The following is a roundup of insights from our investment team on the Russia-Ukraine conflict, featuring views from our U.S. and European economists and analysts on implications for energy, cybersecurity, defence-related industries, financial services and more.
The transatlantic alliance has not been this united since the aftermath of 9/11. It’s quite remarkable how, after years of skepticism and finger-pointing — whether it was over NATO funding, the imposition of sanctions after Russia began the Ukraine war back in 2014, Brexit or the Trump administration’s America First agenda — Europe and the United States have quickly come together in response to Russian President Vladimir Putin’s unprovoked war in Europe.
For more than two decades, the U.S. has unsuccessfully urged Germany to ramp up its defence budget, halt the Nord Stream 2 pipeline and reduce its energy dependence on Russian gas. Yet, within 72 hours of Russia commencing its invasion of Ukraine, German Chancellor Olaf Scholz signaled a radical shift in multiple sacred pillars of German foreign policy: defence spending will quickly exceed 2% of German GDP, including an immediate €100 billion infusion; German-made weapons can now be sent to Ukraine; and Nord Stream 2 has been halted.
Historically neutral Switzerland has stunningly agreed to adopt all European Union (EU) sanctions against Russia, including freezing Russian funds in Swiss banks. Even traditional supporters of Russia, such as Miloš Zeman, president of the Czech Republic, have condemned the attack on Ukraine and called for harsh sanctions.
We should anticipate significant Russian retaliation for these unprecedented sanctions. This could include severely reducing or even cutting off oil and gas exports to sanctioning nations, as well as restricting exports of titanium and other critical metals. While curtailing oil and gas sales to sanctioning nations would deprive Russia of needed revenue, China would presumably fill some of that gap — at fire sale prices. Moreover, Putin has used the time since the imposition of Western sanctions in response to his annexation of Crimea in 2014 to build up Russian cash reserves and enhance Russian resilience.
Furthermore, we should prepare for the possibility of major cyberattacks on European and U.S. communications, energy and financial systems.
The Germans are preparing for a reduction of Russian gas exports, making plans to backfill with imports of liquid natural gas (LNG). This will be complicated by Germany’s failure over the past several years to complete construction of regasification facilities at its North Sea ports. There is little doubt that energy costs in Europe are likely to skyrocket, which are expected to be inflationary and dampen growth.
All that being said, Putin clearly miscalculated on two fronts: First, the fact that the West would come together as quickly as it did, despite European reliance on Russian energy, the newly elected government in Germany, and potentially distracting domestic challenges faced by U.S. President Joe Biden, U.K. Prime Minister Boris Johnson and French President Emmanuel Macron. Second, Putin miscalculated the intensity of Ukrainian resistance from both the military and civilians.
Notwithstanding all that, sadly, in the end, I think we could end up with an ugly “peace,” with Russia expanding its control over eastern Ukraine after having severely damaged the country’s national infrastructure. It is hard to see how Putin backs down at this point, absent massive domestic opposition within Russia. I expect this war will get worse before it gets better.
Markets have typically ignored major geopolitical events, or the impact has been more localized. The exception is when conflicts lead to energy supply shocks. A notable situation was the Yom Kippur War of 1973. After that war ended, OPEC, which was very much led by Saudi Arabia, announced a shipping embargo against the U.S. and Israel’s European allies. Oil prices skyrocketed, and the U.S. was particularly vulnerable, especially since it did not have the domestic production capabilities it has today.
Biden is walking a tightrope of trying to punish Russia while protecting American consumers. The energy market is very tight, and with inflationary pressures and mid-term elections in the fall, I think this could push the Biden administration to renegotiate the Iran nuclear deal. If you have more Iranian oil coming back into the market, it relieves some of the pressure. But this is still not a long-term solution.
It’s a messy policy debate within Europe and the U.S. on what to do about imports of Russian oil and gas. Western politicians are under enormous pressure from high inflation and its effects on real wages and purchasing power. So, while that has played a major role in policymakers providing sanction carve-outs for Russia’s energy supplies, public opinion could very well force a rethink on this. We can no longer rule out either Europe putting an embargo on Russian gas imports or Russia weaponizing its gas supply.
