Another Update

Russia’s invasion of Ukraine is taking a real human toll. The stories and pictures we’ve seen have mostly been horrific, but there are also those of heroism and enduring humanity. While the ins and outs of geopolitics are well beyond my area of expertise, these events continue to impact markets and sentiment more broadly, so of course we need to pay close attention to the details.

In another break from our recent look at bond alternatives, I want to share portions of analysis from my research partners at Bespoke Investment Group and some of a weekly update from JPMorgan. I know you’re getting information from a variety of sources, but these are two that I trust. Bespoke’s is on the longer side but provides a good summary of the situation. [Bracketed notes are mine.]

First, from JPMorgan looking at last week…

Following Russia’s invasion into Ukraine, markets saw a sharp sell-off in risk assets, while safe-haven assets (i.e. Treasuries, USD and gold) outperformed. Russia-linked commodities popped with European natural gas +60% and Brent prices crossing $100/barrel. However, by the end of Thursday, markets largely reversed their course with only minimal moves to the 10Y (-1bps) and WTI (+$1).

Looking ahead, markets will be sensitive to sanctions and Russia’s counter response to them. This is a balancing act as the West wants to punish Russia, but not at the expense of other economies. It is further complicated by the fact that Russia is the 2nd largest producer of oil and natural gas and a major commodities supplier (i.e. fertilizer, wheat, aluminum). As of Friday, sanctions have involved Russian oligarchs, new Russian sovereign debt, Russian banks and Nord Stream 2. But, they have not yet involved Russian oil and gas.

For U.S. consumers, this crisis is likely to dampen sentiment and has the potential to delay peak inflation. Despite these headwinds, Americans are coming into this at a fundamentally healthy position – consumer demand has been robust (i.e. January retail sales surprised to the upside despite Omicron concerns) and consumer balance sheets have been strong. While we might see price pressure on energy and food in the near term, they do not have the same capacity to shock as they once did. [Energy] and food spending now represents much less of Americans’ overall wallet share – 12% of total spending vs. an average of 23% throughout the 60s/70s. Furthermore, America has a greater degree of energy independence and the luxury of natural resources that Europe does not, which should also soften the blow.

In terms of investment implications, remember that staying invested in a diversified, goals-aligned portfolio has paid off through countless geopolitical crises and should continue to do so. Ultimately, portfolios should benefit from quality stocks with durable profits and fixed income for portfolio ballast. We are not advocating for broad rebalancing at this time, but rather are seeking balance between value vs. growth and U.S. vs. international. Diversification will remain key as we ride out volatility. [Your portfolio likely has limited direct exposure to Russian stocks since the country occupies only a few percentage points of the main emerging market indexes.]

And now from Bespoke as of yesterday and again this morning…

[Yesterday] morning in Ukraine, fighting is intensifying around major cities. A residential neighborhood of Kharkiv was hit with a barrage of rocket artillery, while the Russian army is still trying to encircle the capital of Kyiv in the north. Over the weekend, Russian forces mostly laid off heavy urban areas after probing attacks were broadly smashed last week. That may be changing, and Russian doctrine may be getting less concerned with minimizing civilian casualties. For now, the Russian advance remains bogged down, and while Russia has claimed air superiority, Ukraine’s air force has continued to fly sorties. That air force may last much longer than anticipated given the shocking decision by the EU to directly supply fighter aircraft from military reserves of several countries. A broader torrent of small arms including anti-tank weapons and hand-held surface-to-air missiles is flowing into the country via EU borders even as a torrent of refugees flow west.

On the Russian side, losses have mounted. Estimates are difficult to nail down, with conflicting reports between Russian sources, Ukrainian sources, third country intelligence agencies, and open-source intelligence, but at this point the Russian casualty count is in the thousands and hundreds of fighting vehicles (including large formations of tanks in some cases) have been lost to the fight. Russian forces have moved roughly at the same pace as US forces did during the 2003 invasion of Iraq, but in doing so they’ve been hit far harder than the US coalition was at the time, and have been able to secure their supply lines and rear areas to a far lesser degree. While the situation in military terms is still at best dire for Ukraine, the Russian military has underperformed all estimates of its ability to establish air superiority, overwhelm the Ukrainian military, seize cities, and perform basic logistical operations all while taking far larger-than-expected losses.

One possible explanation for this phenomenon is that Russian units are intentionally fighting poorly or even abandoning the field when they are confronted with the reality of stiff Ukrainian resistance. Simply put, convincing Russian units to fight a group of people they broadly view as cousins and friends may be much harder than war planners assumed, on top of Ukrainian resistance being much more effective than anticipated and the poor strategy and doctrine Russian generals selected for the invasion. Hopefully, the peace talks underway in Belarus between Russia and Ukraine as we type this note will yield at least a temporary cease-fire, but given the relatively weak Ukrainian position and the incentives for Russia domestically, we are skeptical anything will come of them permanently.

