As we peer through the fog of war, prospects for a decline in US dollar dominance, durably higher inflation, and persistent heightened geopolitical risk appear on the horizon. However, it can take a long time before ripples either fade out or become waves. And their future path is influenced by their interaction with each other and new ripples that form across the ocean of time. Investors should be patient and thoughtful in implementing any changes to portfolios.
The human toll of this tragedy is top of mind as the world is uniting in support of the people of Ukraine. The cohesive sanctions from Western powers against Russia for its brutal actions have rapidly brought intense economic pressure. Both the war and the forceful and unprecedented nature of economic sanctions are likely to have long-lasting implications.
While some investors and economists have been predicting a decline of the US dollar system for decades, it remains dominant in global trade and central bank reserves and likely will remain dominant for decades to come. However, the unprecedented freezing of Russia’s central bank foreign exchange reserve assets in Western jurisdictions could erode one of the key benefits to central banks in building foreign exchange reserves in US dollars (and to a lesser extent, euros)—reliable access to such assets when they are needed. The freezing of Russia’s assets is functionally no different than the imposition of capital controls. As such, central banks may seek to diversify reserves further into gold and other currencies.
Of course, most countries do not see themselves in the same light as Russia. Still, directionally, this may drive central banks to seek further diversification of their reserves, which would put downward pressure on the US dollar. In the near term, we anticipate the US dollar will appreciate, even from already overvalued levels, benefiting from a flight to quality to US Treasuries and other US assets relatively insulated from the war-related turmoil.
The exclusion of Russian banks from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) puts further pressure on the US dollar system. US adversaries already frustrated with the United States’ use of US dollar dominance as geopolitical leverage will be hardened by this latest move with SWIFT and may seek to develop an alternative less dominated by the West. There is some speculation cryptocurrencies could also benefit as a means for Russia to circumvent these sanctions. It remains to be seen how useful cryptocurrencies will be to this end and if/how crypto exchanges will address these concerns.
Several factors speak to elevated inflation risk over the long term (although we regard runaway inflation as highly unlikely). Both sanctions on technology and supply chain challenges stemming from the war should accentuate the trend toward reshoring. US limits on Russian tech companies’ access to semiconductors and other advanced technology deemed crucial to military, biotechnology, and aerospace industries are similar to those limits the United States has placed on select Chinese companies (e.g., Huawei). In response, China has doubled down on investing in domestic technology, especially semiconductors, and the actions against Russia may serve to put further fuel on China and other nations’ ambitions and localize technology supply chains.
Furthermore, the war in Ukraine serves as the latest reminder that the world has overoptimized global supply chains and that concentration of commodity supplies creates untenable risks. COVID-19 caused corporations to wake up to the risks posed by just-in-time supply chains and develop “just-in-case” supply chains. The war in Ukraine further emphasizes the need for supplier diversification, especially for critical commodities, and the case for bringing production closer to end markets. Just as the massive globalization trend that kicked off in the 1990s as China, India, and the ex-Soviet bloc integrated into the world economy led to significant deflationary trends, its reversal has the potential to lift price pressures. Adding to inflation pressures is higher government spending. This is particularly the case in Europe, resulting from an increase in defense spending and a probable escalation of spending on the energy transition to eliminate dependence on Russian natural gas. However, spending on the energy transition has the potential to be deflationary over time to the degree it provides lower-cost solutions and expands capacity.
Finally, while we expect geopolitical tensions to remain elevated beyond the uncertainty surrounding the war in Ukraine and its potential for escalation, we do not expect Russia’s invasion of Ukraine will embolden China to invade Taiwan. While China seeks eventual reunification of Taiwan with the mainland, China has little reason to act aggressively currently. Indeed, the crippling blow dealt to Russia through coordinated global sanctions should serve as a deterrent to China. To consider upsetting the current status quo with Taiwan, China would need a reason to justify the invasion. It would also need to address its key vulnerabilities of reaching confidence that it would succeed militarily and sufficiently reduce its dependence on US technology and the US dollar banking system. Such an attack would disrupt global trade and risk a major economic downturn in China that would threaten domestic social stability that is central to the legitimacy of the Chinese Communist Party.
These long-term ripples may turn into waves or may subside, but they merit monitoring as investors evaluate their long-term investment strategy.