The Russian invasion of Ukraine is precipitating a security and humanitarian crisis in Europe. The crisis is testing our solidarity, as well as other values and once more the resilience of many countries. The human and economic costs are enormous. Forced displacements, as well as the destruction of infrastructure will weigh heavily on the region. Europe, in general, will be affected directly and indirectly through several channels, given the strong links with Russia and Ukraine. It will be hard to regain the stability in the region given the impact on confidence and social cohesion.

Financial sanctions

As the war intensifies, the western sanctions are becoming more severe. The US, the EU, the UK, and numerous other countries have worked together to exclude Russia from financial markets. Banks are no longer allowed to invest in Russian sovereign debt, Russia is unable to transact in foreign currencies, several Russian banks have been removed from the Swift payments network, and probably the most unprecedented sanction, the Central Bank of Russia’s access to its huge international reserves has been largely restricted. The ruble has been in a free fall and the Russian economy is likely heading towards a deep recession.

Economic impact of the war

The crisis is showing us how fragile geopolitical stability can be. Western countries have united in their support for Ukraine, while other large players like China and India are on the sidelines. Because the conflict is ongoing, the economic consequences are still uncertain.

At this stage, Europe is suffering the largest spillover, but the longer the war drags on, the more widespread the impact will likely become. Europe is highly dependent on Russian energy. Even though all countries have already started to switch to renewable sources, most have not been fast enough.

In addition, Russia and Ukraine produce raw materials that are critical for many industries, including the construction, auto and agro industries. Commodity prices, already quite elevated, have surged since the outbreak of war. Net commodity exporters will benefit from the rise in commodity prices, particularly Latin America and South Africa; the commodity importers, mainly in Europe and Asia, will suffer. And if the conflict drags on for long, global inflation pressures will only continue building up further, affecting the purchasing power of consumers.

Meanwhile, financial disruptions have been most significant for the countries (indirectly) involved in the conflict. The US will likely keep its growth momentum in the near-term, given its limited trade ties with Russia, while China should be less impacted because it has opted to not get involved in the conflict. However, uncertainty and supply chain disruptions will weigh on the economic prospects, and we are adjusting our global economic forecasts downwards.

Mitigating actions: central banks and governments

Russia’s invasion of Ukraine will likely complicate the upcoming decisions on the pace of monetary tightening by the Fed and the ECB. Before the invasion, surging inflation and tight labour markets prompted the major central banks to start tightening their monetary policies. The war will only exacerbate concerns that inflation will be long-lasting, while the overall geopolitical instability is likely to hamper economic activity and lead to increased financial market turmoil. Financial stability has been an important priority for the major central banks over the last decade, which resulted in the current ultra-loose monetary policies. It is hard to envision a scenario where central bankers suddenly abandon the goal of financial stability. Financial markets also seem to be aware of this, having now priced in five Fed rate hikes for 2022 as opposed to seven a few weeks ago, and one 20bps ECB rate hike instead of two 25bps hikes. For now, we expect central banks to stick to their near-term tightening plans, but they might well turn more dovish than expected in the second half of 2022 because of the war and lower growth expectations.

The war also has consequences for government policies, especially in Europe. The economic outlook will undoubtedly deteriorate, and especially lower-income households are likely to suffer from the war-induced prolonged period of elevated inflation. Governments may try to cushion the blow from surging inflation by compensating part of the cost increase, while at the same time expanding their spending on defence. In addition to that, European countries will have to step up their fiscal efforts to help refugees fleeing from Ukraine.

The fiscal policy changes in the eurozone should probably be seen in a different light than before the war in Ukraine started. First, the war might be a turning point in creating a political union. Collective political action against the Russian invasion, collective sanctions and increased military cooperation may also lead to a shift towards a further increase of the EU-budget, on top of the increase we saw in response to COVID. Second, defence spending, like the EUR 100bn that Germany announced this week, is a reaction to the circumstances. Third, this increased spending should not come at the cost of the energy transition. If anything, investments in the energy transition should be intensified. Not only to reduce the dependency on Russian oil and natural gas, but especially to continue countering climate change. The recently published IPCC-report showed once again that the path to achieving the Paris goals gets narrower every second.

Financial market implications

The risk-off sentiment is likely to prevail, as long as there is uncertainty about the extent of the war and the impact of western sanctions, as well as the Russian response. This will lead to elevated levels of volatility and a continuation of a flight to safety. Consequently, demand for safe government bonds such as from the US and Germany, will likely remain elevated, resulting in rising government bond prices and lower yields. Investor expectations for less aggressive central bank tightening will also keep yields supressed. Other safe havens such as the US dollar are likely to strengthen. Equity markets are expected to continue struggling, as a prolonged period of elevated inflation will likely increase margin pressure, setting the scene for negative earnings surprises.