This week we again look to the headlines and look at an issue that has been front and centre for the markets, that of the Ukraine situation (perhaps a reprieve from the endless monetary policy commentary). Firstly, we begin with a rather macabre fact about the markets. Wars (we aren’t suggesting that this will be an all out conflict, at least in the traditional sense) aren’t necessarily bad for returns, think back to the First Gulf War. Looking through history, some of the best returns for equities investors in the first half of the last century were in fact the US’ entry into WWII (1942 - 1945) before entering into a period of what has been termed the postwar blues (1945-50). When was it they saw the next leg up? While it may be a touch oversimplified, entry into the Korean War. For the precious metals fans amongst you, gold hit all time highs over the course of the first year of the Soviet invasion of Afghanistan (1980).
So now with that rather calming start, lets look at Ukraine and where this situation might head. Ending, as always, with the implications for the investor.
A walk down history lane
Again, we begin with the usual disclaimer for the historians amongst you that we are taking a rather broad strokes approach to explaining what can at best be summed up as a complex situation. This is a topic one could write books on, we’ll attempt to sum it up in a few paragraphs.
The second largest nation in Europe (as we know of it today) is one that , some may be surprised to learn, actually preceded the power that now seeks to dominate it in many ways The Kievan Rus’ was a loose federation of tribes (categorised as East Slavic, Baltic and Finnic peoples) that arguably came into existence by the sheer force of the Varangian, being a name given by Eastern Romans to Vikings (primarily Swedes), prince/chieftain Rurik (reigning 862-879). Thus founding the Rurik dynasty which ruled the Kievan Rus’ and its successor states until the 17th century; over the centuries consolidating power and creating some semblance of a Rus’ identity. As with all things, dynasties in particular, this particular federation eventually disintegrated; dissolving into independent principalities each ruled by a separate branch of the Rurik dynasty by the mid 12th century. Of particular importance to remember here is that the Principality of Muscovy became the dominant player in the region. So much so that when Ivan IV (commonly known as Ivan the Terrible) came into his inheritance at the wise old age of three, his appointed regents decided to crown him Tsar of all Rus’ (his grandfather Ivan III, Grand Prince of Moscow, being the first to style himself as “tsar” of all Russia, albeit not officially) .
Unfortunately for the Rurik dynasty, Ivan’s formidable anger also saw him kill his eldest male heir in a fit of rage, he also saw the miscarriage of a daughter-in-law while the one son that did inherit his seat (Feodor) wasn’t able to leave a male heir upon passing in 1598. Leading to the eventual extinction of the house of Rurik (at least in the male line). This again led to disintegration of what was previously the somewhat united Rus’ until the ascension of 16 year old Michael I (Mikhail) of the house of Romanov to the Tsardom in 1613. A decision made entirely by the nobility at the time despite the initial protests of young Michael’s mother; the title carried with it a rather fatal reputation at this point. This particular house, with its quite legitimate concerns around stability (and self-preservation), instituted a trend towards the centralisation of power in the hands of Moscow. Bringing to heel many of the outer principalities, including what we know to be Poland (more recent Tsars also being Grand Dukes of Poland), modern Ukraine, the Caucasus and central Asia.
The above is a vast simplification given that it is primarily Russia-focused. Failing to focus on the uniquely Ukranian principality of Kyiev which reached its zenith in the reign of Vladimir the Great (985-1015) when its place on the top of the food chain ensured that the Rus’ adopted christianity, in particular the Byzantine version of Eastern Orthodoxy. Following the latter’s disintegration, later rulers could legitimately claim leadership of the church. It also ignores its dramatic fall from grace under Polish influence (when that particular polity was still independent of Moscow), the Mongol hordes and the Ottoman Empire (the Rus’ submitting to Mongol rule for 300-odd years). The context we are trying to establish is that the concept of Rus’ is evolving, the ethnicities/cultures quite diverse and the way in which Moscow dealt with the situation was to centralise power.
How did Moscow go about this? Let's take Catherine the Great as an example, her attempt to ensure stability involved inviting Germans into the lands that are now modern Ukraine in the hopes of changing the demographics of the population. Ring familiar to recent events? That is, the granting of Russian passports to Ukranians (Russians, by the way, are the largest ethnic minority in Ukraine). Add to that the process of what is now referred to as Russification, a process by which culture would be standardised and a common language adopted.
