Uncertainty over the war in Ukraine resulted in another volatile week in investment markets as investors worried about the worsening conflict and disruptions to energy supply following the intensification of western sanctions on Russia. Reports of a fire at a Ukrainian nuclear power plant as a result of Russian shelling and the associated risk of a nuclear catastrophe added to the uncertainty. This saw US, European, Japanese and Chinese shares fall for the week.

Despite falling on Friday Australian, shares managed to rise through the week helped by surging commodity prices with gains in resources stocks offsetting weakness in most other sectors. Bond yields fell on safe-haven buying offsetting concerns about higher inflation. Oil prices surged with West Texas Intermediate briefly rising above $US116/barrel on supply concerns before falling back helped by reports Iran and the US may soon reach a new deal but to still be 20% higher over the week. Metal, gold and iron ore prices also rose, and this helped push the AUD up despite safe-haven buying boosting the USD.

From their bull market highs last year or early this year US shares are down 9% and European and Japanese shares are down 15%. Thanks to the surge in commodity prices and upcoming strong dividend payouts flowing from the most recent earnings reporting season Australian shares have held up a bit better and so are only down by about 7%. The strength in commodity prices also explains why the AUD has risen since the war started whereas normally it falls in times of global crisis.

The war in Ukraine remains the key factor driving markets at present and much uncertainty remains about how it will unfold and what its economic impact will be. If the conflict is limited to Ukraine with Russian gas and oil still flowing to Europe and NATO not getting directly involved (Scenario 1), then the economic fallout will be limited, and further share market falls may be minor or we may have seen the low.

But if Russian energy supply is cut off and NATO military forces get directly involved (Scenario 2) then share markets could have a lot more downside (like another 15% or so). Scenario 1 seems more likely as Russia does not want to get into a fight with NATO, sanctions have been targeted to exclude the energy sector and Russia needs the revenue. But the risk of Scenario 2 and, in particular, a disruption to gas supply is high if Putin feels he has nothing to lose as the war drags on and as the now tough sanctions plunge the Russian economy into deep recession. And given the uncertainty, investors may fear the latter scenario even if its ultimately avoided. So markets are likely to remain volatile with oil prices remaining under upwards pressure until there is greater clarity around all this.

However, no one knows for sure how this will unfold. But the history of crisis events and share markets tells us that after an initial hit there should be a decent rebound over 6 to 12 months. There are some things that will help drive this:

• Just as in the Cold War, Russia & the West will likely find a way to co-exist, with mutually assured destruction or MAD providing an incentive.
• The crisis is more inflationary than deflationary but for the next few months, it's likely to be a constraint on more rapid central bank rate hikes.
• Surging oil and gas prices will ultimately incentivise increased production from key OPEC producers and US shale oil producers.
• Additional defence spending will provide a boost to growth.
• While European growth will take a bit of a dent, global growth this year is still likely to be strong at about 4%.
• As a result, company profit growth is likely to remain solid this year, albeit down from last year.

Given the uncertainties concerning the Ukraine war including the potential for financial instability posed by exposure to collapsing Russian assets and cyber-attacks, central banks don’t want to be an added source of uncertainty but will still proceed with tightening - just a bit more cautiously for now.

• Fed Chair Powell’s comments in the past week were hawkish but careful and signalled that the Fed is focussed on controlling inflation, sees the US economy as strong enough to withstand rate hikes but will proceed cautiously given the uncertainty posed by Ukraine – hence while faster rate hikes may be possible at future meetings it looks on track for a 0.25% hike this month, not 0.5%.
• The Bank of Canada raised rates as widely expected by 0.25%, seeing Ukraine as adding to uncertainty but also adding to inflation.
• The RBA sees the Ukraine war as a “major new source of uncertainty” but appears to lean to the view that it poses more of a threat to inflation than to growth but is nevertheless prepared to remain “patient” in assessing the sustainability of the rise in inflation – meaning that rate hikes are at least still several months off anyway.

Our assessment remains that the Ukraine war is more of a threat to inflation via higher commodity prices than it is to growth. Beyond the threat posed by higher energy prices to spending power (which is the main risk) Europe, the US and Australia only have a small exposure to the Russian economy (with exports to Russia being less than 0.7% of EU GDP, less than 0.2% of US GDP and less than 0.1% of Australian GDP). But the rise in energy and food prices (with the oil price up 20% since the invasion started, thermal coal prices up 60% and wheat prices up 25%) will add to inflation. In Australia, the rise in world oil prices will likely add another 15-20 cents a litre to already record petrol prices. And higher wheat prices will push up bread prices.

Flooding in Queensland and NSW is a new source of uncertainty too. But again the floods are more likely to add to inflation than detract from growth. The 2011 floods contributed to a -0.3% fall in GDP in the March quarter of 2011 due to disruption but growth rebounded strongly in subsequent quarters thanks to rebuilding. But the impact on fruit and vegetable prices provided a boost to inflation. This time around we expect economic growth to remain positive thanks to ongoing reopening from the pandemic and the floods being less broad based than in 2011, but the March and June quarters are likely to see about 0.2% added to inflation.

Combined with the impact of higher petrol and grain prices flowing from the Ukraine war this will likely push Australian inflation to about 5%yoy by mid-year (which compares to the RBA’s forecast of 3.75%yoy) and push underlying inflation to about 3.8%yoy (compared to the RBA’s forecast of 3.25%yoy). This means inflation will be well above implied RBA forecasts of about 0.8%qoq for headline and underlying inflation in the March quarter.

As a result, we have brought forward our expectation for the first RBA rate hike to June. Our base case for the first rate hike had been for August with a high risk of June, but with March quarter inflation now likely to come in well above RBA expectations and the ongoing piling on of price rises only adding to upwards pressure on wages growth – which we expect to accelerate to a 0.8-0.9%qoq rise in the March quarter - we now see the RBA concluding that the conditions for rate hikes will be met in June. Following a 0.15% increase in the cash rate taking it to 0.25% in June, we now expect two more rate hikes by year-end taking the cash rate to 0.75% by year-end (up from our previous forecast of 0.5%).

Out of interest the Russian economy at $US1.6 trillion year is only a tad bigger than the Australian economy at $US1.5 trillion.

What to watch over the next week?

In the US, CPI inflation data (Thursday) is likely to show a further rise in inflation to 7.9%yoy and in core inflation to 6.4%yoy. Small business optimism for February will be released Monday and January data on job openings will be released Wednesday.

The ECB (Thursday) is expected to retain a hawkish bias but delay any slowing in bond-buying given the uncertainty posed by the war in Ukraine.

Chinese trade data for January and February will be released Monday and February inflation data (Wednesday) is expected to show CPI inflation remaining low at 0.8%yoy and producer price inflation slowing further to 8.6%yoy. Credit data for February will be watched for a further acceleration in credit growth following recent policy easing measures.

In Australia, the NAB business survey for February (Tuesday) is likely to show a rebound in conditions and confidence following the decline in Omicron cases but consumer confidence for March (Wednesday) may slow slightly reflecting the bad news of the war in Ukraine. RBA Governor Lowe in a speech on Wednesday will likely reiterate the RBA’s preparedness to be patient in assessing the rebound in inflation but his assessment regarding the impact of the Ukraine war and the recent floods will be watched closely given the additional upside risks both pose to the inflation outlook.