Putin and the Eye of Sauron

by Larry Hatheway & Alex Friedman| February 14th, 2022

Perhaps you remember the Eye of Sauron?

In the epic trilogy Lord of the Rings, the Eye of Sauron is a mega-eye whose gaze leaves nothing unseen. It can only focus on one subject at a time. Yet when it brings a new target into focus, disaster usually follows.

The financial markets are similar. Their gaze often ignores threats until there is undeniable movement, and then it reacts with expedient fury.

For a long time, the market’s eye enjoyed the view of accommodative central banks replete with their printing presses. This was a happy time for those who invested in risky assets, for what they saw gave comfort that trees could keep growing higher and higher. Maybe even to the sky. This time is different, rang the familiar tune. Some even indulged in fantasies of limitless money financing social desires — ‘modern monetary theory’ (MMT). Even Omicron couldn’t distract the market eye for long.

Then, seemingly out of the blue, the market’s eye noticed that prices were going up. Supply chains, many said. Transitory, retorted central bankers. But prices kept rising, and before long wages began to surge as well.

The shift in market focus, predictably, caused asset prices to wobble and volatility to jump. Not even another strong quarter of over 20% earnings growth could offset the concern that monetary policy was shifting from market friend to potential market foe.

Indeed, the S&P 500 is down about 8% since its January 3rd high. The Nasdaq is down about 14% since its peak last fall. And growth stocks have gotten hammered, as higher interest rates forced a re-rating of stretched multiples. Overall, 43% of all stocks are down 20% or more. And as the chart below shows, few sectors have been spared.

Still, with a lack of attractive investment alternatives to global equities, markets have not capitulated. While investors have begun to adjust to the withdrawal of easy money, they have largely kept faith in the expansion. From its January 27th low, the S&P 500 has risen 5%.

But the markets’ restless eye has detected new movement, this time in Russia.

Despite a long build-up of Russian forces on all sides of the Ukraine, now topping 100,000 troops, markets have been slow to respond. Last week, suddenly, investors and traders have taken note that Europe faces its biggest military conflict since the Second World War.

Once again, markets are lurching.

Our training in economics and long experiences as investors helps us to formulate probabilities around inflation outcomes and monetary policy responses. We are far less equipped to assess the likelihood that Russia will invade the Ukraine and, if it does, when that might happen.

Still, we must do our best to consider potential scenarios and what their consequences might mean for financial markets. And it isn’t good.

Let’s start with the best-case, least likely scenario: Putin backs down under the guise of a new version of the Minsk Agreement. He withdraws most of his forces as NATO provides Russia with ‘face-saving’ language about their regional security. The markets would enjoy a compelling relief rally. A rational observer might put this at a 10% probability given the Kremlin’s recent statements.

The next case, to which one might assign a 30–40% probability, would be a series of escalating asymmetric aggressions by Russia. This could take the form of a combination of cyber-attacks, information warfare and false-flag operations to justify limited territorial incursions. In this scenario, which might easily go on for months while Russian forces continue to build and exert growing pressure on Europe, Biden would surely respond with strong sanctions, but not the most extreme ones. Indeed, he tellingly said as much about a ‘minor incursion’ at the end of a recent news conference. Market volatility, particularly in commodities, would increase but we should not expect a major negative market reaction.

The worst-case scenario would be a large-scale Russian invasion of the Ukraine, along with extreme kinetic warfare and the installation of a puppet government in Kyiv. The Biden Administration believes up to 50,000 civilians would die under such circumstance. There may now be a greater than 50% probability of such an invasion given the escalation of commitment cognitive heuristics that are likely playing out in the Kremlin, against a backdrop of Putin’s clearly stated belief that Russia should rectify the geopolitical ‘disaster’ of the dissolution of the Soviet Union. Recent diplomatic efforts have largely failed, with some mocked outright by the Kremlin.

If there is a large-scale invasion, it is close to a certainty that Biden (and European allies) will respond with huge economic and financial sanctions. Biden must, essentially, declare economic war on Russia for several reasons. First, he has promised it. He will look weak if he does not follow through. Second, his standing in the polls is already low. He and the Democrats cannot afford a foreign policy disaster. Third, and on a related note, he must blunt probable Republican attacks that the Ukraine is another example of US foreign policy malpractice, along the lines of the disastrous withdrawal from Afghanistan.

While it is unlikely that the US will block Russia from SWIFT (the international intermediary and executor of financial transactions between banks), Biden’s likely sanctions may be a near equivalent. It is probable, for instance, that US banks will be forbidden from transacting letters of credit and other forms of trade finance with any Russian entity or any bank working for a Russian entity. That is an effective way to disrupt Russian exports and imports, potentially sending the ruble and the Russian economy into a tailspin.

If this unfolds, expect oil and natural gas prices to spike. That, in turn, would be an anathema to the markets, as fears of 1970’s stagflation would dominate market psychology. Major indices might then experience extreme corrections.

The world’s investors are right to now focus their collective eye on Russia. Perhaps the most optimistic note is that unlike Sauron’s eye, our merely looking there does not mean the worst will materialize. Either way, we will soon see.

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