Could the war lead to a recession or a stagflation scenario?

At the beginning of 2022, analysts were predicting that this would be the year of recovery: robust growth in much of the world. The global economy, which had already passed the Covid test and was already looking towards a calmer future, has been dealt a new unexpected reality check (again) by the Russian invasion of Ukraine. The whole system is on alert because no one—not even geopolitical experts—can predict the war’s next developments. The most direct consequences for the economy and the markets have not been long in coming: sharp falls in the stock markets, added uncertainty, and even higher inflation expected. All this, of course, will continue to be determined by the duration of the conflict, which could give rise to questions that were not on the table until very recently: Can a recession or stagflation scenario occur? And secondly, will central banks continue with their intention to withdraw stimulus and raise interest rates?

These and other questions were addressed in the webinar “The Impact of the War in Ukraine on Markets and the Economy,” held by MAPFRE, with the participation of Josep Soler, CEO of IEF and member of the Board of Directors of EFPA Spain, Carlos Capela, Business Development Director of Federated Hermes, and Alberto Matellán, chief economist of MAPFRE Inversión.

Preliminary studies suggest that growth will be one of the biggest victims of the conflict. Although it is still too early to quantify its effects, Josep Soler believes that growth “will be reduced by 1-2 points.” So we will see a scenario of slow recovery, at least, for this year.

Therefore, the possibility of a recession, although still distant, is real. Currently, the global economy is experiencing an environment of “uncertainty, where investment decisions are postponed,” with a “cost inflation, supervening, which has a negative impact on disposable income and has a greater impact on Europe,” the MAPFRE Inversión expert stated. The financial situation in Russia could also put more fear into growth: “The freezing of Russian assets and the expulsion of SWIFT, among other measures, have added a difficulty in the system that no one had faced before.” With this and a prolonged conflict in mind, recession in the Old Continent “would not be out of the question.”

The news, at the moment more pessimistic than optimistic, is being transferred to the markets and the decisions of the major central banks. The extreme volatility of the last few sessions has shown that it is not easy to manage the warlike context we are facing. Carlos Capela asserted that the latest falls in European stock markets can give “a perspective of what the conflict could mean.” In fact, and in his opinion, winners and losers are already being seen: “It seems that the emerging markets are performing better than Europe: after the sanctions on Russia, regions such as LATAM (for agricultural production) or the Middle East (energy sector) are benefiting.”

The performance of the European selectives, especially the performance of the banking sector marked in red (due to the sanctions against Russia), shows that this situation can also lead to uncertainty in monetary policy. And here the Fed and the ECB seem to be playing a completely different game. The Fed expects a positive impact during the war from increased demand for its products, so a rate hike for this year remains on Jerome Powell’s roadmap. However, the body chaired by Christine Lagarde will find it difficult, according to Alberto Matellán, to “make far-reaching decisions” in such a short time. “Inflation, being purely external, cannot be fought by touching interest rates. If I were a central banker, I would delay any decision,” the economist said.

The second way of working shared by the experts is the fiscal tool that helped European countries so much to alleviate the most direct effects of Covid-19 (through the Next Generation EU funds). Precisely, the European Union itself is considering a massive bond issue to finance future defense and energy expenditures. Although, as Carlos stated, “there is hardly any room for maneuvering,” Alberto believes that this is an exceptional situation: “Faced with an emergency situation, we have the ECB to alleviate inflation.”

What is clear is that, if the objective is to limit the impact on activity and prevent inflation from getting out of control, with current debt levels “we have very little potential for action.” “If we act too little and let everything take its course, these growth reductions could be more problematic than we think,” Josep warned, who regrets that we have had to reach this situation just “when it was time to do our homework” after the coronavirus crisis. Now, there is a possibility, but the problem would come later: what to do with the new debt generated.

From the most negative consequences that we can experience, lessons can be learned. The CEO of IEF believes in this regard that we are “relearning what inflation, volatility, a cold war situation, and a context that tended towards normality were.” These lessons can be extrapolated to investment decisions. It is logical that the current context may scare investors, especially less experienced ones, and they may think of reorganizing their portfolios towards more defensive positions. But now is the time for professional managers, who remind us that, in the face of volatility, this is not the time to make big changes. “It's time for clients to see if they are comfortable when storms come. And when all this passes, see if your portfolio adapts to your needs,” stressed MAPFRE Inversión's chief economist, who ultimately added the possibility of periodic savings as a way of smoothing the lurches that the market may take.