INSIGHTS

Financial markets are still getting to grips with the prospect of rising interest rates, and now they have an increasingly tense geopolitical situation on their hands as well.

It’s unclear how things will play out between Russia and Ukraine. Markets are on edge, and it threatens to make an already problematic inflation spike even worse.

For New Zealand, the direct economic links with Europe are limited, at least compared to the likes of China, Australia and the US.

In the 2021 calendar year, 9.1 per cent of our total exports went to Europe, compared with a combined 55 per cent going to those other three nations.

The UK is our sixth largest market (by country), taking 2.2 per cent of our exports. The only others in the European region that make the top 20 are Germany and the Netherlands, which take 1.3 per cent of our goods each.

Nonetheless, any military conflict could still lead to economic fallout, as other parts of the world are impacted and as sanctions place an added burden on already strained supply chains.

Russia is a major producer of commodities, notably oil, but also the likes of aluminium and fertiliser. If the situation continues, we should expect further increases in oil and commodity prices (including agriculture). This means higher fuel costs for consumers and rising input costs for many businesses.

This could put additional pressure on the cost of living, which is already rising much more than we would like. It could leave our Reserve Bank, as well as its peers, with some tough choices to make – facing even higher inflation combined with rising economic uncertainty.

They could be forced to choose between tightening monetary policy as planned to combat the rising prices, or backing away from those plans to shore up confidence across financial markets and economies.

With inflation at multi-decade highs in many places, central banks will be reluctant to backtrack much at all, which suggests this flare-up won’t derail tightening plans.

In contrast, any escalation would see longer-term interest rates fall, as investors head for the safety of government bonds. Gold might also catch a bid, as would traditional haven currencies like the US dollar, Swiss franc and Japanese yen.

The severity of any sanctions will be important. This is another reason the situation remains fragile, and it puts many other countries in a difficult position.

Russia supplies a large proportion of Europe’s energy supply. Should it choose to restrict this in retaliation for sanctions imposed by others, countries like Hungary, Germany and Italy are at risk.

Any military conflict would be a negative for global sharemarkets, at least in the short-term. One would expect European shares to suffer, given the proximity to the trouble. The US, which is a relatively closed economy anyway, should hold up better.

Emerging market shares could see some impact, although Russia accounts for just 3.5 per cent of emerging market share indices. China, Taiwan, South Korea and India make up more than 70 per cent these days.

Our sharemarket wouldn’t be immune, but during uncertain periods it’s the predictable, defensive businesses that usually prove more resilient.

The NZX is dominated by sectors like healthcare, real estate, infrastructure and utilities, so it might be more insulated than most.

It’s impossible to say how the situation develops from here. Geopolitical issues are difficult to predict at the best of times, and even more so when Russia is involved.

If the conflict remains focused on Eastern Ukraine, it won’t have long-lasting effects on financial markets, and it might even prove an attractive opportunity for long-term investors.

However, if a minor skirmish morphs into a full-blown invasion of the entire country, all bets are off.