So how did the Bolsheviks handle this trend? For one, it was more of the same, perhaps worse. Once coming into power, their quest for getting rid of feudal traditions and rapid industrialisation led to even greater centralisation in the hands of Moscow. It was Stalin (a Georgian himself) who is perhaps most infamous in the Ukraine story. Manufacturing a famine in the region that wiped out close to five million people in order to force them toward collective farming and quell any vestiges or notions of independence. Suffice it to say, they continued Russification but this time on an industrial scale.
So, the point of the above brief history? Moscow has seen these peripheral territories as her own for the best part of 500 years and any instability (at least insofar as it is not aligned with her interests) is automatically deemed to be her issue.
So, back to the modern context?
Let’s begin with the agreements, handshake or otherwise, that Western governments (NATO included), especially the US, made with Moscow. Eastern Europe was supposed to be out of bounds, Regan went so far as to assure Gorbachev that no military installations would be made there. Fast forward to the Yeltsin era, we all know the debacle and chaos that was 90s Russia. It is within this context that a little known but rather efficient ex-KGB agent named Putin (serving in a number of roles in the upper echelons of the St Petersberg administration) really began his ascent. Appointed by Yeltsin as Director of the FSB in 1998, Putin was Prime Minister by the end of August 1999 with Yeltsin also making it clear that he had found his successor. When Yeltsin unexpectedly resigned on 31 December 1999, Putin became Acting President of the Russian Federation. Arguably escalating the Second Chechen War over the course of his time as Prime Minister/Acting President, Putin’s popularity rose (war does tend to do wonders for approval ratings). That conflict also shows Moscow’s views on stomaching diversity (it is, after all, a confederation in name at least). Officially inaugurated as President on 7 May 2000, Putin installed another strongman, Kadyrov, as “head of administration of the Chechen Republic” in June and ensured the capital’s supremacy. High oil prices during the first half of the 20th century saw a resurgent economy and surging approval ratings.
Fast forward to post-GFC, sanctions had taken their toll and low oil prices saw the economy in doldrums. So, the rhetoric again changed. This time it was Georgia as a substitute for Chechnya, nominally supporting independence for South Ossettia and Abkhazia. The story again, much like the Second Chechen War, centred on stability and ensuring safety (at this point, there may be a pattern emerging). This is all despite ethnic cleansing of Georgians from her previous territories…
Which brings us to poor old Ukraine. A nation that fought for her independence and, during the initial days of the collapse of the Soviet Union, was given assurances by both sides that there will be little interference. Believing this to be the case they promptly disarmed (the nation having one of the biggest nuclear arsenals at the time) and even more promptly fell apart (politically with interference). Being pulled on one side by the prospect of greater integration with the EU, which aggressively took on ten new additional members previously under Moscow's reigns in short order, and on the other by Russian fears of encroachment.
On the latter front, Moscow decided that the best potential strategy was to rig the elections that saw Viktor Yanukovych come to power. Following public outcry, it also decided to use one of its more infamous problem solving techniques; radiation poisoning of the opposition candidate Yushchenko. This however led to the Orange Revolution and, despite back and forth between establishment parties over the next decade, it was the public that paid the greatest price. Yanukovych eventually came to power again in 2010. Some stability followed but following his dislodgement in 2014 in favour of the Pro-EU Poroshenko, Moscow's response this time (instead of poisoning) was an outright annexation/secession (whichever way you wish to look at it) of Crimea. Again, an oversimplification but the broad strokes are there.
The latest foray by Moscow can perhaps be construed as another penalty on Ukraine for the election of a pro-EU government led by outsider, actor/comedian Volodymyr Zalenskyy, in 2019. Whose most recent claim to fame at that point, by the way, was playing the role of the President of Ukraine in a TV show. One can appreciate the level of the public’s disenchantment with the establishment for this to have occurred (with this disenchantment perhaps we see parallels with US politics recently). Again, in sticking with tradition, the message from Moscow is rather clear; if you want stability, the only way you get it is via Moscow.
Not to mention, as with all Tsars of the past (there is little doubt in our minds that the Rus’ never truly let go of the concept, whether they wish to call them Tsar, Comrade or President), justification and legitimacy has always been on the premise of looking towards Moscow for direction. Effectively in his third decade in power, Tsar Vladimir Vladimirovich of the House of Putin does need to justify his rule after all.
