How will the Russia-Ukraine crisis impact risk assets?

 The longer-term effects of the Russia-Ukraine crisis on asset prices could prove more damaging. 

When COVID-19 appeared, it was described by many as a war; a war that resulted in casualties, needed defeating, but was against an unseen enemy. The economic and financial market consequences were seen as similar to wartime as well. But now there’s a real war in Ukraine and among the many questions is the vulnerability of economies and, perhaps more pertinently, the vulnerability of asset prices.

COVID-19 was the most recent example of a hugely negative shock that crushed economies and riskier assets. But growth returned strongly and asset prices rallied dramatically because the answer to the "war" was to throw huge amounts of liquidity at the problem. Central banks cut rates where they could and, where they could not, relied on ever greater asset purchases. It was the same playbook as in the global financial crisis of 2008, and the financial market effects were similar. Investors have come to expect that when bad things happen, central banks will be there to bail them out.

Not just this, the rate cuts made during the bad times were always bigger than the rate hikes when things recovered, with low inflation being responsible for this ratcheting down of policy rates (alongside some other arguments about declines in neutral real rates). All of this has led to our concern, and that of many others, that the strength of assets such as bonds, stocks, and credit has been totally dependent on the monetary largesse of central banks and therefore not reflective of the underlying economic situation.

The real test of this was always likely to come when a shock occurred that tested the ability of central banks to fill up the monetary punch-bowl for investors. That’s the situation we now find ourselves in because inflation has risen to a point where central banks can’t engage the monetary printing presses again; the so-called “everything bubble” risks popping. Of course, central banks won’t turn a blind eye. They might not be able to slash policy rates and engage in quantitative easing, but they can use their powers to try to ensure that liquidity does not dry up as asset prices fall. Recent crises have seen an improvement in liquidity provision, especially dollar liquidity via central bank swaps and repos granted by the Federal Reserve.

The key now is whether these liquidity sandbags are overwhelmed by the flood of investor selling. But even if they can stem the flood in the short-term and stop a slide in asset prices like stocks and credit becoming a huge rout, there is still the question of what happens over the longer-term. In the past, investors seem to have bought into these periods of abject weakness because the playbook of aggressive central bank rate cuts and QE has delivered strong asset price returns over the longer term. But now there’s no such saviour.

In fact, central banks are still very likely to engage in the process of tightening monetary conditions. Some, like the Fed because inflation is so high that it cannot be ignored, and others, such as central banks in Eastern Europe because significant currency weakness could lead to a crisis. The bottom line seems to be that even if central banks can avoid a severe liquidity crunch in the short run, the "bouncebackability" of asset prices won’t be what it was in the past. This war in Ukraine might not have spurred the same dramatic sell-off in risk assets that we saw in the wake of COVID or the financial crisis, but the chances are that its longer-term effects on asset prices could prove more damaging. That’s not because the war is a bigger shock or that it will create more economic weakness. It is because policymakers can’t respond in the same way and, investments that lose their perceived central bank safety-net could prove to be more vulnerable over the long-term, not just the short-term. This is partly because the presumption of this safety net in the past has left asset prices at levels that don’t gel with the economic reality. It is difficult to say just where this "reality” lies, but it looks as if the market is going to try to find it.