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Market Volatility
The Russia-Ukraine war could cast a meaningful economic shadow

Russia’s invasion of Ukraine has already had profound, and in many ways unexpected, geopolitical effects around the world, including the imposition of sweeping economic sanctions and the emergence of a new resolve within NATO.


It’s too soon to gauge the economic ramifications — both the short-term consequences as the U.S. and Europe attempt to minimize the damage from higher crude oil and natural gas prices, and the long-term repercussions as governments rethink the strategic framework that has guided post–Cold War policy. However, the length and intensity of the conflict will matter a lot.


“Much depends on the future escalation and duration of the conflict,” Capital Group economist Jared Franz wrote in a research note to analysts and portfolio managers.


Franz and other Capital Group economists in the U.S., Europe and Asia have tracked developments in Ukraine. The key issues they are monitoring include the economic ripple effect of higher energy prices and the more difficult balancing act facing central banks as they attempt to corral inflation without stunting growth.


Capital Group economists believe a prolonged conflict could aggravate already high inflation while increasing the risk of an economic downturn. Nevertheless, the U.S. economy has distinct advantages, including a robust job market, vibrant consumer spending and corporate earnings that are still expected to rise in the high single digits this year. Assuming the conflict does not escalate further, Franz projects U.S. GDP could rise 2% to 2.5% this year. That’s down from a 2.5% to 3% estimate at the start of the year but in line with pre-pandemic growth.


Here is a look at some central economic and investment considerations:


Energy availability has tended to affect global economies more than conflicts. 


Few outside the global intelligence community saw a full-scale invasion coming — a point to keep in mind when assessing the conflict and its potential course. Capital Group political economist Talha Khan says the situation is following the logic of escalation, with no immediately visible off-ramps. As such, it could become a prolonged and messy war with acute humanitarian and economic costs that reverberate through the global economy.


Energy prices have been volatile and rising this year

Energy prices have been volatile and rising this year. Oil prices started the year just under $80 per barrel and were under $120 on March 22. Prices peaked above $120. Natural gas prices started the year above $3 per 1 million British thermal units (BTUs) and were over $5 on March 22. Prices peaked above $5. Oil prices are daily Brent crude settlement prices per barrel. Natural gas prices are daily Henry Hub settlement prices per 1 million British thermal units (BTUs). Source: Refinitiv. As of March 22, 2022.
Source: Refinitiv. Oil prices are daily Brent crude settlement prices per barrel. Natural gas prices are daily Henry Hub settlement prices per 1 million British thermal units (BTUs). As of March 22, 2022.

Nevertheless, history can be a useful tool when considering potential investment outcomes. Khan examined hundreds of armed conflicts around the world and the corresponding results of the S&P 500 over a five-decade period ended in 2014. He found that even protracted conflicts rarely had a lasting effect, with the index actually rising, on average, about 10% over the course of hostilities.


“These kinds of major volatile reactions have typically tended to be good opportunities for long-term investors to make use of market dislocations,” Khan says. “The one exception is when interstate conflicts lead to energy price shocks.”


That may be the case today. Russia supplies more than 11% of the world’s oil exports and some 40% of Europe’s natural gas. Prices have surged, with Brent crude breaking $100 a barrel at one point for the first time since 2014. Initial sanctions by the West have specifically avoided targeting energy, though more punitive actions and Russian countermeasures could follow.


Khan’s analysis showed that in conflicts that threatened to disrupt global energy supplies or push up oil prices, the upfront drop in stock prices was more pronounced. Even then, however, the S&P showed gains by the end of the combat.


The U.S. likely learned from previous periods of high energy prices and inflation. 


The link between higher energy prices and slower economic activity is well documented. Franz estimates that every 10% increase in the cost of oil could shave 0.2 percentage points from U.S. GDP. In other words, a 50% jump in oil prices — providing it’s sustained — could slash 1 percentage point from growth.


However, today’s policymakers have the benefit of experience. Khan draws a historical parallel to the 1973 oil embargo, in which some members of the Organization of Petroleum Exporting Countries stopped shipments to the U.S. Prices spiked and never eased back to pre-embargo levels, settling about a third higher after the restriction was dropped in 1974. That structural change further fueled stagflation — a condition marked by stagnant growth and higher inflation, which plagued mthe ’70s.


The comparison isn’t precise — the U.S. is far less dependent on foreign energy today, and there was no global pandemic in the 1970s — but Khan says both periods tested the country’s economic policy response. In the ’70s, limited supply drove up prices and squeezed consumer spending power; today, it’s the challenge of reining in inflation while nursing an economic recovery that hasn’t fully taken hold.


“The lesson learned from the 1970s is that you have to carefully monitor inflation expectations and the risk that they become unanchored,” Khan says. “Once you get behind the curve, you risk getting into a wage-price spiral, in which workers demand higher wages to compensate for higher prices, which in turn causes prices to again increase. But if policymakers lift interest rates too quickly, they can hurt the green shoots of the economy before they have a chance to take hold.”


The eurozone faces the most immediate threat from higher energy costs.


