Five areas of impact from Russia/Ukraine

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March 2022

  • Higher defense spending, particularly by European countries, is expected.
  • As Russia and China look more likely to form an ever-closer alliance distanced from the West, it may become challenging to coordinate global climate efforts.
  • The global middle-class consumer base is likely to grow at a much slower rate from here on, presenting a weaker growth backdrop for global consumer-facing multinationals.
  • What role will the U.S. dollar play in international finance and trade settlement in the future?
  • Newton believes Russia’s economy will face a significant decline in 2022, followed by slow-grind stagnation in the years to come, rather than a collapse.

1. Deglobalization

Historians in years to come may well look back on Russia’s February 24th invasion of Ukraine as the event that definitively ended the last 30-year process of international integration and globalization.

According to Newton geopolitical research analyst Richard Bullock, globalization—or the free flow of goods, capital, people, and ideas—was already viewed pessimistically before Russia’s invasion of Ukraine. In fact, global trade as a percentage of global GDP peaked around 2008, he notes.

Bullock points to Russia’s 2014 annexation of Crimea, the Trump administration’s ‘America First’ doctrine on trade, and China’s “dual circulation” self-sufficiency policy as further examples of fragmenting globalization. Those, however, were not as wrenching and sudden as the current situation, which has effectively cut Russia out of the global economy almost overnight.

He says: “One of the major implications of a deglobalized world in which fewer goods, capital and ideas traverse borders as a portion of GDP is a level of overall lower productivity growth and higher inflation. The global middle-class consumer base, which has become such a defining feature of the last 30 years of globalization, is likely to grow at a much slower rate from here, presenting a weaker growth backdrop for global consumer-facing multinationals.”

The case of decoupling Russia’s 144 million consumers from the global economy might have even broader significance than only trade matters.

Bullock points to two possible, defining features. The first is a preference for more localized production and a near-shoring of supply chains for national security purposes. The second is a common values-based alliance among democracies and among more autocratic countries that favor domestic order and social stability. Then between the Western alliance and the China-led alliance, there will be many small and mid-sized countries that opt for a nonaligned status, he adds.

2. Global inflation and U.S. dollar privilege

Geopolitical realignment, higher security spending, a reappraisal of the energy complex, and de-globalization of supply chains tend to have an inflationary effect. Barring a deep or prolonged global recession in which aggregate demand falls materially short of global output capacity, inflationary pressures likely will persist for longer, says Bullock. “These pressures will be extended by the response of the world’s major central banks, which have demonstrated caution around tightening monetary conditions too sharply, effectively accommodating inflationary conditions.”

Bullock sees modern-day parallels to the 1970s, which witnessed a geopolitical event in the shape of the 1973 Yom Kippur war between Israel and several Arab states, followed by a commodity supply-chain shock (oil embargo) that led to a sharp spike in energy prices. He adds: “Central banks were generally slow to tackle inflation during the period, with the U.S. running expansionary fiscal spending to fund the war in Vietnam. It took a bold Federal Reserve [Fed] policy under the stewardship of chairman Paul Volcker in the early 1980s to finally break the inflationary wage-price spirals and restore price stability, albeit at the cost of a sharp jolt to the economy.”

Bullock doesn’t believe today’s Fed, however, is even remotely close to the point of administering the severity of any Volcker-style approach necessary to bring inflation back to target. As such, Bullock believes inflation is likely to remain both elevated and volatile for longer.

The fallout from the Ukraine war will also have implications for the “exorbitant privilege” of the U.S. dollar and its long-term role both as the world’s hegemonic reserve currency and as the principal means of conducting international payments, he notes.

Bullock believes history reveals that long-established international currency regimes do not change overnight. But once a number of large economies begin to explore and trial alternatives, the longer-term process of de-dollarization could be set in motion. That would have far-reaching implications for the U.S. cost of capital, the size of U.S. deficits and the international role of the U.S. Treasury market.

“Owing to the volatility of both geopolitics and inflation,” Bullock says, “even traditional inflation-hedging assets, such as gold, energy, industrial commodities, and equities with pricing power are likely to experience volatility.”

3. Evolving geopolitical world order

Bullock believes Russia’s invasion of Ukraine will reshape the geopolitical landscape and world order for the next decade and beyond, regardless of the outcome. The heavy economic sanctions placed on Russia primarily by the U.S. and Europe may strengthen the Sino-Russian relationship to an even greater degree, as Moscow increases its trade and financial dependency on Beijing. “This doesn’t mean, however, that China particularly wants that burden,” Bullock says.

