Read this article to understand:
- Why some commentators believe the war in Ukraine is the most dangerous international conflict since the Cuban missile crisis
- What the conflict means for globalisation
- The implications of heightened geopolitical risk for financial markets
On Christmas Eve 1979, Soviet armed forces entered Afghanistan to subdue an increasingly brutal civil war and maintain a friendly and socialist government on their nation’s southern border. By the time the last troops left nearly a decade later, across the ironically named Friendship Bridge, the conflict had cost the lives of an estimated one million Afghan civilians, as well as 90,000 Mujahideen fighters, 18,000 Afghan troops and 14,500 Soviet soldiers.
The war wreaked havoc not only on Afghanistan, but on the USSR, whose economy and national prestige took a severe drubbing. In doing so, it made a significant contribution to the collapse of the Soviet Union, which began in November 1988 when Estonia became the first republic to declare sovereignty.
The demise of the Soviet Union brought an end to the Cold War and was hailed by most in the West as an opportunity to forge a more constructive relationship with Russia, put an end to the kind of proxy wars fought in Korea, Vietnam, and countless other countries over the previous four decades, and secure a big peace dividend. More than 30 years on, those hopes have been severely damaged. Ironically, the shadow of an ignominious exit from Afghanistan, this time of the US, has loomed large over recent events.
“(Russian President Vladimir) Putin read the tea leaves, which were Trump, disorder and growing nationalism in Europe, and then the US’s chaotic withdrawal from Afghanistan. The conclusion was the West was weakened and demoralised,” says Sir Dominic Asquith of Macro Advisory Partners, a geopolitics and markets consultancy.
Putin may, however, have misread the tea leaves, with Russia’s invasion of Ukraine backfiring in various ways. From a military perspective, stiff Ukrainian resistance has meant progress has been far slower, and casualties far higher, than he is believed to have reckoned on. For instance, NATO estimates Russian deaths in the first month of the conflict in Ukraine may be on a par with those incurred by the Soviets in a whole decade of fighting in Afghanistan.
At the same time, the invasion has galvanised the West into coordinated action. Countries have imposed harsh sanctions, crippling Russia’s economy; sent large quantities of military and humanitarian aid to Ukraine; and vowed to ramp up their own defence spending. Despite threats from Putin, both Finland and Sweden could be set to join NATO as soon as this summer, according to one UK press report.1
Some foreign policy experts, such as the eminent US international relations scholar John Mearsheimer, claim the war in Ukraine is the most dangerous international conflict since the 1962 Cuban missile crisis.
Mearsheimer says while Putin may have started the war and be responsible for how it is being waged, the mainstream view in the West “that he is an irrational, out-of-touch aggressor bent on creating a greater Russia in the mould of the former Soviet Union… is wrong”.2
Despite Russia’s invasion of Ukraine, and before that Georgia in 2008, many experts, including Mearsheimer, believe Putin is less concerned with capturing territory than halting NATO’s continued expansion eastwards.
Although the Russian leader in 2005 described the collapse of the USSR as “the greatest geopolitical catastrophe of the century”, he qualified the remark by adding: “Whoever does not miss the Soviet Union has no heart. Whoever wants it back has no brain.”
Nonetheless, even if the prospect of NATO getting sucked into the conflict at this stage is slim, some commentators believe that, regardless of the outcome of events in Ukraine, the world is sliding into a new Cold War with far-reaching implications.
The coming decades may resemble the 1930s more than any other period since
“The coming decades may resemble the 1930s more than any other period since,” former US National Security Advisor Elliott Abrams wrote in the National Review in March.3
However, given the ideological divide between Russia and the West is more blurred than in the original Cold War, and that Putin may have little wish to occupy other countries especially after the problems encountered in Ukraine, for others talk of a new Cold War is misplaced.
Asquith is among them, even if he sees little prospect of a thawing of relations between Russia and the West for the foreseeable future, especially given the risk that a negotiated settlement leaves a frozen conflict in the Donbass.
“Given the improbability of Putin climbing down, it is hard to see the level of distrust between Russia and the West disappearing. Relations with Russia will be frozen, and we may see other incidents occurring periodically. But I wouldn’t characterise it as a new Cold War,” says the man who was formerly Britain’s top diplomat in India, Libya, Egypt and Iraq.
Dr Luca Tardelli, assistant professorial lecturer in international relations at the London School of Economics, agrees it would be a mistake to consider the likely outcome as a new Cold War, partly because it was misleading to frame the original one as such.
