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One year of war in Ukraine: implications for investors
Emerging markets investment

One year of war in Ukraine: implications for investors

What has been the short- and long-term economic impact of the Russia-Ukraine war, and what are the implications for investors?
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24 FEB, 2023

By Constanza Ramos

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In the early morning of February 24, 2022, Vladimir Putin announced a "special military operation" in southern Ukraine. Since then, the country has been living a nightmare led by Volodymir Zelensky, President of Ukraine.

A year into the conflict, "Russia's war against Ukraine will be remembered as the beginning of a new era, it has highlighted the need to address the structural weaknesses of Western alliances," according to Mabrouk Chetouane and Nicolas Malagardis, global strategists at Natixis IM Solutions. Along these lines, both experts believe that "a significant amount of capital will need to be invested to finance challenges related to energy security and supply chain resilience." Which should trigger a new investment supercycle and address the secular stagnation argument that has gained traction over the past decade.

Beyond the human tragedy we are witnessing, Europe is facing an unprecedented energy crisis. The conflict between Russia and Ukraine has caused Russian gas imports to the West to decline, leading to an aggressive rise in gas prices. For Hervé Mangin, manager of the AXA WF Framlington Sustainable Europe fund, "this energy crisis is a wake-up call for Europe, which has realized its excessive dependence on gas and, more specifically, Russian gas. There is now no choice but to accelerate the energy transition, increase renewable energy capacity and invest in new technologies to better store energy. The trend to build more solar and wind farms already existed, but it will accelerate. The permitting phase for building green energy capacity will be shortened. And now investment in hydrogen will be boosted.

Investor opportunities after a year of conflict between Ukraine and Russia

The best and worst case scenarios of how the conflict may evolve are underestimated. The chances of the conflict turning into a protracted war have increased, but a ceasefire by the end of next year remains an underestimated possibility, as French fund manager Amundi points out. The risk of direct escalation with the West is also underestimated, when it would be worth anticipating the likely market reactions to the severe economic and financial repercussions.

Regardless of the scenarios, investors face a new global geopolitical landscape, characterized by shorter value chains, increased protectionism and higher inflation. These major and fundamental changes also offer opportunities for investors. The race for semiconductors, artificial intelligence or biotechnologies, as well as the quest for energy independence and diversification of supply chains, will remain key themes in the long term.

In a new and complex environment, commodities can be attractive. The impact varies across sectors and companies in equities, reinforcing the need for a bottom-up approach. This is particularly the case for European equities, for which we offer a view beyond the current 'currency illusion'.

For emerging markets, further war-induced fragmentation means focusing on specific countries rather than emerging markets as an asset class. With much less access to foreign capital, nearly 60% of low-income countries are likely to find themselves under severe debt distress, and many will be forced to restructure their external debt.

On the currency front, the lesson from the war in Ukraine is that central banks will play a key role and will have to rethink their reserve allocations in light of the geopolitical balance that will prevail.

In the longer term, uncertainty about energy prices and supply will require monetary policy to be more proactive and data-driven rather than driven by central banks' forward guidance.

Economic impact

The conflict has devastated Ukraine's economy and productive potential. GDP was reduced by more than 30% and, given the ongoing damage to critical infrastructure, the final cost of reconstruction could exceed $1 trillion.

Until recently, sanctions against Russia mainly affected its capital account when it did not need access to capital markets to finance its war effort. In the long term, the country's foreign income will decline as Europe reduces its dependence on Russian energy.

Russia's defense spending increased by 60%, but revenues from its oil and gas exports have fallen by 40%. The war effort is leading to a sharp deterioration in public finances, with unprecedented fiscal deficits in recent months.

Together with the fiscal drain from the war, a 'brain drain' of its human capital and sanctions on technology imports will severely affect the prospect of reviving investment retrenchment, as well as Russia's ability to diversify growth.

In Europe, the initial energy supply crisis affected GDP by 4% (trade terms) and contributed to the sharp and sudden rise in inflation. Europe has used much of its fiscal power to cushion the impact on households and businesses, but will need a new energy mix to preserve the international competitiveness of its energy-intensive sectors. Reducing dependence on fossil fuels has a 10- to 15-year outlook. The war can reinforce policymakers' determination to accelerate the region's climate agenda and its Net Zero targets.

How much would inflation have increased if the war in Ukraine had not happened?

Last year's inflationary tsunami has several origins that together created the near-perfect storm. The post-pandemic opening caused a huge demand for services whose supply was hampered by the reduction in employment during the pandemic. The distortions in international production chains following the closures led to shortages and price increases, especially in intermediate products. In addition, when the pandemic was no longer in effect, oil prices began to rise as early as the fall of 2021. On February 23, 2022 - just before the Russian invasion - the markets were expecting an oil price of around 79 euros per barrel Brent by June 2022. With the Russian invasion, market concerns about energy supply rose sharply, triggering a full-blown oil price shock. The real oil price averaged €116 per barrel brent in June 2022. Based on financial market expectations prior to the invasion, some rough calculations suggest that the energy price effect alone added 2 percentage points to annual inflation in the euro area, explains Martin Wolburg, senior economist at Generali Investments.

In addition, food prices soared as the supply of Ukrainian grain fell sharply and forced consumers to pay significantly more for their weekly grocery shopping. Compared to the year before the war, the contribution of food to inflation was about 1.5 percentage points higher. However, it is difficult to assess the true impact of the war, as uncertainty surrounds these estimates and second-round effects are not taken into account. Overall, we estimate that euro area inflation without the Russian invasion could have been 2.5 to 3.5 percentage points lower on average, implying an annual inflation rate of between 5% and 6% in 2022, instead of 8.4%. The peak inflation rate would not have exceeded the double-digit threshold, but would probably have been slightly above 7% year-on-year.

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