, have receded. The focus has largely shifted to monetary policy and whether central banks can curb inflation and avoid recession.

So, Russia’s belligerence is just one facet of a complex macroeconomic environment. After years of persistently low inflation, the post-Covid economic restart in late 2021 unleashed inflationary forces across the world as pent-up consumer demand was released despite snarled supply chains. The outbreak of conflict on 24 February 2022 exacerbated inflationary pressures. And in hindsight it seems clear that central banks reacted too slowly. In Europe, meanwhile, the war has had an outsized impact, especially on its energy security.

Amid this backdrop, Invesco experts offer insights into the arc of economic, geopolitical and policy changes since the war started. They also offer their views on key asset classes and environmental, social and governance (ESG) considerations.

Flexible thinking in the fixed income space

The period following the invasion was the worst ever for global credit, which lost 18% from January to October1, surpassing even the drawdowns of 2008.

“In truth, the conflict was more of an aggravating factor to the monetary tightening by central banks which had started in Q4 2021,” said Co-Head of Global Investment Grade Credit Lyndon Man.

“Nevertheless, we did see European assets impacted more acutely given the physical proximity and the tighter squeeze on energy supplies.”

Man expects the US Federal Reserve’s rate hikes to “top out” this year, notwithstanding some recent hawkish2 comments.

"The European Central Bank is playing catchup and European spreads remain wider3 vs. US; Asia also looks attractive having underperformed last year. Though we had a strong rally in January, yields are still at highs not seen since 2009, while flows and corporate fundamentals remain broadly supportive,” he said.

There may further bumps as we approach the top of the monetary cycle, but we believe current yield levels provide a decent cushion, particularly at the front end. We favour investment grade over high yield given the former’s greater resilience in a weakening economy and our expectation of softening rates.

Co-Head of Global Investment Grade Credit Lyndon Man

European equities: Renewables in focus

Fears that Europe could face widespread energy shortages were commonplace at the outbreak of the war. But a relatively warm winter helped countries navigate the crisis despite higher energy prices.

“After the initial shock sell-off when Russia invaded Ukraine and subsequent short-term market recovery, energy security and inflation have become the dominant themes driving the European market,” said European Equities Fund Manager James Rutland.

“Energy costs have already fallen substantially, with economists revising up their negative economic forecasts accordingly. With inflation starting to fall from high levels, we could see the headwind from falling real wage growth turn into a tailwind and therefore a rather better outlook for the consumer alongside the broader economic environment,” he said. 

From a structural perspective, the war has only added to the desire for Europe to become more energy self-sufficient, requiring a significant increase in renewables, something already well underway. Therefore, companies geared into the green transition, including energy, materials and utilities, should continue to benefit.

European Equities Fund Manager James Rutland

ESG and policy: The energy transition

The EU agreed to phase out the bloc’s dependency on Russian fossil fuel imports in March last year. It banned almost 90% of all Russian oil imports by the end of 2022 (with a temporary exception for crude oil delivered by pipeline). In December, it followed up with the introduction of a temporary emergency energy price cap to protect its citizens from excessively high gas prices.

“While much of the response this past year has been dealing with the immediate priority of keeping the lights on by finding alternative sources of gas and oil, political focus is starting to shift towards more structural reforms. These include the structure of the European electricity market and measures to further support renewable energy,” said Invesco’s EU Government Relations and Public Policy team.

The energy trilemma – energy security, affordability, and sustainability – points to renewables in the medium to long term as a resolution to some key underlying pain points around regional energy supply and fossil fuel-led inflation, according to Sudip Hazra, Head of ESG Research.

“Calls for the oil and gas sector, which has the expertise and cash flow to increase investments into the energy transition via diversification into renewables, look set to continue,” he said.

Questions around the idea of a “Just Transition” have also been brought to the fore since the Ukraine invasion – focusing on the equitable spread of the costs and social impact of decarbonisation. Affordability and the cost-of-living crisis are key drivers. Windfall taxes on fossil fuels which have the potential to redistribute profits to consumers remain on the table in some jurisdictions.

Head of ESG Research Sudip Hazra

Fact box: Russia’s invasion of Ukraine

Russia began what it called a ‘special military operation’ on 24 February 2022 with the expectation of a swift victory.

In a speech on 24 February 2022, Russian President Vladimir Putin said the military operation was launched with the aim of the “demilitarisation and ‘denazification’ of Ukraine”. The Ukrainian government rejects Putin’s characterisation of their country. 

This is a war of attrition. Western support for Ukraine must balance the country’s need for weapons, kit and training against the risk of antagonising Putin and escalating the war. The Kremlin has shown no signs of backing down. Sanctions are handicapping Russia’s military, but the economy is coping and even adapting to its pariah status. The conflict has caused a humanitarian tragedy. More than 7,000 civilians have been killed and millions of Ukrainians have been displaced[4].

What might come next?

Invesco’s Global Market Strategy (GMS) office expects persistent geopolitical risks to boost national fiscal and regulatory activism driven by national security considerations. 

Markets seem to be focused on macro factors after a year of war: China’s reopening, hope for a ‘soft landing’5 in the US, lower inflation, and global growth. Europe has coped surprisingly well so far. Energy subsidies, price controls, a more diverse mix of supply and an unusually warm winter have prevented stagflation. Gas costs are now falling.

Looking ahead, Global Market Strategist Arnab Das expects “reglobalisation”, a reform or restructuring of globalisation with guardrails, rather than deglobalisation. Portfolios are likely to be best served by diversification rather than convergence or concentration,” he said.

The energy shocks of 2022 may not repeat even if the war drags on but there is still the risk of a cold winter next year. And in a new cold war, commodity prices might be structurally higher in Europe and the West than in Asia or Emerging Markets. The war is reconfiguring the international system, with major implications for the global economy and strategic asset allocation.

Global Market Strategist Arnab Das

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Footnotes

  • 1 Based on the Bloomberg Global Aggregate Corporate Index in USD hedged terms. Source: Bloomberg.

    2 Hawkish policymakers favour higher interest rates to keep inflation in check.

    3 A spread refers to the difference between two prices, rates, or yields.

    https://data.unhcr.org/en/situations/ukraine

    5 A soft landing is a cyclical slowdown in economic growth that avoids recession.

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