Last week, we outlined three possible scenarios for the Russia-Ukraine conflict and their implications for financial markets. Unfortunately, Russia’s invasion of Ukraine has made the full invasion scenario a reality. While the geopolitical and humanitarian picture is grim, the market response has been surprisingly modest so far. Our longer-term outlook depends on the length and severity of the conflict, but we expect a fairly protracted situation. Below, we share our updated thinking on some key variables.

We believe the conflict will add to the inflationary environment and impose a tax on global growth. We expect higher oil and gas prices even if energy sanctions don’t materialize. Russia cutting off energy supply to Europe is not in our base case, but it’s a strategy Russia may employ as a retaliation tactic or if events don’t work out in its favor. We also anticipate higher food prices—Ukraine is a net exporter of wheat, and disruption to wheat supply coming out of Ukraine could have a significant impact on wheat prices.

Importantly, we do not currently see the situation derailing global central bank tightening. The United States has been approaching peak inflation—and that’s before the inflationary pressure that we anticipate from the conflict. The Federal Reserve is under a lot of pressure to hike. We believe it will move forward with a 25 basis point hike in March. We expect other central banks to continue with tighter policy, though the magnitude of rate hikes may be tempered. Longer term, we think the conflict is likely to create a more complex monetary policy decision environment as central banks grapple with the risks of potential stagflation. Central banks may have to adapt their strategies accordingly.

A Key Risk to Watch

We believe that geopolitical risk premium is elevated. There is a tail risk that tensions escalate between Russian troops and those of NATO[i] members bordering Ukraine. This scenario could result in direct military engagement with NATO forces. While we think this risk is very low, it is a possibility that is arguably not yet priced into the markets.

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