What 4 Different Russia-Ukraine Scenarios Could Mean for Markets

A top Columbia Threadneedle Investments leader sees a significant likelihood that Russia's involvement in Ukraine will continue, possibly with a prolonged engagement or with military action ending and Russia establishing a new government in the country.

Josh Kutin, head of asset allocation, North America, for Columbia Threadneedle said on a conference call Wednesday that he sees a 60% chance Russia will remain involved in Ukraine and a 20% probability for the best-case scenario — de-escalation. That's a change from earlier this year, when he saw 40% probabilities for both continuation and de-escalation.

Two other potential paths include more dire outcomes for the world, namely Russian escalation through extended military operations into other countries or in response to expanded sanctions from the West, or the conflict broadening to China, he said.

China's potential involvement, by becoming more aggressive and providing military aid to Russia, or by using the chaotic environment to introduce its own conflict against Taiwan, would be the worst among the four potential scenarios and lead to "a global recessionary event," Kutin said. The war in Ukraine also could touch China if the U.S. decided to impose retaliatory sanctions tied to its support of Russia, Kutin noted.

"This is really a critical dynamic," he said. Russia accounts for only a small piece of many financial indexes, while China has a far greater impact on the world economy and is a vital part of Columbia Threadneede's analysis, Kutin said.

(U.S. Gen. Mark Milley, head of the Joint Chiefs of Staff, recently told the BBC that the U.S. is closely watching China but doesn't expect an imminent attack on Taiwan. China considers Taiwan a breakaway province that must rejoin the Chinese state.)

Columbia Threadneedle offered a range of potential market reactions to the different Ukraine scenarios, predicting de-escalation would have a 4% positive impact on the S&P 500 total return, and 9% and 11% positive effects, respectively, in the MSCI Europe and MSCI Asia Pacific indexes.

A continuation could have flat to slightly positive impact on the indexes' returns, while Russian escalation would mean a significant drag on the Europe and Asia Pacific indexes and a milder negative effect for the S&P 500, the firm predicted. A broadening to China would deal a significant blow to all three indexes, apart from other factors, according to Columbia Threadneedle.

Cooling Inflation

Speaking of the U.S. economy in general, William Davies, Columbia Threadneedle's global chief investment officer, said economic and market uncertainty could ease, improving sentiment, as inflation recedes this year. He predicted inflation probably will go a little higher from here and slow toward year-end, and noted consumption is starting to come under pressure.

Interest rates will continue to rise but perhaps not as far as people have expected as inflation comes down in the back half of the year, Davies said. Interest rates in the U.S. may reach 3% by year end but it's far less clear that they'll hit 4% in 2023, he said, explaining that the firm would be very wary of extrapolating current rate increases to 2023 as inflation improves.

Recession Risk

The U.S. may "flirt" with recession, and may be in one already, but the firm doesn't expect a deep or significant recession like the one following the Great Financial Crisis, he said.

Davies expects to see a recession in Europe in the back end of 2022. While Europe's economic slowdown or recession may come later, it could be deeper than in the U.S., depending on the effect of disruption in Europe's oil and gas supplies from Russia, he said.

While U.S. equities markets may move higher from here in the second half, Davies said, it would be "far too heroic to think we get back everything we lost in the first half."

Columbia Threadneedle expects volatility to remain elevated and that more companies will lower their earnings estimates as consumption patterns change.

Aside from inflation, the firm considers U.S. economic fundamentals to be sound, with strong consumer finances and healthy aggregate business balance sheets, but expects the pace of economic expansion to be pressured this year by inflation as well as supply chain risks tied to the Ukraine crisis and COVID-19 developments.

The recessions that the firm anticipates appear to be priced into risky markets for the most part, according to Kutin, who said the firm is tilting toward risky markets and keeping its equities overweight in the second half while noting opportunities and improved sentiment in fixed income.

Investment Opportunities

Columbia Threadneedle's asset allocation team is maintaining its neutral stance toward fixed income assets and recommends that investors and financial advisors shift to neutral if they haven't done so already.

The team sees emerging market underperformance presenting opportunities in stocks and fixed income assets toward the quality end of the spectrum, Davies said. The firm considers China a potential growth area in the second half as lockdowns lift and regulatory tightening softens, and also sees an opportunity for investments in renewable energy, given high fossil fuel prices.

The firm predicted that economy-sensitive stocks will come under pressure given recession fears.

Companies with pricing power will survive market volatility and supply chain and inventory issues, although the firm questioned whether the companies that held pricing power when inflation sat at 1% would be the same ones that benefit in an environment with 8% inflation.