The risks of a military conflict between Russia and Ukraine have risen materially. Any conflict is likely to be a volatility shock for markets but will only add to the inflationary regime that we are in.
Geopolitical risks dominated global asset markets last week, as rising tensions between Russia and Ukraine undermined global risk sentiment. We will focus on this in this week’s market strategy; what our current assessment is and what implications are likely if the situation deteriorates further.
Current Assessment
Our base case, since the Russian troop buildup began in Q4 2021, has been that this is most likely an exercise in coercive diplomacy. Therefore, while the pathway may be volatile, a diplomatic resolution was the base case. However, earlier in the year, we initiated tail hedges in Rubles, as we assessed that the market underpriced the probability of a military outcome. Over the course of the last ten days, there have been several developments which indicate that this risk has risen materially. The Sunday night announcement of an agreement in principle for a summit between Biden,Putin and Macron reduces the immediate risks if confirmed, but this is not a structural solution, and tensions remain extremely elevated.
There are several factors which inform this view.
1. Public statements from the US and NATO
These statements clearly indicate that the national security establishment believe that military conflict is the base case. Notably, President Biden stated on Friday in a public address that he has reason to believe that President Putin has given the order to invade. Public reporting from the Washington Post and NY Times indicates this was based on intercepted Russian orders to proceed with a full-scale attack. This reflects the level of Russian military buildup surrounding Ukraine, which has now grown to 150,000-190,000 troops, accounting for 75% of all Russian strike battalion groups.
2. Increased military activity in Eastern Ukraine
- The OSCE Special Monitoring to Ukraine (SMM) said it had observed a “dramatic increase in kinetic activity along the contact line in eastern Ukraine" over the weekend. Specific events in the last 72 hours included the “bombing” of a separatist leader’s car, the shelling of a Ukrainian kindergarten, “sabotage” of a major fuel line, Ukrainian shells landing in the Ros region in Russia, full mobilization in the separatist regions and evacuation of civilians to Russia. While the idea that Ukraine is the aggressor does not seem credible, these actions are similar to what was seen prior to the Russia-Georgia war in 2008, and intelligence analysts assess that these are consistent with the creation of a pretext for a Russian military incursion into Eastern Ukraine.
3. Lack of any diplomatic progress
Despite intensive communication, there has been no diplomatic progress. Russian demands for no further NATO expansion and withdrawal of troops from eastern Europe are unacceptable to the US and NATO, and Ukraine maintaining sovereignty over its foreign policy, which includes the ability to join NATO, are seemingly unacceptable to Russia. The rise in tensions and increased troop buildup have resulted in these positions becoming more entrenched, as evidenced by the speech delivered by President Zelensky at the Munich security conference and public comments to the UN by Russia and the US last week.
4. Russian media shift in communication
There has been a notable shift in the domestic media in Russia. This signpost is one we have been tracking closely, and in contrast with earlier in the year where Russian media had downplayed the risks of military conflict, Russian state media has now shifted to openly discussing military action into Ukraine in support of separatists.
From a market perspective, the uncertainty about whether a military conflict will take place, and the nature of such a conflict will continue to cast a shadow over broader risk assets. We continue to believe that a full-scale invasion and occupation is a tail risk, but any military conflict would likely be a near-term volatility shock, which negatively impacts European and Eurasian assets. Further, the market would price in some risk of an energy shock, which would increase near term stagflationary risks.
Viewed through a wider lens, a Ukrainian-Russian military conflict is unlikely to be a regime shift for the global macro backdrop, but it may add to the preexisting inflationary pressures in the global economy. To that end, flight to quality lead rallies in global fixed income may present opportunities to faded, while any easing in tensions will offer attractive entry points in Russian and Ukrainian assets. In the context of this uncertainty, we have added to RUB hedges and reduced headline equity risk but will re-add to these positions should tensions ease this week. More broadly our view remains that we are in an inflationary environment in which differences in where countries are in their monetary policy cycle create several opportunities for both directional and relative value expressions.