Financial Markets Stress Monitor

• While Russia’s financial markets have unravelled since the country’s invasion of Ukraine, global markets have so far held up relatively well. But the mood seems to have turned a bit in recent days, and there are now some early signs of financial stress beyond Russia’s borders.

• Conditions in Russia’s financial markets have deteriorated sharply, and the country faces its worst banking and financial crisis since at least the 1998 sovereign default. Trading in many assets is limited, if not outright prohibited. And the prices of those assets that are tradeable have generally fallen by huge amounts, amid thin liquidity and dramatic volatility.

• In contrast, global financial markets have, for the most part, taken the war and the initial economic fallout from it in their stride: most risky assets have only dropped a little over the past week, and core money markets have remained stable. But commodity prices have risen sharply, and both actual and implied volatility has picked up across bond, equity, and currency markets. Bond and short-term rates markets, in particular, are experiencing sharp swings. And the cost of hedging against further strength in the safe-haven US dollar has increased.

• Our sense is that investors are not yet bracing for a financial crisis outside of Russia. Instead, we think most of the sharp shifts in markets over the past week simply reflect the extreme uncertainty generated by a war involving a nuclear power and major energy exporter, and the growing risk of a “stagflationlite” environment in which inflation picks up even more and growth slows.

• The economic legacy of the conflict will also be shaped by the political and policy response of other governments, particularly those in Europe. The crisis has already triggered the biggest rethink of German defence policy in seventy years and will mean Germany will in future have the largest military capability in Europe. As we’ve noted elsewhere, fiscal policy in the euro-zone is also likely to be looser this year and next than it would otherwise have been as Germany will be reluctant to re-impose tough fiscal rules at a time when defence, humanitarian and energy expenditure is rising.

• But the war is likely to provoke policy shifts in other areas too. One area to watch is energy security. Germany and other European countries are likely to accelerate their transition away from fossil fuels in favour of renewables, although they may have to keep coal and/or nuclear power running as a transition fuel for longer than they had anticipated. It also seems likely that the EU will seek to greatly reduce its dependence on gas from Russia. The transition to renewables may be inflationary in the short term though it is hard to judge the extent to which the Ukraine war will add to this pressure.

• The Ukraine war may also lead to a lasting reassessment of the political risks associated with cross border investment, both on the part of companies (seeing BP and Shell divest their assets) and central banks (seeing the freezing of Russia’s foreign exchange reserves).

• And the geopolitical fallout will extend well beyond Russia. The West’s willingness to cut Russia out of the global financial system will have been viewed with alarm elsewhere, most notably in Beijing. There is a growing argument that the war reflects a more fundamental fracture in the global economic order between liberal market economies on the one hand and autocratic statist economies on the other. We’ve noted elsewhere that the reality is more nuanced. China won’t risk accelerated decoupling with the West in order to support Russia. But it is likely to redouble efforts to increase its self-sufficiency in key technologies and to develop international economic and financial relations that are not dependent on financial plumbing in the West.

An article by Neil Shearing, Group Chief Economist, Capital Economics with insight from Jonas Goltermann, Senior Markets Economist, Thomas Mathews, Markets Economist and Jonathan Petersen, Markets Economist

2nd March 2022

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The opinions expressed are those of Irongate, this material is not a recommendation, or intended to be relied upon as a forecast.