Nevertheless, the U.S. and its allies will seek rapprochement with current adversaries as necessity dictates. Bullock believes there is now a high probability, for example, that the Iran Joint Comprehensive Plan of Action nuclear deal will be restored (even with Russia’s participation). The U.S. has even been in discussions with the oil-sanctioned Venezuelan regime (since 2019) regarding additional oil supplies.1

4. National security reprised

This reshuffling of global adversaries may limit near-term economic pain, but it could also create other geopolitical distortions in the medium term.

Russia’s invasion of Ukraine is now forcing a clear-eyed reassessment in the Western world, and particularly in Europe, of national security prioritization. Bullock notes the West finds itself in the situation where national security concerns will usurp enhancement of prosperity and living standards for a period of time. How long this period lasts is unknown, and will depend on the ability to substitute supply chains.

There also are investment implications to consider during this conflict. Bullock says: “Expect higher public defense spending, particularly by European countries following on from Germany’s early lead. Militaries will also need to be modernized with the latest equipment, which supports technology players in the industry. The government needs to be involved, but the private sector will also need to be recruited, in order to step up spending on cybersecurity.”

5. Climate change reimagined

Part of the reassessment of national-security needs versus anything else will be the global approach to climate change. Glasgow’s COP26 summit last year, for example, very likely will symbolize the high-water mark for global coordinated climate efforts over the medium term—but its prioritization has been relegated lower in the face of conflict with Russia.

Further, as Russia and China seemingly form an ever-closer alliance distanced from the West (although how long China keeps up its quasi-neutrality remains to be seen), it will become challenging to coordinate global climate efforts, Bullock says. These two countries are crucial as China is the world’s largest CO2 emitter and Russia is considered a vital supplier of many of the resources needed to attain the clean-energy transition.2

Over the medium term, however, beyond perhaps a two-year horizon, countries will double down on their clean-energy efforts because this is now tied inextricably to a national security agenda and not solely to climate-change abatement, he adds.

Bullock believes that the national security benefit of clean energies—including wind, solar, hydrogen, and nuclear—is that they are produced and consumed in the same country most of the time, without the need to traverse borders, and therefore they remove the geopolitical risks and complexities associated with fossil fuels. “What we need now from governments,” says Bullock, “is a new energy policy that combines both climate and national security considerations.”

He adds: “The lifespan of fossil fuels will likely be extended now. Some assets that were previously ‘stranded’ could become ‘unstranded.’ A more holistic conception of energy transition should also include a greater role for nuclear energy. We believe clean energy will enjoy a dual tailwind of climate and national security, but the pace of adoption might be more pragmatic, given the failings of Europe’s existing energy policy.”

The outlook for Russia’s economy

According to Newton estimates, Russia’s economy likely will decline in real terms by 10–15% in 2022. The misery of many Russian households, used to the free flow of non-Russian goods, may be compounded by the withdrawal of Western brands from the country and by high inflation as a consequence of supply-chain shortages and the collapse in the value of the ruble, Bullock says.

Sanctions on Russia’s central bank, its inability to use the SWIFT international payment system, and restrictions on its reserve holdings of euros and U.S. dollars also will constrain the country’s ability to overcome the macro shock of sanctions.

However, Russia does have several notable features that may help dull the economic pain. Bullock points out that strong relations with China are likely to provide the Russian economy with a lifeline, albeit conditionally. The two countries have grown bilateral trade to US$150 billion per year, and recently pledged to grow this to US$250 billion in the coming years, with the West’s withdrawal likely to hasten the attainment of this level, he believes.

Further, Bullock believes it’s likely China will take advantage of its junior partner and become a buyer of discounted Russian energy and metals. China also will likely, but provisionally, put its military, industrial, and technology sectors at the service of the Russians and will aim to fill part of the consumer-goods void left by Western brands. Trade between Russia and China will be financed in rubles or renminbi by using China’s alternative international payment system (CHIPS; Clearing House Interbank Payments System) and will be facilitated by Chinese banks that are immune from U.S. commerce and sanctions.

Bullock says, “Our base-case assumption is that Russia’s economy will face a significant decline in 2022, followed by slow-grind stagnation in the years to come, rather than an existential crisis and ultimate collapse, such as that faced by the Soviet Union between 1989 and 1991.”

1 “U.S. ties easing of Venezuela sanctions to direct oil supply,” Reuters, March 9, 2022.

2 Report: China emissions exceed all developed nations combined,” BBC.com, May 7, 2021.

 

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