Markets in times of war

In an attempt to understand how central banks are behaving with regard to inflation and what impact the conflict in Ukraine is having on financial markets, we present an interview with Antonio Mele, Full Professor of Finance at the USI Faculty of Economics.

For many months now, global markets have entered a phase of re-pricing, and in conjunction with a variety of circumstances. Equity valuations in the US seemed to be quite high even before the pandemic broke out. The fiscal and monetary policies put in place in reaction to the pandemic emergency helped support markets, but the inflation that accompanied the recovery process forced the Fed (the US Central Bank) to review its monetary policy in order to anchor expectations of future inflation at the most acceptable levels possible. The markets have reacted quite strongly in recent months, but I believe that their reaction would have been even more dramatic had the Fed not been so resolute in attempting to respond to inflation. The conflict in Ukraine has brought additional challenges and markets are now discounting a further premium due to the materialisation of geopolitical risks. This premium was of course practically non-existent before the conflict. It is impossible to predict how long the markets will discount such a premium. However, the impact of this war on current market developments is substantially limited to geopolitical risks.

How long does it take markets to recover from a 'shock'?

There are shocks that have an external nature and there are shocks that have an internal nature. An example of an “external shock” is a sudden slowdown in economic activity such as that which occurred in Spring 2020 in connection with the outbreak of the pandemic. If the pandemic had not led to tensions in the global supply chain, the world economy would have reacted relatively quickly to this shock precisely because the economic fundamentals seemed to be good at the time of the pandemic shock. An “internal shock” works differently. It usually occurs while both real and financial markets are affected and almost invariably originates from problems in the functioning of credit markets or even from a financial crisis. Such a shock is capable of dragging on for years and sometimes decades. Fortunately, the world economy has not been affected yet by this type of shocks in the last months.

What could happen economically to the European Union?

The EU must be able to coordinate problems of severely high public debt that some of its member states are facing. Public debt is growing and recovery does not seem imminent. How long will the markets be able to support member states with debt-to-GDP ratios above 100% or 120%? This, in my opinion, is the most important challenge. Unfortunately, I do not believe that Europe has embarked on the necessary political dialogue aimed at establishing new frameworks for solving such issues, which will most likely emerge in less than a year or two. Such a dialogue is as important today as it would have been during the European debt crisis that hit more than a decade ago.

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