Off Ramps for Russia and Markets

Uncertainty continues to abound with respect to the conflict in Ukraine, but signs of a potential path forward are starting to emerge. Against this backdrop it’s helpful to consider what the likely outcomes may be, their ripple effects, and most importantly for investors, the extent to which these scenarios are currently priced into markets.

Consider these three potential outcomes and how the market is grappling with probabilities:

Outcome 1: Quagmire – Long and Protracted Conflict
So far, we appear to have been on this track. Russia’s military advance has been slow and at heavy cost, not what one would expect of supposedly one of the world’s greatest military powers. Despite the carnage, Ukrainian morale has been supported by a robust social media propaganda machine and heavy tolls inflicted on military forces. Each side is under strain, but neither is willing to back down. Encirclement and siege / starvation campaign / war of attrition becomes the strategy for the Russian military as it seeks to extract better terms in an eventual negotiation.

Outcome 2: Negotiated Settlement
This has clearly not been the conflict Vladimir Putin expected, and domestic pressure, while perhaps still limited due to state media control, is building. Putin needs a win and the list of incentives motivating a quick resolution is growing:

• Logistics issues
• Lack of military preparedness
• Poor morale exacerbated by the loss of high-profile generals
• Growing domestic opposition
• Inability to occupy
• Fuel and food shortages
• Questions of lack of military supplies and weaponry

Questions of Russia’s war machine running light on supplies have only gained momentum with news stories of Russian requests to China for military assistance. Putin is lonelier than ever on the global stage and seemingly more so domestically, with reports he recently arrested a number of senior intelligence officials as a result of the poor war effort to date. Meanwhile in Ukraine, President Volodymyr Zelensky is unlikely to cave with morale running high. However, Ukrainian military losses are mounting, devastation is growing, and civilian casualties continue to rise. So how much more can they take?

Outcome 3: Russia Escalation
Frustrated due to lack of progress and looking for a decisive win and show of strength, Putin further escalates the war:

• A limited nuclear strike remains a very low probability event.
• Use of chemical weapons fits the bill of prior Russian aggression, particularly with recent propaganda targeting supposed US chemical labs in Ukraine – which could serve as the pretext for an attack to be blamed on Ukraine and its western supporters.
• Either of these actions would clearly mark a significant escalation and open the door to further sanctions / Western escalation.

War’s Impact on Global Markets
The primary channel through which the war impacts markets remains energy prices. Markets have struggled to price the effects of surging energy prices on consumer demand and global growth. Energy prices have a meaningful embedded risk premium, and each outcome has important implications for that risk premium and the likely path of energy prices.

A long, protracted conflict ensures uncertainty persists and further escalation remains on the table – keeping the risk for higher energy prices open. Similarly, a severe Russian escalation would elicit a severe response from western nations, again keeping energy prices and geopolitical risk elevated. A negotiated settlement, on the other hand, would likely lead to an unwind of the embedded risk premium in energy and commodity prices.

What’s Already Priced into the Markets?
While energy products were explicitly excluded from the first wave of sanctions, the US upped the ante with an outright ban on Russian energy imports. That step remains largely symbolic, however, with US crude imports from Russia amounting to about only 3% of total crude imports. More importantly, with the US now holding the crown as the global swing producer, those imports are largely unneeded.

The UK imposed a modest phase-out of Russian oil and gas, and the European Union (EU) remains far too reliant on Russian energy imports to gather sufficient multilateral buy-in to enact such a ban despite plans to reduce reliance over the course of the year. But the key question is: How much bad news is already priced in?

Consider the chart below. We’ve highlighted various trading ranges for spot WTI (West Texas Intermediate) crude. A spike on March 5 saw spot prices touch $131, as EU energy sanction risk grabbed headlines.

WTI Crude Spot Price (10/28/21–3/11/22)

Source: Bloomberg

Whether the EU finally sanctions energy imports or Putin chooses to place an embargo, have we seen the peak surge in prices? Of course, we’ve seen crude prices settle back in over the course of the last week, but what’s the greater risk from here – a continued surge beyond $130 or a potential risk premium unwind with $130 as the ceiling? Markets love to extrapolate recent trends, and price action from last week certainly suggested investors were extrapolating energy prices continuing higher. But if we’ve seen peak sanctions, we may also have seen peak oil prices.

It’s unlikely we’ll settle back into the pre-crisis trading range, but should we continue to move in the direction of a negotiated settlement, there’s likely additional risk premium to unwind. And should the conflict continue to escalate, we may have an indication of peak prices.

