With global markets testing their June lows, we wanted to provide our latest thoughts on the three key issues that are at the heart of the matter, as they are driving the volatility in interest rates, credit and currencies that are, in turn, driving volatility in the global stocks.  This week, we’ll provide our thoughts on the war in Ukraine, then follow with an update on China, and finally with some scenario analysis on the path of inflation from here.

• As the war in Ukraine enters its 8^th month, the short term outlook points to meaningful risks.  Putin will presumably use the referendums to claim that about 15% of Ukraine’s landmass is in fact Russian territory, and will threaten nuclear retaliation against anyone who violates this new border.  At home, Putin is under increasing pressure as the war goes from bad to worse with Ukraine’s military advancing further while the conscription decree undermines whatever domestic support existed for the operation.  It is easy to conclude that Putin is increasingly isolated, desperate and humiliated, which could cause him to behave in an even more reckless fashion than before.
   
• The biggest risk in the weeks ahead is that Putin could escalate his nuclear threats by actually preparing the weapons for use.  To date, the markets have brushed this off as sabre-rattling but it is hard to say how they would react to more concrete action or even mobilization. Nuclear weapons require a lot of preparation before they can be used and this is something that Western intelligence agencies should be able to detect.  However, the odds of Putin resorting to non-conventional weapons over anything less than an incursion into Russian territory are likely lower than the media assumes.  Nuclear weapons aren’t going to help Russia’s military or act as a deterrent of Ukrainian advances.  They would contaminate the region with radioactive fallout (and that fallout could blow back into Russia itself).  Any nuclear action would be greeted with international condemnation (including China and India where support for Russia is already fraying), and only embolden Ukraine’s NATO allies to solidify their defenses.   In short, assuming Putin is still a rational actor, there would be little incentive for him to pursue a nuclear option.
   
• Despite all the near-term gloom, there’s reason to think some type of a détente could be approaching.  Despite Ukraine’s momentum, it’s unlikely Russian forces can be dislodged entirely from the country, which Ukraine’s allies are likely trying to impress upon President Zelensky in the background.  At the same time, the likelihood that Putin achieves a lasting victory in the Ukraine is virtually nil and in that context the referendums could be just the opening bid in a negotiation over territory.  We would point out that the resolution of the “peace enforcement” operation by Russia in Georgia in 2008 was completed within weeks of Russia recognizing the independence of the breakaway regions of Abkhazia and South Ossetia, which were at the heart of the conflict.  This appears to be a similar playbook to what is transpiring in the Donbas at this time.  Meanwhile, while the headlines focus on escalating tensions, the recent actions of both Ukraine and Russia tell a different story:
  • The two sides conducted their largest prisoner swap of the war last week;
  • The grain export deal remains in place;
  • The IAEA is negotiating for a safety zone around the Zaporizhzhia nuclear power plant.
     
• While Russia’s economy has been more resilient than expected as they have managed to avoid some of the import ban as oil is still shipping to nations like China, India and Saudi Arabia (albeit at a heavily discounted price), the long term economic outlook as a result of the war for Russia is dire.  Russia has already defaulted on its debt, and is increasingly isolated in the global economy.  Russia has already lost companies representing ~40% of its GDP, and the flight of capital and people from the country will further erode its economic base as outlined in a Yale study here.  Meanwhile, Europe, Russia’s best customer, has pivoted to alternate energy sources, including filling its stores of natural gas for the entire winter heating season from imports from Norway, Qatar, Algeria and abroad via LNG.  While this comes at a great cost, Europe has made it clear that they no longer wish to do business with Russia.  Despite Putin’s claims, a “shift to the East” is no simple task – there simply is not enough infrastructure in place to ship oil and natural gas to China and India, and with Russia increasingly cut off from global financial markets, the financing of its construction is difficult to fathom.
   

While it is difficult for us to speculate on the outcome of the war, it is clear that it will add energy security to the list of changes in business culture already occurring, such as a re-alignment of global supply chains as a result of the COVID-19 lockdowns and practices to address climate change.  Corporate priorities are clearly shifting to “friend-shoring,” reliability and redundancy over offshoring, efficiency and cost effectiveness.  While the economic fallout from Putin’s decision to invade the Ukraine will be felt by Russia for decades, we will all be touched to one degree or another over the decades to come by the cost of implementing these changes. 

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