Russia can be either an empire or a democracy, but it cannot be both. . . . without Ukraine, Russia ceases to be an empire, but with Ukraine suborned and then subordinated, Russia automatically becomes an empire. (Brzezinski)
It is the belief of this investor that members of NATO may, quite shortly, become involved in an overt military engagement with Russian forces. Any openly declared conflict will have important implications, both in the short and in the medium term, for global investment allocation models.
An optimal scenario for a bullish global equities market is an extended period of relative economic and political certainty, one in which all vested parties behave, more or less, responsibly, with an understanding of mutual self-interest. To the chagrin of equity investors, it appears self-evident that Russia operates under a different framework and employs the zero-sum game model. With an understanding that a zero-sum game doctrine poses great risk to a holder of any business interests in Russia, since inception in 2000, the global investment portfolio has steadfastly avoided the temptation to own Russian equities, Unfortunately, Russian actions of late have spilled over into the global markets. Accordingly, the optimal outlook for global equities needs to be revisited. Markets abhor uncertainty and until such time as relative certainty is restored, this investor is making certain immediate allocation shifts on behalf of the large cap global portfolio.
To belabor global media reports on the creeping Russian invasion of the Ukraine is unnecessary. However, the bias put forth presupposes that Russia is primarily interested in only carving out a smallish land bridge of Ukrainian territory that will connect Russia with the Crimea. It is assumed that once Russia has taken this land, the conflict will end. The question begs, could this assumption be incorrect? If Russia, with a very modest military expenditure and limited loss of personnel, is capable of swiftly capturing part of the Ukraine, could they not be motivated to conquer the remainder of the country? A resolute and well funded nation, harboring deep antipathy of the western model, can inflict a great deal of economic, political and if necessary, military damage, against a unwieldy and uncoordinated coalition of countries with differing degrees of resolve. The great counterbalancing power, the United States, professes war-weariness. Russia, in stark contrast, based upon rhetoric, domestic public opinion and a significant increase in military expenditures for the past several years, appears war-ready.
As Angela Merkel, the chancellor of Germany, has apparently failed in diplomatic efforts to convince the Russian government to remove its military forces from the Ukraine, Europe faces a stark choice; let the Ukraine be militarily conquered, in part or in full, by Russian troops, or opt for a continuation of politics by other means. Both scenarios pose pertinent risks to equity investors.
A third option is a proxy war that would be fought by providing munitions and training to the Ukrainian government. This will only work if the Ukraine can remain unconquered for a sufficiently long period of time for Europe to make effective decisions; that is by no means assured. Putin, in an unusual display of public bellicosity, recently declared that his troops could take Kiev within two weeks. An abrupt and complete military victory over all of the Ukraine will serve to enhance Russia’s strategic and economic interests and will profoundly reshape the present European status quo. NATO’s enfeebling response is to declare an intention of putting together a 4,000 troop unit by the end of 2014; such a declaration is an unsettling gaffe that should further embolden military planners at the Kremlin.
More to the above point, NATO’s self-declared inability to immediately field even a smallish expeditionary force, capable of fending off a minor Russian incursion, is a damning indictment as to the abilities of NATO to offset a major attack by fast acting Russian shock troops. A highly sobering question should be asked; “why is it that NATO, given its stated purpose and length of existence, is only now making tentative plans for the creation of a fast response unit for military interventions?” As NATO cannot currently, via self-admission, provide a minimum of 10,000 battle tested troops to buttress any of their member’s domestic forces, after 65 years of existence and decades of military exercises; how quickly could a determined and well armed invading force of, say, 100,000 troops, demoralize a whole host of unprepared peripheral countries? Have we learned nothing from the wars of the 20th century? Let’s be clear; no recent invading force has ever told their opposition: “take your time and let us know when you are ready”.
As to why Europe and Russia are contemplating a war over the Ukraine, let’s put aside ideology and think in terms of capital investment. If the Ukraine were a publicly traded company, it would be a workout with great underlying fundamentals, riddled with inept management but available at bankruptcy prices. In purely economic terms, the Ukraine represents one of the last unaffiliated real estate and human capital bargains in Europe. The largest nation, in terms of land mass entirely in Europe, features a population of almost 45 million persons and has a temperate climate capable of producing prodigious quantities of wheat. In the past, the Ukraine was considered to be the breadbasket for much of Europe. Sadly, since its independence from Russia, more than 23 years ago, the Ukrainian government has vacillated between pro-western and pro-Russian policies; to a great extent a series of governments played one side off against the other in efforts to extract the maximum amount of western/eastern handouts, without fully aligning in either camp. Absent any semblance of reasonable forward economic planning, lacking a capable bureaucracy and headed by a seemingly never-ending series of kleptocratic governments that, anecdotally, only look to exist at the behest of prominent oligarchs, the Ukraine has foundered.