That appears to be the logical next step, and one that Western countries have so far avoided in this rising escalation. Ultimately, the events that are unfolding now will hasten Europe’s energy transition agenda and, in the interim, lead to structurally higher energy prices. These factors (or uncertainties) are being closely monitored by the European Central Bank (ECB) and the U.S. Federal Reserve, who will be keeping an eye on whether these feed into medium-term inflation expectations drifting higher.
Fiscal response: I expect European governments to use fiscal policy to support their economies in the face of the shock. We could see other governments adopting similar approaches to France, which has effectively pegged the price of gas for domestic consumers. While this is expensive, it would mitigate the impact of higher energy prices on inflation and damp the squeeze on real incomes. Governments might also consider compensation for businesses that are big users of gas.
As in the pandemic, national governments are likely to lead the fiscal response. Both Germany’s Scholz and Italian Prime Minister Mario Draghi spoke about the need for European solidarity. Given the potential scale of the shock, the EU will likely suspend its fiscal rules again this year, and there might well be discussions about extending or enlarging the size of the Recovery Fund (the EU’s collective fiscal response to the pandemic). As the EU considers its energy security and energy transition, it could conclude that such spending requires more fiscal integration across the bloc.
Central bank policy: The ECB and the Bank of England must decide whether to press on with their intended monetary policy tightening. A substantial energy-induced inflation shock creates an acute policy dilemma. While central banks would typically look through such a terms-of-trade shock, they will be aware of the lessons of the oil shocks of the 1970s. I expect both central banks to proceed cautiously given the extreme uncertainty around the scale and duration of the current shock.
Gas supplies: A further escalation of tensions could encourage Russia to restrict the supply of gas to the EU, or the EU could impose restrictions on gas imports. The EU has stored gas and could increase imports of LNG to see it through to the spring. Even so, in a worst-case scenario, the big users (Germany and Italy) might be forced to ration gas to heavy industry, inflicting a further economic shock. The United Kingdom has relatively low supplies of gas and imports primarily from Norway. But the U.K. is exposed to higher prices and could suffer if Norway diverts supply to the EU.
While the threat to Europe’s economy is far greater, the U.S. economy probably won’t emerge from this conflict unscathed. Rising energy prices were a problem prior to the invasion of Ukraine, and now are moving higher as global markets contemplate a world without Russia’s vast oil and gas supplies.
That could very well lead to higher U.S. inflation, which is already running hot. Price increases for food, energy, and other goods and services essentially rob U.S. consumers of their purchasing power. That can put a damper on consumer spending, which accounts for about 70% of U.S. economic activity.
Could it be bad enough to push the U.S. into recession? I’d put the chances at 25%–30% by late 2022 or early 2023. The R word is a much bigger issue for Europe, of course, because of its proximity to the crisis and dependence on Russian trade, particularly in the energy sector. Europe is more exposed than the U.S., but both economies could falter if the conflict isn’t resolved soon.
With the Fed poised to raise interest rates later this month, some market participants are wondering if the Ukraine crisis might give Fed officials a reason to keep rates near zero. I don’t see it happening.
The Fed is in a tough spot. With U.S. inflation hitting a 40-year high of 7.5% in January — and a war-related energy shock potentially pushing it even higher — Fed officials have no choice in my view but to raise rates at their March 15–16 meeting. In an ideal world, they could pause. But at this level of inflation, I don’t believe they have the luxury. That said, the conflict probably means a hike of 50 basis points is off the table. Rather, a more moderate increase of 25 basis points is likely.
Fed officials have clearly telegraphed their intention to tighten monetary policy. Investors should expect them to do so.
Direct exposure of European banks to Russia is limited, and that too is spread among a few banks. According to Bank for International Settlement (BIS) data as of September 30, 2021, overall exposure of European banks amounted to €70 billion and foreign bank exposure in aggregate was roughly US$104 billion. I’m focused on potential secondary impacts, which are difficult to quantify at this stage and will depend on how long the conflict lasts and how it evolves.
