What does Russia’s invasion of Ukraine mean for markets?

Russia's invasion of Ukraine mean for markets

In the midst of the tragic events taking place in Ukraine, in this document, Schroder’s experts analyze the current situation, what has happened, the possible scenarios and the implications for the market.

With the start of 2022, geopolitical risk has come to the fore as tensions between Russia and Ukraine and the West have escalated. Events have taken a sad and unexpected turn this week, as hopes for a diplomatic resolution have faded, and in the early hours of Thursday, Russia launched a full-scale military invasion of Ukraine.

This crisis continues to unfold and it is impossible to draw firm conclusions about the development of events. There is great concern about the humanitarian impact, but sadly the short-term prospects for de-escalation have faded. This will affect millions of people.   

Taking a step back, it is clear that there will be major consequences on a global level. New information continues to leak out and additional sanctions are being prepared from the West. Below, we analyze the current dynamics, review possible scenarios and assess the implications for the markets.

Geopolitical risk has come to the fore as tensions between Russia and Ukraine and the West have escalated. 

What has changed?

Recognition of breakaway regions and invasion of Ukraine

In the early hours of February 24, President Putin announced a major military operation in Ukraine. It was described as an effort to defend the population of two breakaway regions in eastern Ukraine: Donetsk and Luhansk. However, the incursion has not only extended to these disputed territories. Russia has launched a full-scale military invasion of Ukraine.

Russian troops have massed on its border with Ukraine in recent months. Russian forces have also positioned themselves on Belarus’s border with Ukraine, as well as in Transnistria, a breakaway region of Moldova that is supported by Russia. Since yesterday, together with Russian forces in Crimea and the Black Sea, these forces have launched attacks against targets throughout Ukraine.  

These moves follow President Putin’s decision to officially recognize the independence of Donetsk and Luhansk earlier this week. Both regions have been in a state of civil war since 2014, with neither separatists nor Ukrainian government forces in full control of them. Russia announced that it will recognize these regions in full.   

Russia opposes and has strongly opposed NATO’s expansion into countries it considers to be within its sphere of influence. One of the main issues of contention has been Ukraine’s constitutional commitment to join NATO in 2019. Russia has been seeking revocation of this commitment by Ukraine, or a NATO commitment not to admit Ukraine.  

Diplomatic negotiations have so far failed, and the path to de-escalation seems complicated. Abandoning Ukraine’s interest in NATO membership was always politically difficult for President Zelensky, while the West was wary of heeding the Kremlin’s demands. Given the degree of Russian aggression overnight, neither position seems likely to change any time soon.

Western sanctions

The United States and other Western allies announced new sanctions on Russia in response to the recognition of breakaway regions in the east. The measures were relatively limited in nature, but more severe sanctions are now in the works, details of which we await. Here is a summary of what was announced this week: 

The US sanctions include measures against two Russian banks, the expansion of restrictions on the trading of sovereign debt and on a group of individuals. It has also barred US citizens from investing in, negotiating with, or financing breakaway regions.

The EU sanctions target 351 Russian parliamentarians who voted in favor of recognizing the breakaway regions, as well as 27 Russian individuals and entities that the bloc believes, are playing a key role in relation to ongoing actions towards Ukraine. 

The UK has sanctioned five Russian banks and frozen the assets of three Russian citizens. In addition, Germany has suspended the certification process for the Nord Stream 2 gas pipeline, which runs between Russia and Germany. 

What impact could sanctions have?

Tom Wilson, Head of Emerging Markets Equities at Schroders:

“The Western sanctions response is expected to be forceful, but it is difficult to gauge the impact until we see its full extent. There is also uncertainty about the Russian response to sanctions. These will weigh on future growth, although Russia is a relatively difficult economy to punish, since it is not dependent on foreign capital, it is a net external creditor, it has negative net external financing needs, a disciplined fiscal policy, low public debt and an orthodox monetary policy. a major exporter of oil, gas, industrial metals, precious metals, fertilizers and raw materials soft like cereal. Russian exports in these categories often represent a significant part of world supply.

