Bedrock’s Newsletter for Friday 18th February, 2022

Posted by Honey Soleymani on 18th February 2022

Friday 18th February, 2022

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Financial markets have had a challenging month in February so far, as the risk of an imminent (further) Russian invasion of Ukraine has competed with soaring inflation in the US, Europe, and beyond for the attention of investors. Both factors are decidedly negative for asset prices, and bearish sentiment is on the rise as a result. As of this morning (Friday 18^th February), the S&P 500 Index is down -3.0% for the month and -8.1% for the year, while the NASDAQ Composite is down -3.7% for the month and -12.3% for the year. High growth technology names – particularly those once-voguish small cap ‘stay-at-home’ stocks – have led the sell-off, given their greater sensitivity to rates (which have risen sharply across the curve since the start of the year). However, few sectors have failed to participate in the correction to some extent at least. Interestingly, Europe has held up rather better than the US so far: the Euro Stoxx 600 is down just -0.9% for the month and -4.8% for the year, despite the continent perhaps being on the brink of its bloodiest conflict since WW2. Driving this dispersion is the much more aggressive timetable for interest rate hikes that the Fed has outlined in recent weeks, a topic which we discussed extensively in our last newsletter. However, Europe is far from immune to the inflationary pressures that have sparked a major re-think at the Fed; and a change of policy tack by the European Central Bank (ECB) is not out-of-the-question in the months ahead.
 

But rather than return to the subject of inflation/rates in our newsletter this week, we will instead focus on perhaps the biggest immediate threat to markets: the risk of war between Russia and Ukraine in the next few days. Since late last year, both NATO and Kyiv have warned that the Kremlin is making preparations to invade Ukraine (although whether these preparations are genuine or just to put pressure on negotiations over the rebel-held Donbas region is unknown); and, today, 120K Russian troops are stationed to Ukraine’s north, east, south, and even west (thanks to Russia’s military presence in the Transnistria region of Moldova). A further c.30K troops are currently conducting military exercises inside, and alongside, Belarus, which has been transformed from a nominally sovereign state to little more than a Russian territorial appendage overnight. This puts a significant contingent of battle-ready forces within striking distance of Kiev. In addition to re-locating military personnel to Crimea and the Ukrainian border, Russia has sent a large number of artillery batteries, tanks, and attack helicopters and jets to back them up; and satellite images show that field hospitals have been built in several places, presumably to care for the future Russian wounded. Finally, and just in case tensions were not running high enough already, Russia has given the go ahead to ‘long-planned’ nuclear exercises on Saturday to test the country’s ballistic missile capabilities. The tests will take place just one day before the Belarus military drills come to end… none of this bodes well for peace (or markets).
 

Meanwhile, a sophisticated propaganda and disinformation campaign is underway in the Russian media to paint Ukraine as an aggressor state, which is intent on committing genocide against ethnic Russians in the country’s rebellious east. Russia has already handed out 700K passports in the eastern region; and should any (purported) harm come to their new citizens, that could serve as a pretext to invade. NATO countries are convinced that Russia is planning to stage just such a ‘false flag’ attack in the coming days or weeks to serve as a casus belli; and everything from the discovery of fake mass graves to the alleged use of chemical weapons by Kiev have been floated as possible Kremlin fictions.
 

Of course, despite all of the evidence to the contrary, Russia claims that it has made no plans to invade Ukraine and that Western countries are simply gripped by anti-Russian hysteria (as usual). Ukraine is also downplaying the risk of war (in a desperate attempt to avoid an economic collapse before a single shot has even been fired). Earlier this week, Russia even suggested that its forces were now going to return to their former bases far from Ukraine as planned, and that NATO had been humiliated by the way that Western countries had responded to Russian deployments on Russian soil. This statement caused a brief market rally mid-week. But Western countries now believe that these comments and the subsequent troop manoeuvres were just a smokescreen to re-jig the distribution of forces on the border (and, indeed, bring some units closer to Ukraine).
 

So, what does Russia want? Most crucially, they never want Ukraine to join NATO. Ever. And they want this in writing. They also want ‘legal guarantees’ of their own security and for NATO to pull its forces out of the post-1997 NATO accession countries. This includes the Baltic states, Poland, and the Balkans. Russia says that it feels threatened by NATO, which was established to contain the Soviet Union but now abuts Russia’s Western border (in contravention of promises made in the 1990s by the US, according to Putin). For its part, NATO will never accept a third country dictating who can join the alliance and will certainly not de facto expel countries from the alliance by pulling back troops and/or failing to protect them from coercion or blackmail by Russia. However, there is also no appetite for Ukraine to join the alliance (not least because Russian threat perception is fairly well understood in the West). Should war not break out and some diplomatic fudge be achieved on Ukraine, this episode is likely to have forced a wider debate on European security (which Russia wanted). However, it will probably not go in Russia’s favour (given why the debate is being had and the chorus of hawkish voices from the former Soviet states on NATO’s eastern flank). Thus, it is not clear what this high-stake gambit will have achieved… unless Russia makes concrete territorial gains now. This may well be why a limited war and the further dismemberment of Ukraine is Russia’s preferred course of action. Talking about talking may just be cosmetic. Of course, any ‘military-technical’ response will be met with damaging sanctions. But the control of European gas supplies gives Russia a way to twist the economic knife too. Putin may bet that NATO will be split on what to do should Russia pursue a limited incursion in Ukraine’s east (perhaps to link up the Donbas and Crimea).
 

Therefore, while it is by no means a foregone conclusion, there is a high risk of war in Ukraine. What does this mean for markets? In our view: oil and natural gas prices up, agricultural prices up, precious metals prices up, Russian equities down, credit spreads wider and a risk-off move in equities (but with limited long-term impact). We suspect that rates and inflation will be the biggest drivers of markets in a few weeks’ time, while the conflict in Ukraine takes a backseat once more (whatever Putin choses).