Putin’s poker game

Vladimir Putin is ramping up his aggressive stance toward Ukraine. In a flagrant breach of international law and the Minsk peace accords, Putin has recognized the independence of the separatist regions of eastern Ukraine and has sent Russian forces there. What are the implications of a further (military) escalation? We briefly summarize them here.

The USA and Europe have already responded with initial sanctions, Germany has slammed the brake on the NordStream 2 gas pipeline, and this may be followed by a gradual further tightening of sanctions. The big question, though, is will Putin stop here and content himself with a partial invasion, or will he further up the ante and use the effectively established encirclement of Ukraine with a military buildup of well over 100,000 troops as a launchpad for a full-scale invasion? Given the breakneck speed at which developments are unfolding right now (and given the short half-life of news reports), we want to concentrate in this article on the near-, medium- and long-term impacts of Putin’s poker game in the event of a further escalation. In our reasoning, we are proceeding on the assumption that the president of Russia will stop short of crossing a red line – attacking a NATO member. Any attack on a NATO member would have devastating consequences and would cast doubt on the baseline expectations outlined below.

Already long under pressure (1)
The price of Russian risk is rising

Credit default insurance in Russia (5-year)

Sources: Bloomberg, Kaiser Partner Privatbank

Near Term: Peak volatility and higher energy prices

A war pitting Russia against Ukraine would be a human tragedy and could develop into the biggest geopolitical powder keg since the 1962 Cuban missile crisis. Further selloffs on the financial markets could loom in the near term. We objectively have to acknowledge, however, that stocks have already been in risk-off mode for several weeks now and a substantial risk premium is already priced in. Immediate further downside potential is therefore possibly constrained. Stock market adages like “political markets have short legs” or “buy when the cannons are rumbling” could ultimately once again manifest an element of truth. In this case, the Ukraine crisis would join a long list of geopolitical events that did not inflict lasting harm on price charts on equity markets. This assessment is underpinned by a very recent study by BCA Research, which analyzed the geopolitical crises of the last 100 years. According to the study, stock market corrections (measured on the basis of the S&P 500 index) during events comparable to the current crisis in Ukraine averaged out to between –11% and –14%. The consolidation of the US blue-chip index underway since the start of this year fits perfectly in that template, so there is no cause for further share-price dips from this standpoint.

However, this unsophisticated stance wouldn’t apply specifically to the Russian financial market, which looks destined to remain under pressure in the form of crumbling stock prices, ruble weakness and rising risk premiums on bonds. Meanwhile, the price of crude oil could leap above the USD 100-per-barrel mark in the near term. Higher energy prices could generally dampen consumer and business sentiment (mainly in Europe, less so in the USA). However, the economic recovery from the Omicron wave would probably be delayed by only one or two months at the most, and the additional upward pressure on inflation would probably be constrained. The approaching spring looks set to ease inflation soon. In the face of a protracted conflict, the European Central Bank at its next policy meeting in March would likely reserve the option of exercising maximum latitude to reduce its monetary stimulus. In any case, though, “Putin’s war” would deal a political shock to Europe’s security architecture – with far-reaching consequences.

Already long under pressure (2)
Russian equity market in free fall

RTS index

 Sources: Bloomberg, Kaiser Partner Privatbank

Medium term: Back to business as usual

Putin’s unattainable dream from the get-go of pushing NATO farther away from Russia’s western flank would give way to a personal nightmare sooner rather than later because it already appears inevitable today that the EU and NATO will pull closer together and strengthen their military presence in the east in response to the Russian threat. Moreover, Putin’s military adventure is likely to come at a high economic cost. Western sanctions, such as banning Russian banks from the US-dollar payment transactions system and limiting Russia’s access to Western technology, would further exacerbate the existing problems already plaguing Russia’s economy and would curtail its long-term growth potential. In any event, Russia’s large foreign currency reserves alone do not provide protection against an economic malaise. Europe, in contrast, likely wouldn’t struggle economically. On the contrary, it would likely return to business as usual relatively quickly. Apart from the energy issue, Russia’s weight is much too small to lastingly impact economic activity in the national economies of (western) Europe. Financial markets, economic growth and monetary policy would therefore likely soon return to their pre-crisis trajectory.

Long term: Russia sidelined

Over the longer term, the Russian bear would be shooting itself in the paw with its expansion cravings because Russia faces having to confront direct war expenses as well as high indirect costs. Economically, Russia faces increasing isolation and an accelerated decoupling from the West. Although Russia’s abundant natural resources and good political connections (with China, for example) would probably enable the country to live even with drastic sanctions, autarky isn’t a formula for long-term progress and advancement. In any case, Western companies are bound to think twice about whether they want to do business in or with Russia. And Russia itself could lose its most important customers in the long run because Europeans won’t let themselves get lured into an energy trap again. They are probably striving to secure a better energy supply already for the next winter season. Looking to the years ahead, a faster diversification away from Russian oil and natural gas and stepped-up spending on renewable and atomic energy will likely be on the agenda. A highly armed Russia in economic decline would pose a major challenge for the USA and Europe for an indeterminate time. Given the country’s economic weaknesses, Russia might even become an accomplice to an ever more aggressive China on the great geopolitical stage. In view of this, Western military spending should tend to further increase over the longer run.