Ukraine: War or Peace?

Latest developments

The latest developments in the ongoing Ukrainian crisis have seen:

• Russia recognising Donetsk and Luhansk as independent states
• Russia sending “peacekeeping” forces into those regions ostensibly to protect the inhabitants from “Ukrainian aggression”
• Putin questioning the legitimacy of Ukraine as a state, claiming that the country was a creation of communist Russia and the Bolsheviks
• Sanctions imposed on the Russian state and some Russian entities by various countries including the US, the EU and the UK

The question now is: what next? Does the lack of military response from Western nations embolden Putin to go further and attempt to capture more territory? And at what point will the West be pushed so far that military action is taken? Clearly Putin & Co. thinks it is further than at present. Daniel Murray explores these questions in this Macro Flash Note.

Putin’s primary objective

The West’s desire to avoid military conflict is clear from the response so far. At the same time, Putin needs to be careful how far he pushes for fear of becoming embroiled in a prolonged, expensive and unpopular military engagement. While there is no obvious red line, the message appears to be that sanctions will be the primary route via which the West intends to try to inflict pain on Russia.

It is also worth mentioning that it would be highly unusual for NATO to engage in direct military action in defence of a non-NATO member state. However, it is conceivable, as appears to have happened already, for NATO countries and others to provide support via arms deliveries, intelligence sharing, financial assistance or perhaps in moving troops to NATO countries that are geographically close to Ukraine.

Moreover, fighting in the Donbas between Ukrainian forces and alleged Russian-supported rebels has been ongoing since the Crimea annexation in 2014. Our interpretation is that taking control of the Donbas was always a primary objective for Putin and, whilst disappointing, it is no great surprise that a pretext has been found to fulfil that aim. It appears to us that it would require significant further incursion into Ukrainian territory to provoke a direct military response from the West.

Same facts, different opinion

A fundamental issue relates to the different lenses through which the Ukrainian situation is viewed by the opposing sides. Through the NATO lens any country is free to apply for membership. Moreover, wider membership is viewed as a good thing because it enhances global stability whilst also encouraging and facilitating trade and economic advancement. These factors are generally considered good for the prosperity of the citizens of the countries involved.

However, the Russian authorities view the situation differently. According to their view, NATO has expanded its sphere of influence to incorporate a large number of former Soviet countries, including several that have a direct border with Russia. In this context Russian leaders consider NATO’s expanded membership as a challenge to Russian security, as a means of shrinking Russian global influence, as a threat to Russia’s economic model and, potentially, as a danger to the current leadership if these factors result in civil unrest. This helps explain Russia’s recent actions.

What about the sanctions?

It is not clear to what extent the proposed economic sanctions will impact the individuals and companies involved. Economic sanctions have been imposed on Russia since the Crimea was annexed in 2014 but have so far had little to no impact. Even if the sanctions do have an impact, they will take many years to work. In this context it is notable how long the apartheid regime was able to persist in South Africa despite its global pariah status: political dogma can dominate economic hardship for a prolonged period of time, especially if wealth is concentrated in the hands of the political elite who have an incentive to maintain the status quo.

The energy paradox

There is an inherent paradox in the situation. The best way in which the West could inflict economic pain on Russia would be to stop buying its energy. However, with no easy short-term alternative sources, Europe is beholden to Russian energy supplies¹. Similarly, Russia depends heavily on revenues from energy sales to Europe. And Russia also wants to ensure that it maintains a reputation for being a reliable supplier to encourage other countries to buy its energy. So the uncomfortable reality of Europe being heavily reliant on Russian energy is unlikely to diminish meaningfully any time soon.

Looking further ahead, if the “green revolution” were to see Europe reduce its energy dependence on Russia – for example by enhancing wind, nuclear or solar energy capacity - that too would result in a diminution of Russia’s sphere of influence. Ironically, high energy prices make alternative sources of energy more viable.

Potential consequences

It is important to distinguish between the direct and indirect consequences of the situation. As we have previously highlighted², the direct consequences are limited due to the small size of the Ukrainian economy, the limited availability of Ukrainian assets and the fact that much bad news has already been priced into Russian assets.

However, the indirect consequences are harder to ascertain. We have already seen a sharp increase in energy prices over the past couple of months. This both acts as a tax on consumers and corporates (because it raises the proportion of income and revenues spent on energy) and also feeds through into higher inflation. In turn that exacerbates the complications for central bankers: monetary policy has already started to tighten around the world³ in response to higher inflation but a more uncertain outlook brought about by the prospect of direct military conflict between Russian forces and the West would typically elicit monetary loosening.

It seems likely to us that in the short-term inflation fears will dominate and central bankers will pursue planned tightening. However, if the situation deteriorates over the next few months and there is a negative economic impact the policy outlook will change accordingly. At the very least, it will encourage central banks to tighten less aggressively than previously planned.

Market comment

Markets are rarely driven by one factor and it is notable that previous periods of heightened geopolitical risk have brought about hugely varied market responses. This is partly because geopolitical risk tends to be highly idiosyncratic and specific to the particular events taking place and partly because markets discount a wide variety of factors including the outlook for growth, the policy environment and the corporate situation. The sticker shock and headline risk of geopolitical events therefore often brings about a negative and panicked market reaction to start with followed by a period in which markets settle down as the broader array of relevant factors are discounted.

The current context is one in which markets were already pricing in important changes this year in terms of growth and policy. Economic growth is expected to slow from the exceptional rebound year of 2021. Inflation is much higher than central banks’ target rates in many parts of the world and we have accordingly seen a dramatic shift in expectations regarding the monetary policy outlook over the past few months. And there remains uncertainty associated with what the post-covid world will look like.

Nonetheless, whilst slower than last year, economic growth is expected to remain significantly above trend this year and monetary policy will remain highly accommodative, even if some of that accommodation will be removed. Furthermore, confidence is growing around the world that we are largely through the covid crisis and life can start to return to normal. Objectively, this is not a terrible situation for financial markets even if it is less good than last year and despite current unease over the Ukrainian situation.

Of course, the situation is highly fluid and uncertain but our current assessment is that:

• Geopolitical events typically do not have a lasting impact on markets
• The economic recovery remains intact, despite high energy prices
• The dislocation is providing opportunities in some emerging markets as post-covid recovery takes place and against a background of attractive valuations and fundamentals
• Similarly, US Small-Caps look attractive to us and we are also seeing opportunities in high yield debt and BBB-rated investment grade bonds following spread widening
• However, we think commodities look unattractive as an asset class given high prices and over-valuation

We remain alert to the changing situation and will of course update our view should there be any meaningful developments.

¹  See “Oil market in a crisis” EFG Infocus, February, 2022

² See “Pain in Ukraine” EFG Macro Flash Note, February, 2022

³  See “The Geography of the Global Interest Rate Cycle” EFG Macro Flash Note, February, 2022

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