Sanctions affecting trade can cause global commodity prices to rise, leading to stagflation and causing economic problems. This may be especially serious for Europe, given its dependence on Russian gas. The threat of sanctions does not appear to have deterred the Russian incursion. However, an invasion may prompt a stronger and more sustained Western response than expected. It may be that NATO has redefined its objectives and that the Russian intervention triggers a significant increase in NATO’s presence in Eastern Europe.”

Are there broader implications for world markets?

David Rees, Senior Emerging Markets Economist at Schroders:

“From a global perspective, the focus will be on the impact of rising commodity prices and inflation. We’ve already seen a taste of what will happen with energy prices, but the impact on energy prices raw materials may be broader, given the importance of Russia in this area.

Inflation has been a major theme for investors. We anticipate a moderation in inflationary pressure this year, but above-target inflation levels are likely to persist longer and, indeed, could rise in the near term. Although we still believe some moderation will occur, more sustained inflation will hurt growth.

The last time we published global forecasts in November, we put the price of oil at $100 in a crisis scenario, but we may have to revise these forecasts. $120 could be the new target price in this scenario, but it could go even higher and that would have a bigger impact on growth. We have to wait for more clarity. Markets are volatile and uncertainty is extremely high.”

How have world markets responded?

Russian equities, as measured by the MSCI Russia index, were already down more than 24% in US dollars from the start of the year to February 23. Tuesday saw severe selling, with Russia’s MOEX index down more than -30%, and the Russian ruble down -8.5% against the US dollar. Russia’s 10-year sovereign bond yield has risen to 10.69%, its highest level since 2015. Ukraine’s currency, the hryvnia, fell by more than 9% before yesterday, before trading was suspended.

European and Asian equities also fell. Meanwhile, Brent crude rose around 7% to above $104 a barrel, its highest level since 2014. The US 10-year bond yield has risen to 1.93%, while the dollar index rose 1.2% yesterday.

What are the prospects from now on?

Russia’s recognition of these breakaway regions and subsequent invasion of Ukraine put a stop to almost any chance of the Minsk II agreement being implemented. This was the protocol signed back in 2015, which, although it did not end the conflict in these regions, was established as the basis for a resolution.

The de-escalation now seems even more complicated. Uncertainty has increased and the risk of a new escalation is palpable. Western sanctions are tightening and Russia’s response will be closely watched. The risk of longer uncertainty is high.

Johanna Kyrklund, CIO and Chief Investment Officer at Schroders:

“The main source of uncertainty is how Ukraine and the Western powers will react. The answer is supposed to materialize in the form of tougher sanctions. But there is also the question of whether at some point the West will be willing to intervene militarily.   

On the other hand, beyond the impact of geopolitical risk on risk premiums, the main economic transmission mechanism is through energy prices. This poses particular challenges for Europe given its reliance on Russian energy, has detrimental implications for growth and complicates the picture for the European Central Bank.”

Dorian Carrell, Schroders multi-asset fund manager:

“The magnitude of the military operations is an escalation that the markets did not expect. A number of steps are likely to be taken. Firstly, new sanctions will be imposed by the West. We also hope that Russia will respond to this in some way. Taking this into account, and given that Russia’s ultimate military objectives are still unclear, we do not believe that the peak of uncertainty has been reached. Indeed, market tensions and volatility could continue.”

Tom Wilson, Head of Emerging Markets Equities at Schroders: 

“The overnight invasion has put a lot of stress on the markets. In the short term, uncertainty will remain high and as a result, the risk premium on Russian assets is likely to remain high. awaiting details on additional sanctions from the West, and the response from Russia. The situation in Ukraine is serious, but we remain focused on making rational decisions, based on information as it becomes known.”