The last few days have seen a sharp escalation in the situation between Russia and Ukraine, with Russia recognising the independence of two regions in the Donbas area of eastern Ukraine controlled by Russian separatists and ordering Russian “peacekeeping” troops into the regions.
At this stage it’s unclear how big the force will be, whether it will push beyond the areas controlled by the separatists and, if so, how far. Although President Putin continues to deny plans to invade Ukraine, his comments suggest a move into the areas of Donetsk and Luhansk in the Donbas that the rebels do not yet control.
As a result, share markets have fallen further with US and global shares falling just below their January lows and Australian shares also under pressure, although so far they have held up a bit better.
Bond yields have also fallen due to “safe haven” demand and oil prices have pushed to new post 2014 highs. The market reaction reflects a combination of uncertainty around how far the conflict will go, with Ukraine being Europe’s second biggest country (after Russia), the threat of further sanctions, and uncertainty about how severe their economic impact will be.
There is also the risk Russia cuts off its supply of gas to Europe where prices are already very high, with a potential flow on to oil demand at a time when conflict may threaten supply.
In short, investors are worried about a stagflationary shock to Europe and, to a lesser degree, the global economy generally.
Trying to work out which way this goes is not easy, but it seems there are four possible scenarios, some of which may overlap:
Russia stands down. This would provide a brief boost for share markets, including Australian shares, (eg +2 to +4%) as markets reverse recent falls that were driven by escalating tensions.
Russia moves in to occupy the Donbas areas that are already controlled by Russian separatists with sanctions from the West, but not so onerous that Russia cuts off gas to Europe. This could see a further hit to markets (say -2%), although it looks like it may be getting close to priced-in.
This may be similar to what happened in the 2014 Ukraine crisis (with Crimea) and if that’s all that happens then markets would soon forget about it and move on to other things. Much as occurred in 2014.
Russian invasion of all of Ukraine with significant sanctions and Russia stopping gas to Europe but no NATO military involvement. This would cause a stagflationary shock to Europe and to a lesser degree globally, as oil prices rise further and could see a bigger hit to markets (say -10%) followed by a recovery over six months.
Invasion of all of Ukraine with significant sanctions, gas supplies cut and NATO military involvement. This could be a large negative for markets (say -15-20%) as war in Europe, albeit on its edge, fully reverses the “peace dividend” that flowed from the end of the cold war in the 1990s. Markets may then take longer to recover, say 6 to twelve months.
Given the path Russia has gone down and the stridency of President Putin’s recent comments, Scenario 1 is looking less and less likely, but is still possible if there is a breakthrough in talks.
Scenario 2 looks to be already on the way, with Putin ordering “peacekeeping” troops into the Donbas region. This may be the “military-technical” action that Russia referred to last week.
At the other extreme, it’s still hard to see Russia undertaking a full invasion of Ukraine given the huge cost it would incur. And it’s hard to see NATO troops being involved, particularly given limited public support for it in Europe and the US.
The US has said US forces would not go into Ukraine. However, some combination of scenario 2 and 3 is possible whereby the crisis escalates further, if say; the Donbas separatists and the Russian “peacekeepers” push into Donbas territory that the separatists do not yet control and beyond.
And of course, with Russian troops moving into the Donbas region of Ukraine, investment markets will worry that we will move on to a wider invasion of Ukraine (until signs appear to the contrary). So we could still see share markets fall further and oil prices rise further in the short term.