The one-year anniversary of Russia’s “special military operation” in Ukraine is certainly a shock to all participants, most especially Vladimir Putin.
It was clear from the start that the Russian president never thought long-term Ukrainian resistance was possible and his internal debate was most likely whether he would be greeted immediately with caviar and champagne or would need a few months to mop up the areas of resistance. Had Putin expected Ukraine to fight, he would have gone in much harder and bombed infrastructure before deploying the army. Instead, he led with the infantry, who became the much publicized “bullet-stoppers” over the following months.
We all know from news reports that this is a brutal war. So, as we enter the second year of the conflict, these eight aspects of the war have implications for global economies and financial markets:
1. A Korea-like frozen border: Both sides are clinging to an absolutist position: “I win, you lose.” There is no possible negotiated solution with this mindset. Long term, we expect a Korea-like frozen border to be a likely outcome. Russia keeps the Russian-leaning part of the Donbas, and the remaining part of Ukraine is allowed to join NATO and the EU.
This will make for a sense of lasting peace, as Russia won’t get a chance to take another bite at the apple. Russians and Ukrainians will stare at each other over a DMZ for at least a generation. This solution is politically difficult for both sides, as Russia must accept NATO in Ukraine, and Ukraine has to accept land for peace. Neither side is ready for this, so it is probably not a 2023 event. In fact, we expect this war to continue well into 2024.
2. Russia will occupy Donbas and Crimea, but stop short of Kyiv: The narrative that Russian soldiers don’t want to fight and are taking horrific casualties is exaggerated. Many are fighting hard.
The Ukrainians have probably suffered worse casualties because Russia has shelled soldiers with the same alacrity that we have seen them bombing civilians. Many Russians left their country to avoid the draft, as did many Ukrainians. That is one of the main reasons that Ukrainian President Volodymyr Zelensky probably arrested so many border agents — for a reported price of $10,000, a young man could leave.
It is probably true that, on average, Ukrainian soldiers are more motivated to fight than Russian soldiers. But the continuing narrative that Russian soldiers are about to run away seems like wishful thinking.
In fact, Ukraine has little chance of winning the war on the terms they have defined: Russia out of the Donbas and Crimea. We expect Ukraine will run out of men and Western money well before this is a possibility. We expect Russia to take this territory over the next few months, but stop well short of Kyiv.
Russia also cannot win the war under their original terms of regime change and ”denazification.” They have angered the Ukrainians to the point that they will not be able to control Kyiv, let alone western Ukraine, which has always been the hotbed of anti-Russian sentiment.
Russia has successfully worked around sanctions because so much of the world has decided not to side with the U.S. and Europe.
3. Time is on Russia’s side: Time is more on Russia’s side than Ukraine’s. Russia has more potential soldiers than Ukraine. Additionally, Russia has successfully worked around sanctions because so much of the world has decided not to side with the U.S. and Europe, at least economically. NATO is remarkably united, but China, India, Saudi Arabia, South America, Mexico, most of Africa, and even Israel have decided that they need to trade with Russia more than they need to support Ukraine. When 85% of the world’s population is willing to continue business as usual, Russia is not that isolated. Fortunately, most of these countries won’t help Russia’s war effort directly, but they are happy to consume discounted oil and fertilizer.
4. Oil & gas gets a bid: Europe managed to stay warm through this winter because Russia filled its natural gas storage last summer, while Europe and the Eastern U.S. experienced an abnormally warm winter. But thanks to the rupture of the Nord Stream 2 pipeline, it is not completely clear how to rebuild supplies this summer. We think markets will begin to appreciate this problem over the next few months. All things being equal, oil and gas should get a bid.
5. Zelensky’s blank check may end in 2024: The U.S. policy to let Zelensky decide when to end the war will last as long as oil prices stay reasonable. Right now, with oil having round-tripped, there is no American domestic discontent to pressure the Ukrainian president. If the U.S. enters the 2024 presidential election year with oil prices at $125 and not $78, we expect Zelensky’s blank check to be stamped with a due date. Once again, this is not to diminish the Nelson Mandela-like qualities of Zelensky. The price of oil will be more influenced by the Chinese domestic recovery, but that nuance will be lost on the U.S. electorate if a hot war is raging in Ukraine.
6. The West is divided on regime change in Russia: The West is united against Russia, but some would like regime change in Russia, and others prefer Putin’s devil you know. A civil war in Russia would be welcomed by some, but most would be afraid of 1,600 active nuclear weapons falling into less responsible hands. This is true both in the U.S. and in Europe.
Anyone who spends time watching Russian television worries that Putin is the least bad of the current alternatives. No Russian George Washington is waiting in the wings. The Russian liberal democrats personified by Gorbachev and ubiquitous in the 1990s are all dead, in Siberian camps, or ensconced in Paris and London.
In general, countries closer to Russia are the most aggressively anti-Russian (think Poland), but large parts of Western Europe including France and Germany would prefer to find a solution and try to reconstitute a pre-invasion world. This is the principal reason I believe the West will not support the re-taking of Crimea if Ukraine is somehow successful in retaking the Donbas. Keeping the status of Crimea open is a good bargaining chip for Zelensky, who can trade acceptance of this fact for something he needs such as NATO and EU membership.
By freezing Russian-U.S. dollar savings held in banks, the U.S. weaponized the dollar .
7. ‘King Dollar’ dethroned: The long-term extraordinary sanctions put upon Russia may have some very big implications for the U.S. dollar. By freezing Russian-U.S. dollar savings held in banks, the U.S. weaponized the dollar It made it clear that no country can own dollars, but merely “lease” them at the sole discretion of the U.S. president.
Saudi Arabia, China, or another country that is often in the crosshairs of U.S. foreign policy will be careful not to keep all your eggs in the U.S. dollar basket. “King Dollar” will gradually lose its preeminence, as these kinds of countries look for ways to conduct trade digitally or in other currencies, and invest in non-dollar assets. I don’t expect that will influence the dollar over the next year or two, but the U.S. dollar will become less ubiquitous over the next five to 10 years.
8. Increased defense spending favors defense stocks: We expect a hot war raging in Ukraine will boost defense stocks, as it is clear the world Is unprepared for a long war in quantities of munitions. Every country, but especially those close to Russia and China, will greatly increase defense spending. Poland reportedly wants to order more military equipment than Germany and France combined. As to defense spending in the U.S, the neocons captured both sides of the aisle and there is much more support for guns and butter from Democrats than at any time since the 1960s. While defense stocks have underperformed in the risk-on 2023 market, we think they are attractive as fundamentals unfortunately have improved.
Rhys Williams is chief strategist at Spouting Rock Asset Management.