Russia's Invasion of Ukraine: Where the Global Economy Stands One Year Later

As Russia's war in Ukraine enters its second year, news of unremitting battles and marginal gains has replaced the shock and volatility of the war’s first few months. While there’s no clear resolution for the war in sight, the world economy has largely adjusted to the sudden supply chain interruptions and catastrophic predictions that drove markets in the early part of 2022.

Today, the global economy is rife with mixed signals and uncertainty. While the recessionary forces that are currently rolling through economies are not entirely the result of the Russian war in Ukraine, the invasion created a major catalyst that sped up the timeline of inflation and recessionary pressures sweeping through Europe and headed for the U.S. Over the last year, certain parts of the global economy have teetered on fracture – the U.K. gilt crisis is one example – while other indications support a rosier outlook. The U.S. consumer, for instance, has shown resilience in the face of higher borrowing costs. This confidence may be buoyed by a U.S. labor market that has so far kept adding jobs.

The war came at a precipitous time for inflation. When Russia invaded Ukraine, inflation was already percolating as a potential threat. Supply chains were strained by labor shortages and post-Covid demand pick-up. As Western countries sought to constrain Russia’s ability to fund its war by levying sanctions, supply chains were further stressed, driving up prices and fear. During this time, the view of central banks shifted from price escalation being a transitory, post-pandemic peculiarity to inflation becoming a self-fulfilling economic threat. The Fed moved to curb inflation with quantitative tightening and the initiation of rate hikes in the spring of 2022, followed by the Bank of England and European Central Bank. Market sentiment cratered, and prices across all asset classes retracted in unison, even assets that are typically negatively correlated.

The European energy crisis lingers

Following Russia’s invasion, western countries and companies scrambled to unwind themselves from Russian investments and partnerships. This strained energy supply chains, and many experts predicted an energy crisis to peak in winter months in Europe.

U.S. consumers experienced surging prices at the pump, as gas prices increased over 40% following the invasion, reaching a record price of $5.02 by the summer. Diesel prices came into focus due to its industrial uses and uptick in demand following the pandemic – prices also rose over 40%, and for the first time, a gallon of diesel topped $5 a gallon in the US.

The rise in energy costs hampered industrial production in Europe while creating a cost-of-living crisis. The European Union set a price cap on Russian oil as European governments prepared for a looming winter crisis by replenishing reserves at high costs. Amid the fear of widespread rolling blackouts in the winter months, supplies of liquified natural gas were deployed from the U.S., and France scrambled to bring all of its nuclear reactors back online.

However, a milder-than-anticipated winter has provided some relief. Economic slowdowns and higher interest rates have also helped keep energy demand in check. Meanwhile, Russian oil production has not fallen off, as initially feared. Instead, countries like China and India have become the beneficiaries of lower priced Russian oil. As energy supply chains adjusted, fossil fuel prices fell from summer peaks, with some prices globally returning to pre-invasion levels.

Energy prices in Europe, though, remain historically elevated. While temporary measures and favorable weather have helped stave off the worst outcomes, the structural energy issues that predated the Russian invasion remain strong headwinds for Europe going forward. For Europe to remain competitive on an industrial basis and to ease government and household budgets, European governments will need to secure more dependable supplies for both fossil fuel and renewable energy production and bring energy costs down long-term.

The end of the easy money era

The starkest economic contrast between the start of the war in Ukraine and today is the end of accommodative monetary policy. At the beginning of the Russian invasion, even with inflation heating up, the Fed was still holding the federal funds rate at around zero, while providing fiscal stimulus through bond buybacks.

The unprecedented era of stimulus dates to the 2007/08 financial crisis, when the Fed slashed rates down to around zero. Since then, rates peaked at a still permissive 2.50% before reaching zero again after the pandemic. As recently as this summer, the Fed funds rate ranged from 1.5% to 1.75%. The persistence of low rates boosted equity prices as investors looked beyond unattractive fixed income yields and invested in companies building historical balance sheet strength. That economic cycle is over.

The interest rate hikes that have already occurred will create demand headwinds, but it takes time for the rates to have an impact on the economy, so earnings and margins have not yet fully reflected the higher borrowing costs and decreasing demand. And, more interest rate increases are on the way.

While the rate of inflation has come down off its highs, inflation remains a threat. The core personal-consumption expenditures price index rose 4.7% year over year in January, higher than economists expected. Market expectations of a potential rate cut in 2023 have decreased, coming back in line with the Fed’s expectations of holding rates higher for longer.

Higher interest rates have led to weakness in interest rate sensitive areas of the market – a year ago, the 30-year mortgage in the U.S. averaged under 4%. Mortgage rates rose to a peak of over 7% by October. Rates haven’t fallen much since then, coming in today at about 6 1/2%. The weakness in the housing market serves as a reminder that, as the U.S. and European economies head into the later cycles of rate tightening, the risks are increasing of parts of the economy breaking down.

Inflationary pressures may begin to impact other global economies. China’s easing of its strict Covid policies has led to an influx of investment capital, with investors anticipating pent-up consumer demand to boost Chinese equities. While inflation in China has been more moderate, an uptick in demand could lead to an inflationary cycle. Meanwhile, in Japan, where disinflation has been a greater risk in recent history, inflation has been on the rise. The Bank of Japan recently adjusted its yield curve control policies, possibly signaling a larger move from quantitative easing to tightening. Such a move could significantly impact U.S. equities as cheap capital dries up. This push and pull of capital costs coupled with volatile currency effects indicates that the global economy is adjusting to a new, less accommodative cycle.

The Takeaway

Investors who are digesting the events of the last year and looking at the myriad of risks and crosswinds in the global economy ahead may anchor to the idea that all asset prices are susceptible to fall. However, as equities that were boosted by accommodative monetary policy return to reasonable levels, and as interest rates normalize for fixed income investors, a more natural (and unpredictable) ebb and flow of markets should return in 2023. Being diversified across a broad range of asset classes and geographies did not help over this last dismal year in the markets. But staying diversified may be what saves investors in 2023.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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