While there is some ideological dimension to what is happening now, it's quite different from what we had in the Cold War
“It may have been cold in Europe, but it was pretty hot in much of the rest of the world. In any case, while there is some ideological dimension to what is happening now, it's quite different from what we had in the Cold War,” he says.
Tardelli, like Asquith, nevertheless believes Russia will find itself isolated from the West, economically and politically, for some time, even if some of the harsher sanctions are removed as peace is eventually restored.
“Whatever happens, European states will continue to become less reliant on Russian energy. I’m not sure Russia will become a new North Korea, but it won't be far off in terms of its detachment from the globalised world.”
United in their dislike of US hegemony, Moscow and Beijing have in recent years been busy forging closer ties. That culminated in February with a 5,000-word statement in which Putin and his Chinese counterpart Xi Jinping vowed their countries’ friendship had “no limits”, with Xi declaring there would be “no wavering” in their partnership.4
China, for the first time, explicitly joined Russia in opposing any further expansion of NATO, while the two countries denounced Washington’s Indo-Pacific strategy and described Taiwan as “an inalienable part of China”.
Beijing and Moscow say they will work with other countries to promote “genuine democracy”
Beijing and Moscow say they will work with other countries to promote “genuine democracy” and counter American-led ideology and institutions. Even if it is unclear how many others would wish to join them, some have concluded the likelihood is a realignment of the world order.
Stephen Hadley, the national security adviser under President George W. Bush, described the statement as “a manifesto for their global leadership”. 5 John Bolton, the hawkish former US national security adviser, says the partnership “will last” because the two countries’ interests “are mutually complementary for the foreseeable future”.6
Others, however, are less convinced the world is about to divide into two competing military and economic blocs. Asquith believes while the world will become increasingly fragmented, it will be one which remains interdependent “in terms of people, finance, technology, data, climate change, you name it”. In this world, allegiances will be more fluid, shifting according to what is deemed in the national interest on particular issues.
Besides, it is unclear how long Xi’s bromance with Putin will last. According to Charles Parton, senior associate fellow at the Council on Geostrategy and the Royal United Services Institute, a defence and security think tank, Xi’s relations with Putin are based on a shared distaste for the United States, as well as interests common to authoritarian regimes. From Beijing’s perspective, a swift conclusion to the war, a result Putin may have assured Xi would happen, meant that the positives of the war in Ukraine outweighed the negatives. But it has not turned out that way.
The longer the conflict drags on, the bigger the risk the scales tip in the other direction. Furthermore, lacking a common ideology, and with potential areas for disagreement, the two nations make for uneasy bedfellows, locked in a marriage of convenience which Russia needs more.
China doesn’t want India well armed, but Russia wants to sell it arms
“If you look at India, China doesn’t want it well armed, but Russia wants to sell it arms, while Russia is worried by China’s growing influence in central Asian states like Kurdistan and Kyrgyzstan. Since they too were part of its former empire, Moscow would be as unhappy about China dominating them as it was about events in Ukraine,” says Parton, a former diplomat who spent 22 years working in or on China, Hong Kong, and Taiwan, and advises UK lawmakers.
Even if there are doubts as to how enduring the Sino-Russian friendship proves, the US and its allies sense a growing menace, with US President Joe Biden warning the world is approaching a decisive struggle between democracy and autocracy. NATO is preparing to deploy a permanent full-scale military force on its eastern flank capable of repelling a Russian invasion, the head of the alliance said on April 10.7
The problem is that Biden’s stated goal is to adjust foreign policy to better reflect the rise of America’s most significant military and economic competitor, China. The US, UK and Australia in September signed a security pact (AUKUS) to counter the growing threat posed by China in the Indo-Pacific region. Then, in March, leaders of the Quad grouping of countries – the US, India, Australia, and Japan – vowed to prevent a repeat of events in Ukraine unfolding in the Indo-Pacific.
The US and its European allies may have displayed renewed purpose by strengthening their commitment to defend democracies and challenge the expansion of authoritarianism, but by diverting attention and potentially resources away from Asia, the war in Ukraine is complicating matters.
To compete with China, you need a very strong voice in Europe, otherwise China will gain influence
“What this shows is that the US is too enmeshed to reduce its role in Europe, let alone abandon it. Besides, if you want to compete with China, you need a very strong voice in Europe, otherwise China will gain influence,” says Tardelli, whose research focuses on international security, military intervention, and US foreign policy.
