War Footing – Possible Ukraine Scenario Outcomes

BNY Mellon Investment Management has released its quarterly Vantage Point outlook for Quarter 2, 2022 discussing possible scenario outcomes to be considered by investors over the war in Ukraine.

The war in Ukraine is primarily a human and humanitarian tragedy. But coming hard on the heels of a global pandemic, it will challenge an already fragile world economy in ways that are hard to predict. Surging energy and commodity prices will likely hit importing countries hard, while complicating the outlook for central banks, who are faced both with much higher inflation and, potentially, much lower growth. The scale of financial sanctions is unprecedented and will prove calamitous for the Russian economy. But given how interconnected to the rest of world Russia has become in energy, commodity and financial markets, there could be unintended consequences for counterparties that have yet to emerge. No wonder markets are jittery.

The global investment outlook can be summarised in the following 4 scenarios for the Russo-Ukraine conflict:

1. Best case (35% probability) – the conflict is short-lived and remains localised.
   1. Energy – European energy flows improve, with oil and gas prices falling back. Energy, metals, and agricultural producers alleviate supply shortfalls and commodity price hikes abate
   2. Supply chains – Asian producers re-emerge, improving supply chains, easing developed countries’ demand.
   3. Policy response – G4 central banks adopt steady tightening. Financial conditions improve gradually, and globally, risk assets recover sharply
2. Inflation surges (10% probability) – a short-lived, localised conflict, but central banks are spooked.
   1. Policy response – global central banks take fright and defer policy normalisation, desisting from tightening.
   2. Market impacts – inflation stays high as price increases become broad-based. A pick-up in growth and risk assets upturn in the near-term, but a belated policy-driven adjustment raises DM bond yields and hurts global risk assets
3. Widespread recession (35% probability) – the conflict grinds on as mediation falls short
   1. Energy – global energy producers unable to make up shortfall of Russian energy and disruptions become longer-lasting spreading to other commodity markets. Oil and gas prices rise further and stay high for longer, hitting real incomes in energy-importing countries
   2. Policy response – global central banks maintain tightening. Demand destruction causes core inflation to ease and central banks loosen policy settings. Asset prices rebound after a year but 2022 sees a global recession
4. Liquidity crunch (20% probability) – supply-chain dislocations
   1. Policy response – central banks continue tightening but are less able to offset liquidity disruptions and a run on risk assets. A liquidity crunch in certain parts of the world and heightened risk premia would persist.

Investment conclusions:

Equities – the immediate outlook is poor. Short-term duration parts of the market likely to outperform long-duration assets. High-quality shorter-duration stocks with dividends that protect against inflation likely to do best. US and non-European DM stocks are likely to fare better than European. Within EMs, commodity exporters such as are likely to outperform, and for China we will wait for further clarity.

Fixed income and Credit – rising inflation expectations likely to put pressure on DM sovereign bond prices in 2022. We see material risk of further widening in spreads for US and Europe IG corporates.

FX – the USD should be well supported throughout 2022. EM FX commodity exporters are likely to do well while commodity importers will likely come under pressure.

China – the ‘China challenge’ has not entirely gone away. The foremost challenge remains the zero-covid strategy which could still upend retail activity and domestic demand. Another comes from the property sector which is undergoing consolidation – it will take time before prices stabilise and start growing.

Aninda Mitra is a Vice-President and the Head of Asia Macroeconomics and Investment Strategy at BNY Mellon Investment Management Singapore Pte Ltd. He is based in Singapore.