Off Ramp Coming into View
While the two sides remain far apart, talks continue and demands have been falling. The sticking points now appear to be:

• Formal recognition of Russian control of Donbas
• Russian land bridge to Crimea
• Ukraine swearing off NATO in return for security assurances
• De-militarization

Despite Ukrainian pushback, the first two demands are largely a formalization of the on-the-ground reality. Recent comments from President Zelensky have reiterated his prior openness to neutrality in return for security assurances.

Russia’s request for military assistance from China is a new twist in the narrative, but keep in mind the following:

• While China is one of Russia’s few remaining friends, China has so far been unwilling to be supportive other than in name.
• Western nations have been clear that any actions by China to undermine sanctions will likely bring China into the crosshairs as well.
• With Covid creating new domestic risks to growth as the country holds onto its zero-Covid policies at a time when global consumption is likely to begin slowly shifting away from the goods surge, the risks to domestic growth are mounting.
• Behind the scenes, there seem to be some divisions between China and Russia – suggesting dissatisfaction in the trajectory of the conflict. Also, outright support could be costly for China.

Combat is moving closer to NATO borders with Russia’s strike on a military installation close to Poland. There are reports of kidnapped mayors, and the potential for referendums in these cities akin to what occurred with the Crimea invasion is also playing out. On the other hand, rhetoric from both sides certainly seems to be moving in the right direction, suggesting an agreement could soon be reached. While there’s still ground between the two sides, there’s sufficient political cover on each side to bridge the gap.

What About the Other Commodities?
While energy gets the limelight, there are plenty of other commodities that have been bid up in recent weeks. Last week brought fears of retaliatory embargoes from the Russian Federation as Putin signed an order to limit commodity exports, though that list has proven so far to be largely symbolic. Shutting off key exports would lead to even more self-inflicted damage even if those proceeds couldn’t be utilized.

The bigger question that remains unanswered is on the soft commodity front. With Ukraine a key source of global wheat, corn, and sunflower production, might we see a sustained bid for soft commodity prices as existing shortages and droughts are exacerbated by a missed planting season?

What About the US Consumer?
Demand destruction is the buzzword. But this is not your parents’ commodity price surge:

• US energy intensity has fallen 64% since 1970 and 21% since 2008, the last time we saw crude prices at these levels.
• Consumer spending on energy has fallen dramatically as well over that time, with energy consumption representing just 3.9% of disposable income, down from 5.4% in 2013 and 6.3% in 2008.
• Food and energy consumption as a share of personal consumption remains near all-time lows at 12%, down from nearly 14% ten years ago and over 22% in the 1970s.
• Food and energy price spikes do not have the same effect they once did. Could these price gains curtail consumption at the margin? Of course, but narratives of broad demand destruction leading to a recession are probably overdone.

Stagflation Not on US Radar
There seems to be some confusion over stagflation (persistent high inflation combined with high unemployment and stagnant economic demand). Remember, slower growth does not equal slow growth. Inflation with real growth of 4% and nominal growth close to 8% does not equal stagflation. The US is now a net exporter of oil. As such, increased consumer spend does not lead to an aggregate slowing in growth as those profits are recycled within the US, not shipped abroad to foreign producers. It represents a rotation in growth from energy consumers to energy producers. Growth shifts from households to the energy complex. Lower consumption would be offset by increased growth and profitability in the oil patch.

Also, there’s still significant US growth in the pipeline. The housing market remains strong, household balance sheets are robust, corporate balance sheets are flush with cash, there is an emerging capex cycle, and many state and local governments are reporting budget surpluses. Add on top of that yet another leg of reopening on the horizon.

In Europe, the risks of stagflation and recession appear more elevated. Energy expenditures remain a relatively larger portion of consumption spend in the region. But consumers have built up excess savings, although in materially smaller quantities relative to the US.

Overall, there are clearly still downside risks as the Russia-Ukraine crisis plays out. But it’s hard to get too bearish with market sentiment so negative. Many investor portfolios have already de-risked, and a lot of bad news is already priced into the market. The skew certainly suggests we could be primed for a sharp relief rally.

There remain plenty of unanswered questions. But a path to a resolution is starting to take shape.

Unfortunately, it seems unavoidable that there will be far too much death and devastation to come. But hopefully some of the most dire predictions will remain just that – predictions that fail to materialize.