Some have speculated Xi could see the West’s preoccupation with Ukraine as an opportunity to invade Taiwan, the self-ruled island China lays claim to. However, although Biden in March dispatched a delegation of former high-ranking officials to reassure Taiwan and remind China of the US’s ongoing commitment to the island, Parton believes events in Europe do not make an invasion of Taiwan more likely. On the contrary, he says they may make China think more carefully about what the reaction of the West might be.
“I think China will start to see more clearly some of its vulnerabilities to sanctions and other possible measures if it misbehaves in Taiwan,” he says.
While the perceived threat from Russia and China may have led nearly all countries in Europe to align with the US, globally the picture is far from uniform. As many as 35 nations, mainly in Africa and Asia, abstained in the March 2 UN vote to condemn Russia’s invasion.8 They included some important regional powers, notably India. Delhi considers Russia an important ally, not least because it relies on it for most of its arms. In recent weeks, it has taken advantage of the steep discounts on offer by stepping up purchases of Russian oil.
Saudi Arabia and the United Arab Emirates refused to take calls from Biden when he wanted them to pump more oil
Further backing up Asquith’s notion of a more fragmented world, Saudi Arabia and the United Arab Emirates refused to take calls from Biden in March when he wanted to persuade two longstanding US allies to pump more oil.9
Yet while events in Ukraine look to have unified a previously squabbling West, internal divisions could dissipate as politicians turn their animus to an external foe and voters shift away from more extreme political leaders, many of whom have expressed admiration for Putin. But it is far from clear how long-lasting any such shifts will prove. The same economic forces that drove the rise of nationalism could even intensify as governments step up spending on defence and inflation soars.
Western countries may have felt able to dramatically reduce defence spending after the end of the Cold War, as shown in Figure 1, but that trend is going into reverse. Various European countries including France, Italy and Spain have vowed to boost military spending, while the most striking pledge came from Germany, which is to provide an extra €100 billion for its armed forces in 2022.10
Figure 1: Defence spending as percentage of GDP
Source: World Bank. Data as of March 20, 2020
The pressure for increased defence spending could hardly have come at a worse time given the extent to which government budgets have been stretched by COVID-19, and in view of competing claims for extra spending on areas such as healthcare and the energy transition.
The economic challenge is especially acute in Europe, where households are experiencing a cost-of-living crisis due to soaring energy and fuel bills and where government budgets will be strained by the cost of hosting and integrating a huge number of Ukrainian refugees, which the Center for Global Development puts at $30 billion in the first year alone.11
Aviva Investors’ head of multi-strategy funds, Ian Pizer, says the risk of ongoing dislocation in commodity markets means those economic problems could worsen significantly, especially if either the West or Russia were to “weaponise” energy.
“You've got this weird sort of interdependence. The longer this goes on, the greater the chance one side views it as in their interest to discontinue this policy of doing business with the other. As we head towards summer, Putin’s got less control, but that changes if this conflict drags on towards winter. Even turning off the gas taps for a day or two could create panic and lead to ongoing uncertainty, even once delivery resumed,” he says.
Turning off the gas taps for a day or two could create panic and lead to ongoing uncertainty, even once delivery resumed
The war in Ukraine seems likely to prompt a seismic shift in the cost-benefit analysis for the large number of companies that have in recent years relied on doing business with authoritarian regimes.
BP has put its near-20-per-cent stake in Rosneft up for sale, while rivals ExxonMobil, Shell and Equinor of Norway are also pulling out of all their operations in Russia. Although Chinese investors are rumoured to be looking to buy these and other Russian assets at knock-down prices, the danger is the Russian government simply expropriates them, putting billions of dollars-worth of investments at risk.
Just as some reckon the conflict could lead to the creation of two opposing military blocs, others predict it will mark yet another nail in the coffin of economic globalisation.
Pizer says the web of global supply chains will continue to be redrawn as companies shift further away from the just-in-time model. Such decisions will be driven in part by how countries choose to align themselves.
“It’s no longer acceptable to get whatever it might be from Russia, but tomorrow that could be someone else. If most of your sales or your suppliers are from countries in dispute with your country of domicile, you would be concerned. Companies will be looking at the exposure of their business models to this sort of raised conflict,” he says.
However, there are limits to how fast deglobalisation can happen given the integration of supply chains. As Parton says: “Whatever people’s inclinations are with China, it’s going to be more difficult to put them into practice so I wouldn’t be too glib about saying we’ll now put the heat on China. Will people be as sanguine when they can no longer get hold of their iPhones?”