In 2013, according to the CIA World Factbook, the nation reported an official GDP of just $175.5 billion (at official exchange rates), or $3,991 US per person; as dreadful as this figure seems, it is most assuredly ginned up. To place this into perspective, let’s compare the Ukraine to Romania. According to 2013 figures taken from the World Factbook, Romania’s economy, reported $189 billion US of GDP; Romania’s population is less than half that of the Ukraine. Romanian 2013 GDP stands at $8,700 US per person, using official exchange rates.
Even the Ukraine’s historic position as a breadbasket nation, one that produces and exports a significant output of wheat, needs to be called to account. Farmers in Canada, by way of comparison, produced about 2.7X more wheat per hectare in 2013 than did those in the Ukraine.
Both western Europe and Russia have clear strategic and economic interests in having the Ukraine get off the fence and choose a path. Geopolitical certainty and potential windfall economic multipliers are the ultimate prize for the side that aligns the Ukraine with its sphere of influence. The west would wish to modernize the Ukrainian antiquated infrastructure in efforts to unleash the economic potential of the nation. This carrot comes with a price, such aid would require structural reforms that entrenched interests deem unpalatable. For the people of the Ukraine, status quo, that being perpetual economic stagnation, is no longer tenable. Russia seems determined to pre-empt any choice that would be pro-western in nature.
If one accepts my zero-sum game premise as the overarching doctrine now guiding Russian actions, based upon results to date, it is clearly in the overall best interests of Russia to continue their overt aggression in the Ukraine; the corollary must be that it is clearly not in the best interests of the EU to permit the Ukraine to be conquered by Russia.
Countervailing military intervention from Europe could serve to shock the investment markets. Those in the United States and in much of the non-EU world appear blissfully sanguine as to the dimensions of this potential conflict. Some investors look back in recent history and point out that wars, however brief, are often attended by rising equity markets. That is certainly true for the victorious party. However, in this interconnected global economy, an adversary that operates with a zero-sum game philosophy will not think twice of expropriating (nationalizing) foreign business interests to save face. Should Europe elect to respond to Russia’s militaristic adventurism in kind, many European and western based multinationals will stand to lose their entire investment in Russia, in one way or another. According to the World Bank, foreign direct investment in Russia exceeded $264 billion US. from 2009-2013. From automakers, to brewers, to chemical manufacturers, to consumer products companies; the list of businesses, large and small, whose balance sheets may be impacted by Russian retribution could be legion. A cut-off of the Russian supply of natural gas to Europe cannot be discounted. This would result in power shortages and lead to manufacturing output slowdowns. A European recession of some consequence would ensue, under a standoff whereby power is withheld in the winter.
Most will suggest that such an outlook is outlandish; their assumption is that Russia will not wish to be further hurt economically. Certainly it will be costly for Russia to withhold their natural gas to Europe for an extended period of time. However, those who have historically underestimated the ability of the Russian nation to endure lengthy hardships generally wind up the wrong side of the bet. An effective and lengthy propaganda campaign has convinced a healthy majority of Russians that their time is now and that they can easily outlast Europe in any war, be it economic attrition or otherwise. Russia is presently winning the propaganda and political battles now being waged in global media; they seem fully aware of their actions and are prepared to act as an isolationist state. Russia’s national psyche is that they are nation of tough people who have overcome superhuman hardships in the past and can do so again, if need be. Trade sanctions can readily be circumvented by Russia; replacing this winter’s supply of natural gas by Europe is not so easily done.
Based upon this outlook, is apposite to review the entire portfolio and determine which companies may be impacted from a business perspective. This represents a separate assessment from any potential shock scenario that would result in a flight to liquidity and that may generally affect global equity markets. As an equity owner that remains fully invested, at all times, acceptance of inevitable periodic market shocks is part and parcel of the business. That said, owning multinational businesses highly likely to be on the wrong side of punitive Russian courts is undesirable. Too, should attendant sanctions, with real teeth, be enforced by western powers, there will be deleterious impacts upon many businesses. At the very least, meaningful sanctions will serve to dampen forward profit forecasts for the global economy. A world that reverts to a cold war; one based upon sanctions, trade barriers and overt animosity, this seems to be the best outlook that this investor can forecast and that would be tolerable; no doubt there could be some compression of valuations in a new cold war. However, global recessions are seldom telegraphed and often commence in the aftermath of an unanticipated external shock. Could a war fought over the Ukraine be such a shock?