The impact of exclusion from the SWIFT system seems to have been limited so far. Only seven Russian banks will be disconnected from the global messaging system for financial transactions, excluding both Sberbank and Gazprombank.
There might be some impact on dividends, however. So far, only Raiffeisen Bank has canceled the 2021 dividend, and it is likely an outlier. No other bank has signaled any change in the dividend policy. I do see some downside risk to return of capital, and in particular to buybacks, but not a broad policy ban on dividends.
There’s no doubt that European banks need higher interest rates in Europe to improve their net interest margins, and the rise in rates has been put in question with this geopolitical shock. That said, the valuation of European banks is not yet discounting a higher rate regime.
The current conflict has been boosting global energy prices, but I would not go as far as arguing that they can now only keep going higher. Having said this, where we go on energy prices depends on the extent of U.S. and European sanctions against Russia. Importantly for the global energy complex, Russian oil and gas have been excluded from the sanctions for now. If this holds, it means we should expect some stabilization in oil and gas prices, although at higher levels.
Clearly, this is a very dynamic situation, and I would look for the following signposts as far as energy prices are concerned: One, further sanctions from the U.S. and Europe on Russian exports would imply higher prices in the short and medium term; and two, if we see Russia attain its strategic goals in the Ukraine, however those goals are defined, the sooner oil prices could decline to a more reasonable range of around US$80–US$90 per barrel. This assumes some “permanent” political risk premium.
As the war in Ukraine unfolds, cyberwarfare is likely to play a role. I suspect we will be confronted with some incredibly ugly realities that need addressing. My initial assessment is that this will support increased cybersecurity spending in the near term, but it will be more likely a meaningful inflection point for the industry. The Overton window (the range of policies politically acceptable to the mainstream population at a given time) around cyberwarfare as a tool in international relations could open wide and expose incredible weakness in U.S. and EU security.
Most U.S. critical infrastructure assets fail even basic cybersecurity protocols and penetration testing. I feel reasonably good about the U.S.’s large financial institutions’ security and the tech companies, but that’s about it. Energy and utility companies in both the U.S. and Europe have substantially underinvested in cybersecurity, and many companies remain vulnerable.
Against this backdrop I think cybersecurity investments have strong potential. I have been positive on the cybersecurity industry for two reasons: 1) the spending outlook and 2) the fundamental change in industry structure that allows for platform formation and hence more sustainable growth.
In the short term, I think accelerating cybersecurity budgets among corporations, and U.S. federal and state governments is a near certainty. And if the situation in Ukraine escalates, I think there is a chance for much more pronounced long-term changes.
The single biggest change could be a substantially different regulatory environment. Federal and state laws could become extremely prescriptive about minimum cybersecurity standards, especially in industries that are relevant to national security or impact the public. We could see an enormous investment cycle, specifically in the energy and utility sectors. In Europe as well, we could see a massive cybersecurity investment cycle and possibly an acceleration in cloud migrations.
Given the inherent difficulty of predicting geopolitical events, one has to plan for a range of outcomes for the U.S. defence complex. Assuming Putin stays in power after this war ends, I believe U.S. defence spending will accelerate from 2% to 3% year-over-year growth to 4% to 5% year-over-year growth over the next three years.
The U.S. defence budget growth drives U.S. defence stock prices. In addition to better fundamentals ahead, defence stocks are still cheap and consensus estimates could be too low. My belief is that these events will be significantly more impactful for European defence than for the U.S., but I can still pencil out double-digit base case returns for the entire defence group from current levels.
The setup today is supportive of this sector given the full-scale invasion of Ukraine coupled with the reaction from Germany, which announced it is substantially increasing defence spending. EU countries are taking Russia’s actions seriously. It is not clear how the U.S. government will react as it relates to defence spending, but I think it’s reasonable that we could see 4%–5% growth from current levels, given the need to modernize the force and compete with Russia and China. U.S. defence spending as a percentage of GDP is near all-time lows of 3.2% versus a level of 4%–5% that we have seen during periods of heightened threat levels or war, leaving a lot of headroom for budget growth in the U.S.