Russia's Ukraine invasion has ignited a new Cold War amid already-heightened U.S. and global economic risks.
Yet, despite a new era of heightened geopolitical risk and potentially intensified cybersecurity warfare, Wall Street initially reacted like the global economy had dodged a bullet. That's because the initial barrage of sanctions announced by President Joe Biden and U.S. allies was tailored to degrade Russia's military and economic potential over the long term, while shielding the U.S. and Europe from a near-term blowback.
But with the conflict bogging down amid Ukranian resistance — perhaps longer than either Vladimir Putin or NATO members had anticipated — pressure quickly mounted to pull the plug on the Russian economy. Steps taken over the weekend will restrict Russia's central bank from access to much of the $630 billion in reserves it holds internationally and restrict Russian bank access to the Swift interbank messaging system that facilitates cross-border payments.
In response, the central bank hiked its key interest rate to 20% from 9.5% on Monday, as the ruble plunged an additional 30%.
In the U.S., major indexes were set to open solidly lower on Monday, reversing momentum after the stock market continued to rally on Friday, following Thursday's turnaround session.
The sanctions could go a long way to turning Russia into an economic basket case, undermining its ability to carry out the invasion while maintaining order at home. But the intensified financial warfare raises risk that the military conflict could take an unexpected turn. It also increases the risk of higher inflation, if trade in Russia's key commodities is disrupted.
Federal Reserve Economic Risks
If nothing else, a protracted Ukraine invasion could add a premium to oil prices because of the greater chance that some of Russia's indispensable crude supply could be shelved. The price of oil briefly topped $100 a barrel Thursday. It's now eased back to above $91 — still the highest since 2014.
While soaring energy prices might dampen consumer spending, they could send the CPI inflation rate past 8%. That might compel the Federal Reserve to plow ahead with its plan to aggressively tighten monetary policy, even if economic growth might sputter.
"If anything, this aggravates the inflation problem in the U.S.," Krishna Guha, vice chairman of Evercore ISI, told firm clients in a Thursday webinar on the implication of Russia's invasion. "It makes it harder to achieve the soft landing" the Fed is trying to execute.
In the past, a geopolitical crisis triggering a market correction would spur the Fed to put off rate hikes.
Goldman Sachs economists note that the Fed moved to ease policy after 9/11 and as China trade war tensions spiked. Yet this time is different. "Inflation risk has created a stronger and more urgent reason to tighten today," wrote Goldman's Joseph Briggs and David Mericle.
"With some signs of problematic wage-price dynamics emerging and near-term inflation expectations already high, further increases in commodity prices might be more worrisome than usual."
The Fed is now expected to initiate rate hikes next month with a quarter-point move, instead of a half-point. Yet persistently high inflation, partly due to Putin's Ukraine invasion, may force the Fed to adopt a more hawkish posture.
Just ahead of Russia's Ukraine invasion, JPMorgan economists forecast quarter-point rate hikes at nine straight Fed meetings through next April.
Russia's Natural Gas Leverage
The U.S. economy is dealing with the highest inflation since the last Cold War raged. Europe's economy has been rocked by a natural gas price shock. So with several European nations opposed, Biden had little choice initially to set aside his ultimate economic weapon: cutting Russia off from the Swift interbank messaging system that facilitates cross-border payments.
Europe relies on Swift to pay Russian producers for 40% of its natural-gas supply. Fear that Russia's natural gas exports could be frozen sent Europe's natural gas prices shooting up as high as $40 per million BTUs vs. about $5 per million in the natural-gas-rich U.S.
If sustained, such prices would plunge European economies into recession, as consumers struggled to pay bills and manufacturers were forced to shutter their factories.
Yet Germany has relented in its opposition to some degree, with news over the weekend that some Russian banks would lose access to the network. Just how far-reaching the impact will be is unclear.
There are still potential workarounds to limit the damage. If Russia is cut off from Swift. BCA Research said it expects Germany to find an alternate way of transmitting payment instructions to keep energy flowing.
Russia might use China's much smaller CIPS messaging system for conducting regional commerce, driving the countries closer together. Still, it's not clear how effective any of these alternatives will be, so risk will rise of price increases or supply disruptions for a number of key commodities.
Russia's Other Riches
Russia's economy is "basically a big gas station," but otherwise of little global importance, Jason Furman, top economic advisor to President Obama, said recently.
For S&P 500 companies, Russia only amounts to 0.1% of total sales, according to a Bank of America report.
Yet Russia controls big enough slices of key commodity markets beyond oil and gas to roil global supply chains that are still trying to recover from Covid disruptions.
Russia accounted for 6% of global aluminum and 5% of nickel supply in 2021, according to the Cru Group's commodity market research.
On Thursday, aluminum prices rose more than 3% to hit an all-time high $3,450 per ton, while nickel reached a decade-plus high around $25,000 per ton.
Inventories of base metals are already extremely low, JPMorgan said in a note to clients. That leaves "very little additional cushion for further supply disruptions — either from Russia directly or via higher-for-longer gas and power prices," the firm's analysts added.
Russia also controls 35% of palladium and 10% of platinum supply. Those precious metals are used in catalytic converters to reduce auto emissions.
The U.S. neon supply, key in the advanced lithography chipmaking process, comes almost entirely from Russia and Ukraine, says the Techcet research and consulting firm.
With nearly 25% of the global wheat supply between Russia and Ukraine, the invasion also could exacerbate food inflation.
For the U.S. and its allies to target these crucial commodities with sanctions would be shooting themselves in the foot.
Ukraine Invasion Timing
The West will sanction less-essential Russian exports, like diamonds. But Putin likely counted on Russia's major income streams remaining intact. The surge in oil prices and global inflation pressures, by lowering the risk of the harshest sanctions, meant Putin believed he was invading Ukraine at the most opportune time.
