Tensions between Russia and Ukraine may lead to increased market volatility and even recession

The first half of 2022 has been chaotic for markets and economies, and the Russian-Ukrainian conflict since February has contributed to adverse effects, including “higher interest rates, inflation, supply chain disruptions.” supply, geopolitical instability, rotation within markets and a shift in consumer preferences,” said William Davies, chief investment officer at Columbia Threadneedle Investments, during a recent roundtable.

Ukraine’s economy could shrink by more than 45% due to the war, the World Bank estimates.

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According to the World Bank’s April 2022 update for Europe and Central Asia, Ukraine’s economy could contract by more than 45% due to the war, which has “triggered a catastrophic humanitarian crisis”. and weighed more broadly on Europe. Risks to its natural gas supply, partly controlled by Russia, have recently intensified. The region’s economic output is expected to contract by more than 4.1% during the year, according to the World Bank. The Russian economy was expected to plunge 11.2% due to sanctions that triggered a deep recession in the country.

How do these events relate to the global economic outlook and what do they mean for the US economy and markets? Columbia Threadneedle investment strategists presented four possible scenarios at the July event:

The status quo continues. A continuation of the conflict at roughly the same level as in recent weeks could mean a prolonged engagement in Ukraine. Eventually, Russia could set up a new government in the country after a ceasefire. In this scenario, markets in the US and Europe can expect slower growth with more sticky headline inflation, mainly due to higher oil prices. US and European markets can expect gains in 2023 of just 1.8% and 2.2%, respectively, while Asia-Pacific markets can fall 0.3%, according to Columbia Threadneedle.

Russia is stepping up. More conflict will result in increased market volatility and economic turbulence. It’s not an unlikely scenario: Russian Defense Minister Sergei K. Shoigu ordered his troops to “further intensify” military action in Ukraine last week due to retaliatory skirmishes by Ukrainians in territories occupied by Russia.

Columbia Threadneedle estimates that with such escalations, 2023 stock markets in Europe and Asia-Pacific could fall 16.7% and 10.2%, respectively. They expect US markets to fall just 2.2% next year.

China gets involved. The most dire scenario for global economies is if China decides to become more aggressive militarily, expand aid to Russia, or take advantage of the situation to reignite its own conflicts. Formal retaliatory sanctions against China could trigger a deep global recession in 2023, with Asia-Pacific markets falling 34%, followed by European and US markets nearly 27% and 20% respectively, according to Columbia Threadneedle.

“Russia itself is a relatively small part of the financial indexes,” Davies says. “Its activities have been dramatic in terms of the human element, the economy in Europe and oil prices, but we cannot deny that China’s impact on the world is currently stronger. It makes up a much larger share of most financial indices and is very much tied to the global economy.

De-escalation is happening. The relatively optimistic scenario for markets described by Davies is a de-escalation of the war to the point where Russia surrenders or regime change leads to an end to the conflict. At this point, the US, Europe, and Asia-Pacific markets could see growth in 2023 of around 3.6%, 8.7%, and 11.3%, respectively.

Davies said the US economy could just be ‘flirting’ into recession or we may already be in one. Russia’s invasion of Ukraine has pushed up commodity prices and rising inflation has raised interest rate expectations. Markets now expect nine hikes (including a couple of half-point hikes in the second quarter) “carrying the fed funds rate to 2%-2.25% by the end of the year,” says Davies.

This would slow economic growth, but the US economy should rebound next year given strong consumer finances and healthy corporate balance sheets. Europe, however, could slide into a deeper recession towards the end of the year, especially if it experiences disruptions to its energy supplies, Davies says.

Strategists at Columbia Threadneedle believe companies with pricing power will survive volatility and supply chain and inventory issues, while economically sensitive stocks will continue to come under pressure. Volatility will continue to be a concern.

However, they see improved confidence in fixed income assets that have generated high returns and say emerging markets are a tremendous opportunity.

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