Global strategic insight: Putin’s invasion – turning back now
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The tragedy of the unfolding events in Ukraine is the pure futility of the widespread loss of life. The Russian invasion has manifestly failed to achieve quick regime change. There are only dim prospects of the Russian military achieving anything other than further destruction over coming months, given the now evident strength and depth of Ukrainian forces. Even if this initial opposition was overcome, the resources now required to occupy the nation seem beyond Russia’s means. As a result, we would now highlight that it is in both Putin’s and Russia’s interest for the war to be stopped. The timing of such a move is necessarily uncertain but we believe investors should be on guard for Putin abruptly standing down Russian forces in Ukraine. This would lead to a rapid reversal of negative sentiment towards risk assets and significant falls in energy and food prices. With implied volatility in European equity markets already matching the highs of March 2020, it is already too late to “panic-sell”, in our view.
Less than two weeks ago, Russia abandoned its seemingly rational maximum pressure negotiating strategy on Ukraine by transitioning from the threat to the actuality of military force. Nevertheless, there is even now a just-open window in which this invasion could be presented as having achieved its objective, within Russia at least. Putin may look for concessions on NATO membership and a removal of the toughest sanctions in return for a withdrawal of forces. However, the prospect of demilitarisation of Ukraine appears remote, given the ongoing risks presented by the Russian land border.
The Russian military appears to have dramatically underestimated the strength of the Ukrainian forces which have successfully stalled the Russian attack, while at the same time continued to mobilise a reservist force which is likely now to outnumber the invaders. As a result, Russian military tactics seem to have shifted to heavy bombardment of civilian areas. This has fully erased the narrative of any liberating force.
Russia may be presenting a brave face for global media, but we believe Putin and his senior officials will have been taken aback by the rapidity and extent of the international sanctions on Russia, especially after over a decade of indifference to Russian hybrid tactics.
In the weeks leading up to the invasion of Ukraine, dialogue between Putin and western politicians may even have convinced him that he could persuade any European nations currently reliant on Russian energy to look the other way on Ukraine, given his internal aim of rapid regime change. Even after Russian tanks crossed the border, certain nations in Europe were resisting sanctions on SWIFT, for example. Now there is even talk of an embargo on Russian oil and gas.
Western politicians have realised they have the popular support to economically pressure Russia, no matter the short-term impact on oil prices or the economy. We also note the remarkable absence of push-back on sanctions from the corporate sector. Even where material losses will be incurred by global companies who are faced with writing off significant multi-decade investments, there has been a near-universal acceptance of what must be done. This extends from oil and gas through to the digital economy and global accounting firms.
Russia’s GDP is only 60% larger than that of Iran. Therefore, the direct costs to global GDP of sanctions which prevent Russia from participating in global trade is likely to be relatively modest, especially when compared to the impact of the COVID-19 pandemic.
Nevertheless, Russia holds several trump cards – including a 5% share of global energy production and 17% share of global wheat exports. In addition, Ukraine has a further 12% of wheat exports currently under threat of disruption from the war. Russia is also a significant global player in nitrogen fertiliser production with a 13% market share, a value-added by-product of hydrocarbon production.
We expect all these cards to be played during any negotiations. In addition to the direct costs of excluding Russia from the global economy, the recent 60% increase in oil prices to US$124 is likely to act as a significant drag on global economic activity, if sustained. Furthermore, Russia’s gas supply to Europe, which has stayed remarkably constant as it transits Ukraine during the war to date, may yet cause disruption to Europe’s manufacturing sector in the event of further sanctions. Russian gas is currently enjoying a premium of 150% to pre-invasion prices, reflecting fears of a future supply interruption.
Global wheat prices have also soared by over 40% since the invasion. This is likely to push headline inflation higher in the second half of the year, extending a period of above-target inflation, to the discomfort of central banks already contending with a rapid post-COVID surge in price indices. In developing economies, there is the risk of increased political volatility given the rising cost of food. Nevertheless, both food and energy prices could fall substantially when hostilities between Russia and Ukraine cease as they are both well above long-run marginal production costs.
Aside from these important but narrowly defined pressure points, Russia is poorly placed with respect to sanctions. This is reflected in the 30% decline in the Russian ruble and 80% decline in Russia-based ETFs which we use as a proxy for the Russian equity market which remains closed since the invasion. Russian 5-year sovereign credit default swaps are now trading at 26% per annum, a level implying a very high probability of default. In the circumstances, we believe Russia’s banking system will be under extreme pressure as it is effectively locked out of funding markets and will be likely to have to turn to emergency facilities provided by the central bank.
European equity markets may be down 13% since the start of hostilities but this is not by any means a systemic risk. Global markets have not even entered a correction and are only 7% lower. The market impact of the sanctions on Russia is therefore clearly asymmetric.
To offset the impact of sanctions, Putin may be looking towards China for support and there has reportedly been a boom in stocks set to benefit from Sino-Russian trade in recent days. However, geopolitically Putin’s invasion risks creating more difficulties for China, which has only recently shifted to a more assertive foreign policy. By uniting western nations onto a common cause and potentially highlighting the shortcomings of authoritarianism, it is difficult to see how Russia’s bloody and chaotic conflict furthers China’s international agenda. As a result, we believe there will be pressure from China on Putin to secure a ceasefire and resolution, despite being an ostensible if nascent ally.
It remains a possibility that the recently increased assault on civilian infrastructure by Russia represents the final escalation of hostilities in Ukraine. This escalation does not appear to have provided the military breakthrough which may have been anticipated. Furthermore, estimates of the resources required to maintain a force of occupation must have increased dramatically since the start of hostilities, potentially making winning the invasion a losing proposition. There seems to be no identifiable Russian plan for the level of spending which would be required to supress the Ukrainian population’s national identity under a puppet regime.
The rational course for Russia now appears to be to accept its strategic error and retreat, while securing at least some notional geopolitical objectives in return for withdrawing its forces. This could also provide political cover within Russia. European equities in particular would respond favourably to this development, while energy and food prices would be likely to fall sharply.
Such a scenario may appear remote at this instant, but as with the shifting position on European sanctions two weeks ago, the situation is very fast-moving and all non-zero probability scenarios should continue to be factored into long-term portfolio planning. Nevertheless, the damage to Russia’s reputation on global markets has been severe. Even in a scenario of a ceasefire, Russian assets may continue to trade at depressed levels as the international community maintains economic pressure on the incumbent regime.