Where does this go then?
Perhaps the one of the best analogies to the world of geopolitics is that it is closest to the game of chess. At the end of the day the outcome is predicated on the king, it is not a question of who takes the most pieces in the game. Great powers/leaders are exactly that. It is not quite immediately obvious how precarious their situation is until the very end (and they can usually move very little). But the pieces around them are exactly that; some are pawns, some rooks and others queens. Their survival predicated on their ultimate necessity to the king, sacrificing a piece is so often the play. Don’t believe us? Look at the Cold War. How many proxy wars? How much collateral damage? And yet the two “kings”, the US and Soviet Union, never came into direct conflict. Only to fall like a house of cards. More recently, the untouchable Gaddafi (who died in a gutter). And if certain intelligence services are to be believed, the supposed rigging of an entire election in that bastion of democracy that is the United States of America (take your pick, depending on which side of the political spectrum you sit on, 2016 or 2020).
Back to the issue at hand, neither “king” can afford to lose face and must withdraw amicably, perhaps at the cost of a pawn (i.e. Ukraine). Basically, Moscow cannot lose face nor its influence in its so called backyard. Europe cannot put its energy supply at risk and the US cannot afford a war over Ukraine (to be blunt, it just might not be valuable enough). There will be a solution at the expense of Ukraine for the kings to draw back and not surrender at the feet of the other. Biden ironically made the first move by implying that Russia was amassing troops at the border for an invasion which Moscow explicitly stated was not the case (they were of course in our view waiting for the right weather and an opportune excuse). If they invade, it makes them look like they reneged on their word to the international community. However, if they withdraw Putin loses face to the gallery (i.e. electorate) with the added advantage the US administration can claim to have de-escalated the situation. Our base case? Some nonsense about perceived (real or otherwise) oppression of ethnic Russians being sorted out and lip service given. It will be back to business as usual with Russia gaining concessions and biding its time, waiting to rig the next election. There will also be an understanding that Ukraine will not have the opportunity to join the EU or NATO any time soon (if ever). At least not as long as Tsar Putin is in power (given that he has spent part of his reign ensuring he can basically remain in power indefinitely, this could be a while).
As Biden unfortunately put it, Russia would “be held accountable if it invades [but] it depends on what it does…it its a minor incursion….etc”. Basically indicating that it could get away with something, within reason of course. In many ways this dovetails perfectly with the other side of the equation; the Russian stance here reeks of Putin testing where the line is (in saying that, his Chinese counterpart will be watching this unfold with great interest). He may stick his toe over the line but we doubt very much that he would cross it properly and risk full scale war with the US/NATO (though the odd cyber attack clearly isn’t off the cards).
Outcome driven, pure and simple, no one actually wins. The major players will advertise that they did while Ukraine certainly loses. Its the unfortunate reality of the world we live in.
Implications for markets?
The uncertainty will certainly put continued upward pressure on the price of Brent and LNG. Although a perceived resolution should see some reprieve, given our contention around peak oil, this will be short-lived (a buying opportunity perhaps?). The most important implication for us however will be the impact on monetary policy, especially CPI data (upon which central banks must at least be seen to do something about). We could either see this turn the Fed more hawkish or offer a much needed excuse for why inflation is not transitory thus allowing them much more flexibility. If the latter, then this may be good for the marginal investor. If the former, we could have a problem.
Nevertheless, we stick to our contention that there is very little breathing room left for the Fed. Why do we say this? If we go to historic norms about the nominal yield being at least 50bps above inflation, then the rate should already be at around 4%. Good luck with that. Effectively quadrupling the interest burden on state and local governments within the space of a year? One wonders how long central banks may stay independent in that instance (i.e. without pushback from the political establishment).
If there is an accident and there is a conflict (more likely to be via a proxy). It will almost certainly allow for more dovish stances from central banks with some much needed reprieve for the equities investor (not to mention precious metals).
The above may seem a rather cynical and blasé approach to take and we do firmly acknowledge the blatant unfairness and disregard for even common decency that the situation entails in relation to the Ukrainian citizenry. Being a pawn in a larger game of geopolitical chess is no fun for the pawns. If you do truly want to avoid more wars in Eastern Europe, pray that oil prices stay high enough and sanctions are dialed back enough that the modern Tsar wont need another war to push up his approval ratings domestically.
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