China treads a tightrope
That has not stopped financial markets from speculating China and its companies may end up being targeted by the West. “There are concerns China could face similar sanctions and that has led to a phenomenal dislocation for Chinese entities with overseas listings,” says Aviva Investors’ global equities portfolio manager Jonathan Toub.
China could face similar sanctions and that has led to a phenomenal dislocation for Chinese entities with overseas listings
Should that happen, it could spell trouble for Western companies. German automakers Volkswagen, BMW and Mercedes-Benz all agreed to suspend production and sales in Russia. Those decisions may not have been especially painful given between them the trio sell less than 300,000 vehicles a year in the country. China is a different matter. It accounts for more than a third of sales at all three companies, and in Volkswagen’s case more than half its profits.12
With the conflict causing the West to think ever more clearly about China and the nature of its regime, Parton says Xi is treading a tightrope. On the one hand he is keen to do what he can to help Putin, on the other he is wary of antagonising the West by helping him evade sanctions, especially since China has mounting economic problems of its own.
“One lesson China will have learned is the West is prepared to suffer considerably more hardship than seemed likely. That means self-sufficiency becomes ever more important from a Chinese perspective,” Parton says.
According to at least one media report, while China's state refiners are honouring existing Russian oil contracts, they have been avoiding new ones despite the steep discounts on offer, a potential sign of nervousness in Beijing.13
Pizer reckons China will continue to trade with Russia and look to secure long-term contracts for energy and other raw materials, but will be wary of the threat of retaliation.
“It will not want to overstep the mark, but there is a risk it does, either by design or miscalculation. Then again, I don’t think the West wants the conflict in Ukraine to lead to a further souring of relations with Beijing either,” he says.
The war in Ukraine is just the latest manifestation of rising geopolitical tensions
The war in Ukraine is just the latest manifestation of rising geopolitical tensions, a trend that has been apparent for several years. Where that leads to and whether it causes the kind of seismic changes that followed the end of the Cold War is less certain.
As Asquith explains, whereas a year ago Washington’s priorities were “probably China, climate, Iran and Russia”, today it would be “Russia/Europe, Iran, China and climate”.
“Speculating what might happen over the next year, let alone the next decade, is quite quixotic. The only thing you can really be sure of is that international relations will become ever more complicated and volatile,” he says.
How events in Ukraine are impacting the investment landscape
Experts from our multi-strategy and emerging-market-debt teams give their thoughts on what the latest bout of geopolitical risk means for markets.
Russia’s invasion of Ukraine and the West’s response to it has disrupted supply chains, convulsed commodity markets, and sent inflation that was already uncomfortably high rocketing. In turn, global growth forecasts have been cut, prompting some to warn stagflation could be set to return for the first time in more than 40 years.
The Organisation for Economic Co-operation and Development on March 17 estimated the war could knock more than a percentage point off global growth this year and add two and a half percentage points to inflation.14 However, gauging what this means for financial markets is not straightforward. For a start, there is uncertainty as to whether current high rates of inflation prove to be temporary or become more deeply entrenched.
It is also unclear how governments and central banks will respond. Take fiscal policy. Spending on defence is certain to rise as countries react to what they perceive to be the growing challenge posed by Russia and other authoritarian regimes. With budgets already stretched and deficits sky high, it remains to be seen whether governments will try to claw back the money from elsewhere.
As for monetary policy, while central banks have been keen to talk up their inflation-fighting credentials, the need to help governments continue funding deficits could trump their enthusiasm to raise interest rates.
Figure 2: Dutch TTF gas futures (€ per MWh)
The possibility inflationary impulses prove only transitory is another reason they may hesitate to remove the punch bowl. Further complicating the task facing investors, these impacts are likely to vary greatly, depending on the country and region.
Europe will be among the worst affected regions, given is dependence on Russian energy. In 2021, two-fifths of the continent’s gas came from Russia, as did over a quarter of its crude oil imports.
Having briefly soared to record levels in the wake of Russia’s invasion, European gas futures contracts for near-term delivery have fallen back sharply. However, from a historical perspective, prices remain extremely high, and markets are indicating they will climb once more as winter approaches.
Soaring energy prices may have been the main driving force behind inflation in recent weeks, but they are not the only factor. According to the World Bank, non-energy commodity prices were 32 per cent higher in March than 12 months earlier,15 while ongoing bottlenecks in global supply chains continue to raise the price of numerous finished goods.
