Bedrock’s Newsletter for Friday 4th March, 2022




“No foreign policy… has any chance of success if it is born in the minds of a few and carried in the hearts of none.”

Henry Kissinger

Friday 4th March, 2022

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The Russian invasion of Ukraine has sent shockwaves around the world and through financial markets, sparking drawdowns on equity indices and a flight to safe havens and commodities. Although Western intelligence agencies had been warning for months that the Kremlin was (at least) planning an invasion of its Slavic neighbour, the consensus was that such events were simply unimaginable in the modern European context. Following the fall of the Berlin Wall in November 1989, many came to believe that the politics of ‘blood and iron’ (to quote the Prussian Statesman Otto von Bismarck) were over. Large, conventional, interstate wars on the European landmass seemed to be little more than an unpleasant memory from a by-gone era when kings, fanatics, and tyrants fought one another for land, influence, and treasure, unconstrained by international law, global supply chains, or mutually assured destruction. However, what began on Thursday last week proves that the optimistic view of international affairs was (and is) almost certainly wrong. At best, it would seem that the arc of history does not always bend towards progress; at worst, that the past 33 years were a historical aberration when democracies in Europe (and elsewhere) flourished unperturbed only thanks to the comforting embrace of a globally hegemonic United States (a ‘unipolar moment’, now in its twilight years). American supremacy has been fading for some time of course, courtesy of China’s economic rise, growing inequality at home, and a hyper-partisan political culture that makes solving even simple problems almost impossible. However, an example of the naked embrace of military force by a rival great power to overturn the status quo had yet to rear its ugly head… until last week. What seems clear is that only in a world where Putin feels able to ‘padlock the embassies’ and look to East Asia to meet Russia’s needs would he take such a high-stakes gambit; and it may yet turn out to be a colossal strategic failure and his personal undoing. (Perhaps the product of a bunker mentality following the covid-19 pandemic.) But much like 9/11, 24/2 will go down in history as a date that changed the world (and perhaps allowed us to glimpse the future).
 


In our last newsletter, we stated our view that there was a high chance of a Russian invasion of Ukraine and that an invasion would almost certainly lead to soaring energy and commodity prices, an equity sell-off (albeit one that is focused on Russia), and a widening of credit spreads. For the most part, this forecast has proven to be accurate. The initial moves in US and European equity indices on Thursday were indeed sharply downwards. However, there was then a full retracement which carried investors through to the end of last week (particularly in the US). This rally was driven by a rather tepid first response by Western countries and as markets priced in a rapid end to the war in the Kremlin’s favour. However, sentiment has since changed. Russian forces have met with stiff resistance from the Ukrainian army, and they are now well behind schedule due to logistical failures and (apparently) low troop morale. As of this morning, the Russian military have failed to capture any major cities, such as Kiev, Kharkiv, or Mariupol, and they are resorting to increasingly bloody tactics to achieve their goals. This more or less guarantees a long period of international isolation for Russia in the wake of the conflict (should Putin ever want to come in from the cold). Indeed, the number of countries in Russia’s corner seems to be shrinking by the day: at the UN General Assembly meeting yesterday, only Syria, North Korea, Eritrea, and Belarus voted with Russia against a motion to condemn the aggression. Just the team you want making your case…
 


The Russian economy, meanwhile, is being pushed into the abyss after Western resolve hardened last weekend. Numerous Kremlin-linked oligarchs and companies have been sanctioned by the EU, while the US and UK have decided to sanction President Putin and Foreign Minister Lavrov personally (for the first time). Perhaps most crucially, a large number of Russian banks (including VTB) will soon be ejected from the SWIFT interbank messaging system that allows them to transfer money internationally. This will severely impair the functioning of Russia’s financial system as well as the ability of the Russian government to receive payments for exported goods. Furthermore, the assets of the Russian central bank have been frozen, which has limited the bank’s access to $630bn of dollar reserves and further destabilised the plunging Ruble (now down almost -50% against the dollar year-to-date). In response, the central bank has been forced to raise policy rates from 9% to 20% and President Putin has banned the transfer of foreign currency abroad (including to service debt). The result has been a downgrade of Russia’s credit rating to junk by Fitch and Moody’s. Beyond the banking system, Germany (which was historically dovish towards Russia) has finally decided to halt the controversial Nord Stream Two gas pipeline project, begin sending weaponry to Ukraine, and boost military spending by EUR 100bn in response to the invasion. This is particularly surprising coming from the new SPD chancellor, Olaf Scholz, but it shows the strength of the anti-Putin consensus taking hold in the West (and further afield).
 


Given the economic turmoil that has been caused by such restrictive sanctions, it is perhaps no surprise that the Moscow Stock Exchange has not re-opened since the close of trading on Friday last week. When it does, massive price drops are all but certain: most Russian GDRs/ADRs that trade in the US and UK are down >90% at present! And price discovery is likely to involve some very wild swings in the days that follow. However, beyond Russia, we do not think that the risk-off move will last. The Russian, Belarussian, and Ukrainian economies represent a fairly small share of world GDP, and the chances of Russia pushing on beyond Ukraine (e.g., into Moldova or the Baltics) are slim given that the military is already so overstretched. Many US, Emerging Market, and European companies now offer good value for money and the extent of bearish sentiment points to a recovery when the current wave of selling abates. The wild card is inflation – made a lot worse by the rise in commodity prices brought on by the Ukraine invasion (Brent Crude hit an intraday high of $119.8/bbl in yesterday’s session). Central banks may well have to raise rates more slowly in light of events even as near-term inflation forecasts worsen. Bond markets are already pricing in fewer hikes than at the start of the year with huge moves in Gilts, Bunds, and Treasuries seen this week. However, this change in the outlook for interest rates is certainly not a good reason to add duration (curves are very flat and policy rates are going to have to rise some distance from today’s levels to contain inflation and maintain central bank credibility). However, it does suggest that good performance from equities and commodities should follow. Therefore, this is what we favour going forward.