‘Months when decades happen’ put an end to post-pandemic expansion dreams

In the past month, we have seen Russia launch a full-blown invasion of Ukraine.

Whether this is the result of, an increased sense of security threatened by NATO’s expansion, a dreary pandemic sparking existential fear for a leader in isolation, or a combination of both these factors, it is hard to imagine a conclusion to the war in Ukraine which will not have far reaching negative implications. 

Numbing economic sanctions imposed on Russia, the delivery of arms to the government of Ukraine to stiffen resistance, and the remilitarization of Europe all indicate that there is no turning back.

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The world has now changed, and it is a difficult task to sketch the economic impact with any certainty. 

What is clear is that the beautiful expansion that was supposed to follow the long-awaited exit from a painful pandemic is now a pipe dream.

All data releases for February only remind us of what could have been.

Expansionary PMIs, record-low unemployment, and robust consumption underpinned by squeaky-clean balance sheets point to strong economic momentum at the start of this war.

Many hoped that 2022 would be the year when inflation might recede.

Its descent would not necessarily be rapid or complete, but it would be a start, with a gradual slowdown of pent-up demand further impelled by the response of monetary policy.

The war will instead reignite global supply lines disruptions and worsen inflation.

The economic ramifications are brutal.

Food and fuel are potential weapons in this war.

Europe, whose dependence on Russia for oil and gas is formidable, faces the risk of an economic recession in the next 18 months.

The US is more self-sufficient in its energy needs but less energy efficient.

Oil price inflation will hit growth hard and yet require an unrelenting US Fed policy tightening.

Emerging market commodity exporters may be partially shielded but most will suffer from higher food prices, tightening financial conditions and the rise in global risk aversion. 

The west’s choice to respond to military aggression with economic measures is unlikely to bring Russia to its knees or deter its advance.

The end point of this rendezvous with destiny is unknown and common grounds for negotiation seem elusive at this stage. In this new and unstable environment, we consider three economic scenarios.

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First, the odds are high, at 50%, that war inflicts a stagflation shock.

With some luck, growth will remain positive this year, propelled by the post-pandemic economic restart, but it is likely that demand will be destroyed as inflation accelerates.

Second, in an alternative scenario, with 40% odds, central banks get emotional.

They shy away from tightening financing conditions in the middle of a war.

Inflation remains higher for longer, and wages may follow, benefitting growth at least for some time before inflation reduces purchasing power and demand. 

Third, there is a 10% odds scenario that central banks score a home run.

The fine balance they were aiming for to combat the extraordinary pandemic inflation from supply and demand imbalances has become ever finer.

Now, they must walk the narrow path, beating off inflation and warding off recession.

They have the toolbox and can think the unthinkable, if need be.

These scenarios imply downside risks to equities, higher commodity prices, and a safe haven bid.

Uncertainty about what to price in can only heighten volatility.

Agnes Belaisch is chief European strategist at Barings Investment Institute

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