The war in Ukraine is having a significant impact on global economics and financial markets which we need to consider, even when the most important topics are the deaths, ruined lives, destroyed communities and flattened cities in Ukraine. It is difficult to know just how the war is progressing given the propaganda emanating from Russia. The length and any possible escalation of the conflict will be a key determinant in the path of the world economy over the coming months, which could have longer lasting consequences.
Economic reality
We should remember that prior to the invasion of Ukraine the world was facing sharply rising inflation, higher interest rates and slowing economic growth, mainly driven by higher energy prices and labour costs and some supply chain shortages. All of those factors have been exacerbated by the war.
Central banks; the days of “all talk and no action” are firmly behind us
Central banks have always used rhetoric as a way of managing financial markets and expectations of future policy, which can in itself impact on economies. It was often possible for them to get the desired result without taking any significant action. That is not the case today. Inflation is so high and with significant ongoing upward pressure, the banks have had to act, but they are also, still, talking a good game.
In the US, the Federal Reserve Bank (Fed) raised interest rates as expected by 0.25% at their March meeting and also signalled that there may be as many as six more increases this year. The Chair of the Fed, Jerome Powell, followed up those comments on Monday 21 March with even tougher talk of the Fed taking the necessary action to quell inflation, which would suggest they are willing to risk economic growth and possibly recession in the fight. That is quite a change in stance and language since the global financial crisis in 2008.
The European Central Bank (ECB) has not had to contend with such a strong economy as the Fed and has been more sanguine in words and actions, but that has also had to change; not to the extent of actually taking any action so far. But they are clear that they will be doing so.
In the UK we have had three increases, taking the base lending rate to 0.75%, with clear indications that there are more to come.
These actions increase the cost of borrowing for individuals and companies and will slow economic activity, although not in the short term.
Are governments following the lead?
There is no independent central bank in China, which you would expect to be the case. The economy has been stumbling and there are big concerns around the highly indebted property sector causing a financial crisis. COVID cases have been rising and the war in Ukraine has shone a light on the Chinese response to Russia’s actions and what its stance may be. Unsurprisingly, Chinese financial markets have been suffering. More surprisingly, the government has said that it will take action to boost the economy and markets in the short term; an unusual move.
At home, we are experiencing a sharp jump in the cost of living; energy prices are leading the way, closely followed by food, both of which are as a direct result of the war. This is coming at a time when tax increases from central government are coming through and higher council tax bills are arriving in letter boxes. Without some of the external pressures, we should be enjoying a recovery driven by the easing of COVID lockdown restrictions. Instead we are facing a tough time ahead.
In the Chancellor’s Spring Statement, we saw him provide some immediate support for lower earners and the promise of a lower basic rate of tax in 2024. However, middle earners will still feel the squeeze. The significant reduction in growth forecasts and increase in inflation expectations are not really here or there in the short term; it is very difficult to forecast in this environment. However, how the Bank of England reacts to the actual outcome does matter.
In no way can the economic uncertainty or pain we are experiencing be compared to what Ukrainians are going through, but we are experiencing direct consequences of Russia’s actions.
Financial markets have not been calm, but they have been robust in the circumstances
Clearly the prices of oil and gas have been strong, as have industrial metals and agricultural products, meaning that commodity markets, overall are higher. However, bond markets, although weak, and stock markets have been better than might have been expected.
Bond markets would be predicted to be weak in the face of rising inflation and interest rates. However, they do provide some safe-haven characteristics in times of stress and investors are already looking beyond the medium term and thinking about rapidly slowing economies, recession and the attraction of bonds in that environment.
Stock markets are not homogeneous in nature; they are made up of a diverse range of companies from different geographic regions and industry sectors. They are further diversified by size, quality, growth prospects, and management teams amongst other factors, meaning that each company’s share price is impacted by a number of different factors. However, we typically talk about “stock markets” as one.
Overall, markets, if taken as the MSCI World Index, are higher than they were on the day of the invasion. But this hides many different features; fairly obviously oil, gas and resource companies are, mostly, higher and those companies negatively impacted by the war are lower. As I mentioned above there are many factors that drive share prices; company specific factors are one and macro-economic factors are another. The latter of those has meant that a number of large technology and communications companies that had performed very well through COVID and sold-off as economic recovery came through have come back in favour. These include Apple, Amazon and Microsoft, although associated others have picked-up as well. These are large companies and therefore drive market levels themselves.
In the short term it should be expected that all asset classes will be volatile, whilst we have such uncertainty abounding.
What does that all mean for the medium and long term?
It is too early to count the financial cost of the war, in fact given the potential long term ramifications that I wrote about in the last update, such as a reversal of globalisation, we may never know. But, the cost will be counted in trillions of US Dollars. In the shorter term, President Zelenskyy has already said that the physical damage, alone, to Ukraine will cost US$100 million to repair and that is before we even consider the wider consequences.
In broader and global economic terms, the global economy will suffer, the cost of living will rise and it will be with us for some time.
As for asset prices; bond markets are likely to remain out of favour unless they regain their safe haven status in the face of escalating military action. Stock markets have recovered well and are likely to remain fragile; but within global markets we are able to find countries, industry sectors and individual companies that we are able to invest in with confidence for their prospects over the long term. There are other asset classes such as property that can be attractive in this environment as well.
It is appropriate to express some caution on financial markets overall, but we manage active funds and seek to take advantage of volatile market conditions in the short term. In the long term there remains plenty of opportunity.
By Neil Birrell, Premier Miton