Russian invasion: Economy stable for now, but risks mount

The volatility surrounding Russia’s invasion of Ukraine continues to evolve. The conflict is a humanitarian tragedy that has already affected the lives of millions of people. Markets have responded sharply. On the one hand, the U.S. market (as represented by the S&P 500 Index) has largely recovered, with the benchmark equity index up by 0.01% compared to where it stood one week ago (as of mid-morning Pacific time on Feb. 28.) European markets, on the other hand, have been hit harder—as it relates to the policy developments over the weekend—with the German DAX Index tumbling by 2.1% on Feb. 28. The situation is likely to remain fluid in the coming days and weeks. Here are some of the risks and likely outcomes that we have identified.

Spread of conflict outside of Ukraine is unlikely

The absolute worst-case scenario—from both a human and economic cost perspective—would be that the fighting extends past the Ukrainian border. Neighboring countries like Poland are members of the North Atlantic Treaty Organization (NATO). Under Article 5 of that agreement, attacking one member is considered a provocation of the entire alliance. This would drag NATO into the war and potentially trigger a global conflict, with all the appalling consequences that would entail. If we consider the nuclear deterrent and assume that the Russian President Vladimir Putin is a rational actor, this outcome seems very improbable.

Energy price spikes: A risk to consider

A more likely worst-case situation would be the disruption of energy supplies from Russia to Europe. Many European countries are dependent on Russian oil and gas. Germany relies on Russia for about 60% of its natural gas imports. The challenge for Russia, on the other hand, would be the loss of revenue this strategy would entail, especially considering the huge costs of its war effort.

Europe's vulnerability has been reflected in its sanctions thus far, with carve-outs or exemptions for energy purchases from Russia. Even the restrictions related to the SWIFT payment system have not yet been applied to Russian energy companies or energy-related financial firms like Gazprombank. If the West were to take a harder stance on the Russian oil and gas sector, we’d expect a significant spike in prices which, in turn, could trigger a recession in Europe. For now, this risk still seems unlikely, but is not out of the question.

Cyberattacks could be imminent

Of all the potential risks still to come from the conflict, we believe an increase in cyberattacks is the most likely. It has been rumored that there are more people working in cyber in Russia than there are people working at Microsoft. This could be an indication of how much the country has invested in its cyberattacking capabilities. If Western sanctions tighten, this would be a way for Russia to respond in a way that would also be deniable by the Russian government.

Putin's priorities unambiguous, but ongoing stability uncertain

Putin has made a choice to prioritize national security over the economy. Sanctions could knock the Russian economy by up to 5% of GDP (gross domestic product). This could have ramifications for the political stability of the country. In his last two military campaigns (in Georgia in 2008 and in Crimea in 2014), Putin enjoyed a significant nationalism bounce and a boost to his approval ratings. It remains to be seen if the Russian public will react that way this time, especially if things go badly and Russia suffers heavy losses. Ukraine represents a greater challenge to Russia than Iraq did for the U.S.: its land-mass is greater and its population is larger. Social media has been decidedly anti-Putin.

Any decline in Putin's popularity at home could take years to manifest itself given the nature of the political system there. Social unrest in Russia will not be good for global stability or the world economy.

China and Russia move ever closer

Russia and China are forming a nexus. With economic restrictions tightening on Russia and China shifting toward Moscow for its resource dependency, their alliance is a natural fit. As the West’s sanctions bite, Russia will be reliant on China for access to capital and export revenue.

Taiwan is a worry, but not for now

Despite the obvious political parallels, Russian aggression in Ukraine does not necessarily mean a Chinese invasion of Taiwan is imminent. While the fate of Taiwan is something to monitor over the next decade, conflict is unlikely in the near-term. Unlike Putin, the Chinese government still believes that it can achieve its goals through economic means.

The bottom line

There will be continued economic and political uncertainty in the coming days and weeks as the war unfolds. It seems highly unlikely that the violence will spill over Ukraine’s borders into NATO countries. As it stands now, the crisis does not appear likely to derail the global economic cycle and bring forward a recession. This could change, however, especially if Europe’s Russian energy supply is cut off—and that leads to a sustained price spike. In the near term, this risk could make central banks a little more cautious on rate hikes.