The long-term implications of the war in Ukraine

In our base case, we see a new cold war developing. The high humanitarian cost of the war in the Ukraine will necessitate a new relationship between Western democracies, NATO members, and Russia. Many emerging economies will either try to remain neutral or side with the partner whose interests or offerings are most advantageous to them. Economic and financial interests will drive the strengthening of existing alliances and the building up of new ones. The divide between West and East will persist, in our view, even after a potential cease-fire agreement has been signed between Ukraine and Russia. Absent a change in leadership which leads to a change in the country’s hostile geopolitical trajectory, Russia will remain isolated from the West, with its trade relationships seriously impaired. Business activity with Russia will be much lower than it was before the war and will likely decline further in the years ahead as new commodity supply routes are developed. The historical evidence from other countries affected by US and Western sanctions suggests that sanctions on Russia will be lifted only in a few select areas, if at all. Europe, in particular, will strive for energy independence from Russia and reduce its commodity imports.

In our risk case, the cold war escalates further, and commodity trade with Russia is halted this year. Insufficient near-term substitution possibilities lead to a severe economic downturn, particularly in Europe. The world becomes even more bipolar as Russia strengthens its alignment with China and other emerging countries, hurting international trade and global growth. Cooperation within the respective Western and Eastern blocs rises as the divide between them widens. Ensuring strategic access to commodities becomes an even greater economic priority, with further embargos on tech transfers, restrictions on capital market access, and additional (secondary) sanctions.

While we do not rule out a benign outcome, we see this as the least likely scenario. In our upside case, select sanctions are lifted as part of a cease-fire agreement with Russia. While some trade relationships with Russia are re-established, trust in Russia remains low. The lifting of sanctions implies less urgency around substituting commodity imports from Russia and the risk premium on commodity prices falls. Commodity supply diversification will remain in focus as a longer-term goal, as the need for Europe to become less dependent on Russia is clear. 

We believe the war between Russia and Ukraine will change various global trends accelerate in an environment of heightened international mistrust. We identify three areas where we expect existing trends to accelerate.

The growing importance of regional economic, social, and political coalitions

One immediate reaction to Russia’s invasion of Ukraine was the freezing of the assets of Russia’s central bank and various oligarchs. While these measures have wide public support in many countries, they may have created skepticism in others, including concerns around the protection of property rights and the rule of law. As a result, some investors are reconsidering their choices of safe-haven markets, which may result in some wealthy individuals, pension funds, and sovereign wealth funds seeking to diversify their exposure away from countries where they see a greater risk that their assets may be confiscated or frozen.

Supply chain and commodity supply diversification

Sanctions against Russia have so far sought to avoid supply disruptions, yet we think importers are likely to seek to reduce their dependence on Russia over the medium to long term, and more generally diversify their sources of supply. This reinforces the broader trend toward supply chain simplification, diversification, and security that emerged during the trade conflict between the US and China and has been accentuated by COVID-19-related disruptions (Fig. 1).

Growth in global trade volumes has leveled off in recent years
Global trade volume, % of real GDP

Source: Oxford Economic Forecasting, UBS, as May 2022

As a result of greater uncertainty, companies are reassessing the costs and benefits of maintaining complex international supply chains. Meanwhile, commodity supply chains are in the process of being rerouted. Russia is well known as a supplier of oil and gas, but it is also an important producer of precious and base metals, agricultural products, and potash, which is used for fertilizer.

The growing relevance of ESG

Following Russia's invasion of Ukraine, some investors have begun to wonder how they can further integrate ESG analysis into their investment views to better account for sovereign-level risks, as well as company exposure to countries with higher social and governance risks.

Incorporating ESG considerations, as is common for rating agencies and state-of-the-art credit analysis, enables investors—whether sustainability-focused or not —to assess risk-return expectations of bonds and equity holdings more holistically.

Growing economic, political, and financial divides along coalition lines have implications for reserve management. But while we see scope for increased allocations to CNY and gold among reserve managers, in our view the US dollar’s leading role as a reserve currency is not at risk.

The US dollar’s dominant position is not at risk

The freezing of Russian central bank reserves has also led to discussion of the US dollar’s function as a reserve currency, with some reserve holders potentially fearing sanctions on their assets held abroad.

Even in countries where the perceived risk of being affected by US sanctions has increased, the US market might still remain the dominant choice. It remains difficult to find a valid alternative to the US dollar that could satisfy reserve managers in terms of liquidity, stability, and breadth of investment universe.

CNY – underpinned by longer-term structural shifts

The CNY made up around 2.8% of global allocated FX reserves as of end-2021, far behind other major currencies. But we do expect the Chinese renminbi to gain market share gradually, particularly in emerging markets, as reserve managers attempt to diversify holdings and reduce the potential impact of asset forfeiture.

Gold and precious metals – is this time different?

In the context of reserve asset diversification, it is also important to look at the role gold and other precious metals could play. Increased reserve manager interest may help gold resist the potential drag from real rates for longer. It also suggests that pullbacks in the yellow metal and other precious metals might be limited and shorter-lived compared with previous periods when monetary policy conditions tightened.

The war in Ukraine has brought Europe’s need to bolster its defenses into sharp focus. Defense spending across European NATO members is set to increase to 2% of GDP. Much of the increase in spending will go toward hardware, with a particular focus on modern warfare (for example drones instead of planes).

Military spending expected to increase substantially
Military spending, in % of GDP

Source: Stockholm International Peace Research Institute (SIPRI), Yearbook: Armaments, Disarmament and International Security, as of February 2022

Cybersecurity will become increasingly important, as digital skirmishes will serve as yet another front in the new cold war. Recent cyberattacks following Russia’s invasion of Ukraine have underlined the risks to governments, companies, and individuals, and they are a reminder of the need for greater investment in cybersecurity defenses. The US government is already lifting its planned spending for 2023, with the Biden administration’s budget request earmarking USD 10.9bn for civilian cybersecurity-linked spending, an 11% year-over year increase, of which USD 2.5bn is to be used for the cybersecurity and infrastructure security agency.

In the new cold war, ensuring the stability of production, access to technology, and food supplies will also be in focus. Russia is a significant part of the supply chain for raw materials and rare earth metals, with fertilizer and foodstuffs also at risk. For Russia and its allies, ensuring access to technology will be key, although this could accelerate the digital divide (i.e., the silicon curtain).

The immediate impact of these changes will be evident in a rerouting of supply chains and increased investment in domestic production, including agriculture. Companies may also need to hold higher inventories for some time to come, weighing on their financial metrics.

Russia’s invasion of Ukraine has cut availability of coarse grains, wheat, and vegetable oil supplies and altered trade flows, particularly in light of self-imposed sanctions by some grain traders, trade finance providers, and vessel owners.

Soaring food prices
Global wheat prices

Source: Bloomberg, UBS, as of May 2022