Source: Eikon Datastream. Data as of April, 13 2022
Bond market correction
Central banks, having in many cases already started raising interest rates, are widely expected to tighten monetary policy further. With debt-to-GDP ratios at, or near, record levels, and governments vowing to splurge on defence, it is little surprise bond markets have been under pressure.
US government bonds lost 5.6 per cent in the first quarter, the worst showing since record-keeping began in 1973, according to the Bloomberg US Treasury Total Return Index.[i] That left ten-year yields at a three-year high. Despite the severe sell-off, Aviva Investors’ head of multi-strategy funds, Ian Pizer, believes the correction will likely continue.
“The market may have priced quite a lot of tightening, but the peak in rates is expected to be in line with the last cycle. Given the inflationary dynamic, a peak in (US) rates of 275 to 300 basis points, with cuts then priced in to 2024, seems optimistic. Expect further re-pricing,” he says.
While the US economy is firing on all cylinders, with limited spare capacity and an extremely tight labour market, the same cannot be said for Europe. That means, unlike in the US, there is little sign of second-round effects with inflationary pressures broadening out. Whereas the US rates market is arguably pricing in too little tightening of policy, the opposite may be true for Europe.
Figure 3: Real yields on government bonds
“The European Central Bank is priced to hike by 75 basis points by the end of the year, but there is a risk they won’t get there. The impact of soaring energy prices on household and corporate finances will be brutal. If gas prices go up again it could tip Europe into recession,” says Pizer.
Tellingly, whereas the real yield on US ten-year government debt has risen 78 basis points since the start of the year and is on the verge of turning positive for the first time in two years, in Germany it has fallen deeper into negative territory, as Figure 3 shows.
While average global inflation will likely be higher over the next decade than the previous one, Pizer says “the jury's still out as to whether that's enough to put an end to the ‘Japanification’ of Europe”.
Hence, despite the fall in real yields, European bonds look attractive relative to US debt, although he would be wary of owning them outright since no other G10 rates market would be likely to escape unscathed were US Treasury yields to rise appreciably further.
A deteriorating fiscal backdrop is likely to be another negative factor bond markets will have to contend with, especially in Europe.
“Europe probably needs to redraw the fiscal compact. Nobody wants Italy to refuse to lift defence spending because of budgetary constraints. But for now, the worsening fiscal outlook is not uppermost in investors’ minds,” adds Pizer.
Source: Eikon Datastream. Data as of April, 13 2022
Emerging market implications
Though the war looks set to take a sizeable toll on richer nations, the impact on some emerging market economies promises to be greater still. That is especially true in Eastern Europe, where many countries rely especially heavily on Russian energy and are hosting large numbers of Ukrainian refugees.
Liam Spillane, head of emerging market debt at Aviva Investors, is concerned many countries in Eastern Europe could be heading towards stagflation.
“The region is heavily reliant on trade with Russia and Ukraine. Commodity prices are rising sharply at a time when domestic factors had already led to higher inflation. That will require a much greater response from central banks,” Spillane says.
Soaring food and energy bills are especially problematic for poorer countries since spending on both items tends to account for a proportionately bigger share of the typical household budget. With many countries still struggling to repair the economic damage caused by the COVID-19 pandemic, the threat of stagflation is hanging over many other countries too.
Spillane favours debt issued by countries whose central banks have acted sooner and more aggressively than others, and where rates may be closer to peaking as a result.
“Latin American nations such as Brazil potentially stand out as offering value in that regard,” he says.
Given the turbulence seen in commodity markets and the sharp rise in bond yields, equities might have been expected to sell off. However, while the initial reaction was to do just that, most developed markets have since recovered strongly, taking many by surprise.
Since Russian tanks rolled into Ukraine on February 24, the EURO STOXX 50 index of leading euro zone companies has lost around four per cent. But it has gained more than 12 per cent from its March 7 low. Somewhat surprisingly, over the same timeframe both UK and US shares have gained ground, with the FTSE 100 and S&P 500 rallying by one and 4.4 per cent respectively.
Pizer says these markets’ resilience is partly explained by the fact equities have historically tended to hold up in the face of higher inflation until such time rising interest rates start to impact economic growth. And with interest rates still close to zero despite soaring inflation, there are few viable alternative destinations for investors’ money. Nonetheless, he is surprised stock markets have held up as well as they have.
“It is strange given even before the invasion stocks were nervous over the prospect of higher US rates and we’ve blown through those levels and then some. If you think real rates rise quite a bit more, some sectors such as technology are going to come under pressure, although that doesn’t mean other sectors won’t do better, at least for now,” he says.