Investors appear to be refocusing on pre-war concerns about economic fundamentals—but finding that this horrific conflict has exacerbated them.

Last week was the third week of Russia’s invasion of Ukraine. It was also arguably the week in which global financial markets renewed their focus on economic fundamentals.

Volatility persists—but it is accompanied by a shift back to market patterns associated with pre-war concerns about inflation and rising rates. Oil prices pulled back sharply, government bond yields have increased, Fed Funds futures are pricing for seven rate hikes in 2022, long-duration growth stocks have resumed their underperformance.

This economic focus might seem inappropriate, given the appalling nature of the conflict and the heroism of Ukrainians’ fight for their lives and freedoms, but it is far from unusual.

Historically, markets have often looked through geopolitical events. The S&P 500 Index bottomed out a week after the Cuban Missile Crisis flared up, and had gained 14% three months later. The 9/11 attacks caused a 12% drop, but prices recovered within a month. The outbreak of the Korean War and the Tet Offensive show similar profiles. Even the deeper, more drawn-out losses following the Pearl Harbor attack were erased well within a year.

On this occasion, there are perhaps two catalysts causing the market to refocus on pre-war concerns.

Inflationary Pressures

The first was the message from the European Central Bank (ECB) that, despite the war, it remained more concerned about inflation than about threats to growth, and would accelerate the tapering of its asset purchases. Last week, the U.S. Federal Reserve put out a similarly hawkish message, hiking rates for the first time in this cycle and projecting six more hikes this year in its “dot plot.” Chair Jerome Powell emphasized that the U.S. economy is “very strong” and the labor market “extremely tight,” indicating that it both warrants and can withstand tighter policy.

The second catalyst was the growing sense of stalemate in the conflict and a slight softening of tone between Ukrainian and Russian negotiators. It could still be months away, and the situation could worsen if talks break down, but we may be seeing at least the beginnings of a settlement process.

That outcome could ease the risk of a catastrophic escalation and enable a return to pre-invasion levels of sanctions against Russia, potentially taking some of the economic tail risk out of markets. We may have seen the start of that in the pullback in oil and European gas prices.

That said, the invasion’s profound and lasting global strategic implications leave residual geopolitical and economic risks for markets to consider, though these may take time to fully understand. And, as the ECB identified, the major economic impact of the conflict is likely to be an exacerbation of pre-war inflationary pressures.


Grain and fertilizer shortages could become an issue later this year, but energy prices remain the major immediate transmission mechanism to the broader economy of this crisis. In its Oil Market Report for March, published last week, the International Energy Agency (IEA) warns the invasion “could turn into the biggest supply crisis in decades.”

The U.S. ban on Russian oil imports, which, according to the Energy Information Administration, accounted for only around 3% of total U.S. oil imports, is likely to have a limited effect on global energy supply-and-demand dynamics.

The longer-term picture is one of increasing tightness, however, in a world where OECD countries’ oil inventories were already at eight-year lows, according to the IEA.

IEA data indicate that European Union (EU) countries get 20% of their total oil imports from Russia. That made them unwilling to ban Russian energy exports immediately, but they are now targeting independence from Russian fossil fuels by 2027. The U.K. has committed to phasing out Russian oil imports by the end of this year and is exploring options to end gas imports.

In the meantime, the IEA warns that “self-sanctioning” by major oil companies, trading houses, shipping firms and banks has resulted in those entities “backing away from doing business” with Russia. Oil continues to flow due to trades made before the invasion, but “new business has all but dried up,” putting three million barrels per day of Russian oil supply at risk of being “shut in” from April onwards.

Can that gap be filled? My colleague Jeff Wyll, our Senior Research Analyst specializing in the energy sector, says that the message coming from recent company management meetings is that there is very little appetite to ramp up capital allocation elsewhere, due to longstanding pressure from shareholders to maintain capex discipline, increase returns on investment, as well as other factors.

In the U.S., there are capacity constraints due to tightness in the services market and in labor. In Venezuela, the issue is the energy-sector skills drain and the condition of the oil industry infrastructure. Saudi Arabia has so far been slow to act as it remains committed to the OPEC+ production schedule, in addition to other political considerations. Iran could ramp up production, but that is dependent on the current nuclear talks enabling a reduction in sanctions.

Other longer-term implications of the crisis also appear inflationary.

Higher spending on defense in Europe now seems likely, for example. Renewed unity of purpose within the EU, building on its collectively financed pandemic recovery plan, could increase the impetus toward fiscal union that has been building since the Euro Crisis 10 years ago. Russia is an important source of the metals that are essential for the transition to a net-zero emissions economy, which was already an inflationary trend and which the war has given new urgency. A return to Cold War-like tensions could speed up the ongoing trend to localize supply chains and deglobalize markets.

Fundamental Forces

With all that in mind, let’s take another look at that list of violent geopolitical events and their impacts on equity markets.

The one that arguably hit the S&P 500 Index hardest was the 1973 Arab-Israeli War. Initial losses were recovered within a week—but it was down 40% a year later, due to a fallout that included an oil embargo, numerous policy mistakes and extreme stagflation.

Structural, fundamental economic forces are the ones that matter for markets, ultimately. It’s not surprising that a war in Europe overshadowed the announcement that U.S. inflation just hit 7.9%. But it’s the lasting inflationary effects of the war, and the resulting policy decisions, that are most likely to determine the fate of markets on a 12- to 18-month horizon.

Inflation and rising rates were the prime causes of volatility before the war began. It’s why we led our Solving for 2022 outlook for the year with the view that higher and more problematic inflation would make for a more volatile economic cycle. And it’s why we believe volatility will persist even after Russia and Ukraine lay down their arms.

In Case You Missed It

  • U.S. Producer Price Index: +0.8% in February month-over-month and 10% year-over-year
  • Federal Open Market Committee Meeting: The FOMC raised its policy rate by 0.25%
  • U.S. Retail Sales: +0.3% month-over-month in February
  • NAHB Housing Market Index: -2 to 79 in February
  • U.S. Housing Starts: +6.8% month-over-month to SAAR of 1.77 million units in February
  • U.S. Building Permits: -1.9% month-over-month to SAAR of 1.86 million units in February
  • Bank of Japan Policy Meeting: The BoJ made no changes to their policy stance
  • Japan Consumer Price Index: +0.9% year-over-year in February
  • U.S. Existing Home Sales: -7.2% month-over-month to SAAR of 6.02 million units in February

What to Watch For

  • Wednesday, March 23:
    • U.S. New Home Sales
  • Wednesday, March 23:
    • Japan Purchasing Managers’ Index
  • Thursday, March 24:
    • Eurozone Purchasing Managers’ Index
  • Thursday, March 24:
    • U.S. Purchasing Managers’ Index
  • Thursday, March 24:
    • U.S. Durable Goods Orders

    – Andrew White, Investment Strategy Group