The Russia-Ukraine crisis ignored by the financial markets?

RUSSIA, UKRAINE, US DOLLAR, MILITARY STOCKS, RUSSIAN RUBLE, CRUDE OIL, NORTH STREAM 2 – TALKING POINTS

  • Russian-Ukrainian tension unsettles US – fears of military encounter grow
  • Russian ruble and non-military stocks could fall if geopolitical pressure increases
  • Media headlines aside, what are the markets telling us about the outlook for investors?

Tension between the United States and Russia has escalated as Russian troops and tanks continue to build up along the Ukrainian border. Despite the apparent rise in temperature, investors continued to ignore the prospect of a military escalation between the two nuclear powers. Does this cavalier position prepare the markets for a bad surprise?

BETWEEN AN EAGLE AND A BEAR

For the past 30 years or so, Ukraine has been the subject of strategic interest for both the United States and Russia. Its geographical position makes it a key strategic bottleneck for both powers. Moscow and the US-led NATO alliance view Ukraine as a key strategic buffer zone containing each other’s influence and territorial ambitions.

Political instability plagued Ukraine, from the Orange Revolution and subsequent mass unrest to the annexation of Crimea. President Vladimir Putin continues to follow a regional-building foreign policy approach – a bit like China in Southeast Asia – to secure its interests and its regional influence. Ukraine plays a key role in this vision.

Domestically in Russia, this echoes the sentiment that sees Ukraine as historically linked to its large eastern neighbor via “Kievan Rus” heritage as well as membership in the USSR. For Mr. Putin, reclaiming and expanding Russia’s sphere of influence – especially in Ukraine – resonates strongly on a national patriotic level. This, coupled with Russia’s military and strategic position, means that Moscow is likely ready to vigorously defend its interests here.

IMPENDING INVASION?

Will Russia invade Ukraine? The short answer is “most likely, no”. Mr. Putin is testing the resolve of Washington and that of President Joe Biden. The withdrawal of his admiration from Afghanistan was apparently motivated – at least in part – by an underlying strategy of reallocating resources to combat China’s growing economic and political influence, regionally and internationally.

With that in mind, Mr. Putin might carry some weight in that Washington might not want to get involved in a conflict that distracts him from the fight against China. As a result, Moscow could take a more aggressive approach to assessing how far the United States is prepared to go to defend Ukraine – and by extension – Europe as a whole.

What makes the situation tense is the timing: Russia has a small window – between February and March approximately – for a possible invasion. The necessary military equipment includes tanks and armored personnel who can only cross the border when the ground is frozen for a few weeks. After that, a muddy season ensues which would make any ground military incursion much more difficult.

To avoid a military face-off, the United States has threatened to impose crippling sanctions more severe than those deployed after the annexation of Crimea. Mr Biden wants to make the economic cost of invading Ukraine so high that it would outweigh the political benefits Mr Putin would derive from moving in.

The sanctions in question could include measures under financial, technological or commercial channels, or even a combination of these. In the financial sphere, the seizure and freezing of Russian assets and the prosecution of the country’s major financial institutions could scare off investors, triggering capital outflows that send the Russian ruble plummeting. The goal here would be to apply an economic squeeze that would turn Russian public opinion against the actions of the Kremlin. A similar method was used against Iran before the landmark nuclear deal in 2015.

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Technology-related sanctions can include cutting off key inputs — such as semiconductors — that are needed for advanced military hardware, like jet planes. In addition, Washington could go so far as to restrict Russia’s access to any microelectronics based on US patents or designs. This would likely magnify existing global supply chain issues, with multi-iteration consequences.

And finally, a third method could be blocking deliveries of key consumer goods such as refrigerators, cars, and iPhones. If a crippled currency and shortages of in-demand goods trigger a domestic reaction, political pressure could mount to push Russia to reconsider the cost of its military efforts in Ukraine.

To complement these tactics, Washington could provide weapons to Ukrainian insurgents to fight Russian occupation forces. This is called the porcupine strategy: making it as painful (militarily, politically and economically) as a state “consumes” it – that is, occupies it – another. The United States must now weigh these options in ongoing negotiations.

A senior Russian diplomat said talks with the West were nearing a “stalemate” amid concession talks. A major stumbling block is Putin’s demand that NATO deny membership to Ukraine and all former member republics of the USSR. This would be in addition to the withdrawal of all weapons and troops currently deployed and controlled by the United States in post-Soviet states.

However, Putin must be careful not to reach out too far. Too many demands with such high prices could cause the United States to call Moscow into a bluff. At this point, the Russian president may be forced to follow through, which could cause more upheaval than expected. In the meantime, the Russian Ruble, US Dollar and military industry stocks will be watching the stalemate closely for clues on next steps.

Stock market outlook

In the event of a military clash, military industry stocks such as Raytheon and Lockheed Martin are likely to diverge higher while broader stocks and the Russian ruble suffer. These names have risen sharply while non-conflict-focused stocks have plunged amid broader risk aversion during periods of geopolitical turmoil over the past 3 years.

Chart showing: Stock prices of Brent Oil, Lockheed Martin and Raytheon

Chart created using TradingView

The graph above shows examples of how the heightened tension between Iran and the United States has catalyzed defense stocksshopping spree. Given the size of Russia’s and the United States’ military might, even the slightest hint of armed conflict is likely to drive those stocks higher. The Russian ruble, on the other hand, would likely dip given the prospect of Washington sanctions.

Written by Dimitri Zabelin for DailyFX

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