"Putin was ready for this crisis," said Lori Esposito Murray, president of The Conference Board's public policy arm, in a podcast this week. "He's been planning this for a while."
Murray highlighted the $630 billion in currency reserves that Russia has built up to buttress its economic foundations for war. But he may have lost access to about 40% of those reserves held in the U.S. and Europe.
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Russia's Weak Spot
Instead of directly targeting Russia's resource-rich economy where it is strong, Biden will aim his sharpest arrow where the Russian bear is weakest.
Strict export controls will deprive Russia of advanced semiconductors with both commercial and military purposes that will "impair their ability to compete in (the) high-tech, 21st-century economy," Biden said.
The Biden administration's export controls are expected to follow the same playbook as the restrictions already imposed on Cuba, Iran, North Korea and Syria.
The export ban would cover electronic chips, software, machine tools and other advanced technologies or equipment. The goal would be to undermine key Russian industries, like aviation, and thwart initiatives into emerging areas such as quantum computing.
While Russia can get a lot of its technology elsewhere, that would still leave a void. China, for example, hasn't been able to match the capabilities of U.S. chip-equipment makers.
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Russia-Ukraine Conflict: Democracy Vs. Autocracy
The higher Putin can drive oil prices without cutting exports, the more Russia stands to gain — up to a point. Prices much above $100 a barrel will lead to some demand destruction, economists believe. Yet maximizing Russia's income stream may not be Putin's only concern.
Biden framed the Russia-Ukraine conflict as "a contest between democracy and autocracy, between sovereignty and subjugation," assuring that "freedom will prevail."
But, unlike in Russia, the U.S. and European roles in the conflict require that the government maintain popular support. Putin has a clear interest in undermining the democratically elected governments that are aligned against him. He could try to stoke inflation and disrupt supply chains to make sure that political leaders such as Biden lose at the ballot box.
Yet it's also possible that Putin may be wrong to take for granted that a severe deterioration of economic conditions in Russia won't be destabilizing.
Oil Price Relief?
Biden has a few potential cards to try and counter high oil prices. He indicated on Thursday that a multinational, coordinated release of strategic petroleum reserves could come soon. But Biden has tried this before, without much to show for it. Democrats also are debating whether to temporarily halt the 18.4-cents-per-gallon federal gas tax.
Biden might also be able to offset the Putin premium on oil prices with diplomacy. "Some contained market relief might come from the fading of another geopolitical risk: the stalled negotiations of the Iran nuclear deal," wrote UniCredit economist Edoardo Campanella.
The escalation of the Ukraine crisis "creates an incentive to accelerate the negotiations," he wrote. However, Iran's insistence that future U.S. presidents honor the deal could remain a sticking point.
Cyberwarfare Threat
The economic risks to the U.S. from the new Cold War aren't only about oil prices and rate hikes. "If Russia pursues cyberattacks against our companies, our critical infrastructure, we are prepared to respond," Biden said Thursday. "For months, we've been working closely with the private sector to harden our cyber defenses, sharpen our ability to respond to Russian cyberattacks as well."
Shares in Palo Alto Networks, Fortinet, CrowdStrike and other computer security companies popped Thursday on expectations of high demand for their specialty.
"We expect a surge of cybersecurity attacks from Russia state-sponsored organizations that could change the game for U.S./European enterprises and governments over the coming months," said Wedbush analyst Daniel Ives in a report.
NATO has a cyberdefense team in Latvia, while the European Union has formed a new group in Brussels, according to a Wells Fargo report.
"It's clear the world is entering a new much more hostile world, and cyber is a big part of the geopolitical spectrum of hostilities," Needham analyst Alex Henderson wrote. "In this environment, we think there is likely increased spend on security technologies and likely a shift in some spending priorities."
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Taiwan Is Not Ukraine
Biden telegraphed in advance that U.S. troops wouldn't contest a Russian invasion of Ukraine. There was no reason to expect otherwise. Yet Biden's stance seemed to open the door to the "sinister vision for the future of our world" that he described on Thursday — "one where nations take what they want by force."
Meanwhile, China refused to call Russia's incursion into Ukraine an "invasion," as the two authoritarian countries move toward a united front vs. the world's leading democracies.
China's foreign ministry said Taiwan was "not Ukraine," but that hardly assuaged concern that Beijing could follow Russia's lead. The Chinese government was saying that its claim over Taiwan was much clearer than Russia's entitlement over Ukraine, a United Nations member.
Beijing already moved to assert control over Hong Kong in 2020. However, analysts see an invasion of Taiwan — a base of operations for the world's most advanced semiconductor manufacturing — as unlikely in the near future. Beijing's current focus on strengthening its middle class, even at the expense of tech giants such as Alibaba, would be set back as economic risks spiral.
A China attack on Taiwan would likely sever deeply intertwined supply chains, creating massive economic pain far beyond that of the Russia-Ukraine conflict.
Taiwan's importance might be more likely to trigger a U.S. military response. America has long been deliberately ambiguous on that point.
U.S. Capital Spending Boom
Still, the return to a Cold War mentality, coming on top of pandemic supply chain crises, will only add to the urgency of bringing advanced manufacturing back to the U.S. Congress is currently working on a bill that would spend $50 billion to build more chip manufacturing capacity in the U.S.
Taiwan Semiconductor already plans to build a factory in Arizona, while Intel expects to build multiple new "fabs" in the U.S.
Elevated capital spending should be a tailwind for the U.S. economy in the years ahead as businesses reorient their supply chains for a world with wars and pandemics.
But in the near term, the U.S. economy could face a white-knuckle ride as Russia's invasion of Ukraine and its inflationary effects increase the chances of a Fed policy mistake.
Reinhardt Krause contributed to this article.