Western sanctions over the weekend were of the “shock-and-awe” variety, with a broad coalition of countries (including the US, EU, UK, Canada, and others) limiting Russian access to the SWIFT payments messaging system for Russian entities, blocking access to a wide range of Russian reserve assets, and starting the process of evicting Russians linked to the most powerful elites from their respective countries. The Central Bank of Russia [the CBR] has responded by banning sales of foreign equities in the Russian market, hiking interest rates from 9.5% to 20.0%, establishing a trading band for the ruble, and requiring sales of hard currency by corporates.

At the lows overnight, [Russia’s currency, the Ruble] traded down 30%. It has since rallied to a 20% decline versus Friday’s close (still one of the largest drops from any emerging markets currency on record), as the CBR has apparently been able to defend its ruble trading band for now, but it’s not clear how long it can do so given that its access to reserves held outside Russia and held in a range of developed market currencies has now been sharply curtailed. For US investors, [Russia-specific] ETFs like ERUS or RSX are down ~24% pre-market, and their underlying holdings cannot be liquidated under the CBR regulation change, even if markets were open in Russia to sell those holdings […]

An incredibly important side effect of Russia’s aggression in Ukraine is to pull European countries together for common defense and policy. This week, the Finnish parliament will consider a popular initiative to join NATO while even the Swiss are signaling that they will mimic EU/US/UK sanctions on Russia. EU-level policymaking has been unified despite some wobbles initially and has been expanded to include arms transfers. The biggest shift, though, has been Germany, where a huge swath of key policy approaches ranging from low military spending to bans on arms transfers to tight fiscal policy to closures of nuclear power plants have been effectively reversed over the course of a single speech from Chancellor Olaf Scholz on Sunday. Russia’s invasion of Ukraine has given every European country on its borders a huge imperative to join the alliance while driving Europe together to sanction Russia, unwind reliance on Russian energy supplies, and expand fiscal and military capacity on a joint basis. The policy specifics are quite lengthy, but at the end of the day, this weekend was the largest step forward for EU integration since at least Mario Draghi’s “whatever it takes” response to the Eurozone crisis in 2012, and possibly since the adoption of the euro. This unity has implications both for the response to the current conflict and far beyond it, with the unlocking of more fiscal capacity, more EU wide investment in resilience, and a more cohesive EU-wide grand strategy for dealing with geopolitical challenges.

China has so far tried as hard as it can to avoid explicitly backing or condemning Russia over Ukraine, and it remains to be seen how much the [People’s Bank of China] works to accommodate the CBR as a source of liquidity (for instance, sales of gold reserves) given sanctions on other Russian reserve assets.

[And this morning…] A re-evaluation of Russia’s doctrine and tactics appears to have temporarily at least slowed the pace of ground fighting in Ukraine. After leaning heavily on deep strikes and relatively light columns earlier in the war, Russian units now appear to be massing to use overwhelming combined assaults to gain ground. This has the unfortunate side effect of larger potential for loss of civilian life, especially around cities. Large bombardments are much harder to control, and the Russian military could be running low on the sorts of precision guided munitions which limit (though do not eliminate) civilian collateral damage when hitting targets. In concrete terms, the UK released a public assessment this morning describing the Russian advance as stalled, reporting more shelling in civilian areas, and still citing a lack of Russian air superiority. Ukraine is receiving reinforcements of MiG-29 fighter jets from Poland as well as shipments of TB2 drones from Turkey, so the air war may not end any time soon.

With respect to civilians, we’re seeing increasing numbers of videos showing non-violent resistance across the country, with groups of civilians blocking convoys and shaming invading troops. In practice, this is not a dramatic hindrance to the Russian ground assault, but it illustrates how much opposition there is on the ground to invaders...fertile ground for a bloody insurgency even if Russian troops are able to capture Kyiv, kill President Zelensky, and declare a puppet government. We also note that calls from aggressive commentators in US and Europe for a “no fly zone” in Ukraine enforced by NATO are thankfully falling on deaf ears. That policy would lead to direct NATO-Russia airborne combat, and dramatically increase the odds of a full-blown war between those belligerents with a substantial risk of nuclear exchanges. While a “no fly zone” may sound like an attractive way to protect innocent civilians, the potential costs that it would include are extreme to say the least and no serious, informed international relations commentator we are aware of is calling for one. A different step that the UK is reportedly exploring this morning: removing Russia from the UN Security Council.

[…] On sanctions, this morning shipping giant Maersk reported it would stop accepting bookings to Russia except for food, medical supplies, and humanitarian supplies. [This is on the heels of other major western companies making similar moves in recent days. Essentially, these companies are independently setting aside their profit motive in favor of making a strong statement against Russia’s actions.]

Finally, an update on Russian markets: equities remain shuttered, but Russian equity tracker funds in Europe continue to plunge this morning with a London-traded MSCI Russia fund down 23% (80% in total since the invasion).

Here’s a link to Bespoke if you’d like to check them out.

https://www.bespokepremium.com/interactive/research

And here’s a link to JPMorgan’s Weekly Market Recap.

https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/weekly-market-recap-us.pdf

Have questions? Ask me. I can help.

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