Given its high dependence on Russian energy, Europe is deeply exposed to the economic turmoil caused by the invasion of Ukraine. However, the Continent is already exploring ways to reduce its reliance on Russian natural gas, says Capital Group political economist Michael Thawley. The Group of Seven economic bloc, which includes Germany, France and Italy, refused Russia’s request to pay for natural gas in rubles. Germany halted the certification of Nord Stream 2, a pipeline that would have ferried even more Russian natural gas into Europe. Alternatives include expanding renewable energy, turning to liquefied natural gas and simply sourcing gas elsewhere. But pivoting away from reliance on Russia won’t be fast or cheap. 


“Europe is going to have to restructure its energy sources and depend much less on Russia,” Thawley explains. “That means it will have to rethink both gas supplies and how it fulfills its energy needs. That will mean moving faster and spending a whole lot more money.”


Central banks could slow their plans to tighten monetary policy.


As part of their effort to control inflation and return to a more typical monetary environment, the Federal Reserve and the European Central Bank have signaled plans to taper accommodative policies. The Fed raised interest rates in March and telegraphed its intent to do so as many as six more times this year; the ECB has accelerated its plans to ease a bond-buying program. But the current instability could make policymakers rethink some of that, says Capital Group economist Robert Lind.


“Strong demand for oil and gas will compound these significant supply restraints,” he notes. “This could effectively raise inflation and depress growth at the same time. That would be the worst of all possible circumstances for policymakers because the combination of higher inflation and weaker economic growth is very hard for central banks to navigate.”


The problem isn’t as binary as “raise rates” or “don’t raise rates,” Lind adds: “If you leave policy too loose for too long, then you can actually add to the problem itself. I think they’ll be very cautious, very conscious to avoid those historical mistakes. I think they’ll proceed to tighten, but perhaps a little bit more cautiously than they would have done otherwise.”


Sanctions have been sharp and could become more so.


The U.S. and Europe have enacted a series of punishing sanctions on Russia. These include barring the Putin government, as well as certain banks and companies, from accessing Western capital markets. The U.S. imposed export controls that prevent Russia from purchasing critical technology for military and commercial uses. The West has also taken the rare step of targeting Putin’s personal finances, as well as those of business and government leaders close to him.


Perhaps most critical, the U.S. and Europe removed some Russian banks from the SWIFT financial communications system, essentially barring those institutions from conducting international transactions. Notably, the prohibition did not extend to all banks, especially those processing energy-related transactions. If it were to come, a blanket cutoff would mark a notable financial escalation that could effectively cleave Russia from the world financial system.


Select sanctions against Russia following the invasion of Ukraine

Select sanctions against Russia following the invasion of Ukraine. The United States is targeting approximately 80% of all banking assets in Russia; blocking Russia's technology and defense imports; blocking 13 major companies from raising money in the U.S., spanning multiple industries; and barring certain Russian banks from SWIFT. The United Kingdom is freezing assets at all major Russian banks; prohibiting all major Russian companies from raising funds; levying sanctions against more than 100 individuals, firms and subsidiaries; and barring certain Russian banks from SWIFT. The European Union is targeting approximately 70% of the Russian banking market; banning exports on equipment and technology for the energy sector; limiting the sale of "golden passports" to Russian elites; and barring certain Russian banks from SWIFT.

Other commodities could be shaken by the conflict and resulting sanctions.


Sanctions could affect more than just oil and gas. Russia is a significant supplier of minerals such as palladium (used in electronics), titanium (used in aircraft), nickel (a critical component for some renewable batteries), copper (ubiquitous among a wide variety of manufacturing and industrial applications) and potash (for fertilizer).


“The issue here is that Russia could reduce or cut off supplies of some of the key materials to counteract Western sanctions,” Thawley says. “Even if that doesn’t happen, importers are going to look to develop new supply chains that don’t depend so much on Russia.” That could mean higher prices as competitors chase new sources in tighter markets and higher prices for the finished goods.


Russia is a significant exporter of many commodities

Russia is a significant exporter of many commodities. Russia was the top exporter of fertilizer in 2020, based on value, at $7 billion; China was No. 2 at $6.57 billion; and Canada was third at $5.16 billion. Source: Statista. As of November 1, 2021. Russia was the top nickel and nickel products exporter in 2020, based on value, at $3 billion; Canada was No. 2 at $2.77 billion; and the U.S. was third at $1.47 billion. Source: Statista. As of May 26, 2021. Russia was the No. 2 exporter of crude oil in 2020, by share of value, at 11%; Saudi Arabia was No. 1, at 17.2%; Iraq was third, at 7.7%. Source: Statista. As of October 6, 2021.
Source: Statista. As of November 1, 2021. | Statista. As of May 26, 2021. | Statista. As of October 6, 2021.

While the hope is that the fighting will not spill outside of Ukraine, a wider conflict would compound these issues. Many governments have announced at least nominal support for Ukraine, and Russia has warned that it may seek to punish those offering material assistance or allowing military goods to flow through their borders to Ukraine.


“We should be sensitive to the risk that this could spread,” Thawley says. “It’s not negligible.”


Focus on the long term, and avoid the urge to time the market.


Any type of uncertainty, particularly a military conflict, is unsettling. Nevertheless, the best course of action has historically been to stick to your long-term investment plan. The pullback in global stock markets so far this year has reduced valuations while potentially creating opportunities among companies that have been swept up by selling pressure. Though it can be difficult to stomach market downturns as they play out, rallies have often come at unexpected times. And although past results are not predictive of future outcomes, markets have historically risen more than they’ve fallen.



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