War is Imminent
President Biden said on Friday that the United States had intelligence showing that President Vladimir V. Putin of Russia had made a final decision to invade Ukraine.
“We have reason to believe the Russian forces are planning to, intend to, attack Ukraine in the coming week, in the coming days,” Mr. Biden said in the Roosevelt Room at the White House. “We believe that they will target Ukraine’s capital Kyiv, a city of 2.8 million innocent people.”
Putin has claimed that Ukraine is committing “genocide” in the eastern Donbas region and his ambassador to the United Nations has compared the government in Kyiv to Nazis. Setting the stage for “defending” his fellow ethnic Russians.
The United States and its NATO allies have warned for days that Russia might use false reports out of eastern Ukraine about violence threatening ethnic Russians living there to justify an attack.
And, right cue, Russia-backed separatists in eastern Ukraine called for the evacuation on Friday of every woman and child in the region, claiming that the Ukrainian military was about to launch a large-scale attack. Ukraine has denied these claims, and its military has reported a tenfold increase in shelling by separatists in the past three days.
In my view the situation is grim, I believe Russia is engineering a humanitarian crisis as a pretext to invade Ukraine. Putin’s strategists have played out this “chess game” to the end and Putin wins in every scenario, and, hence, he has every reason to invade.
Here is a brief analysis of Putin’s motivations and strategy:
- Putin has a mindset similar to Stalin’s, he is focused on expanding Russian influence and power. He and many Russians feel that the end of the USSR was an unfair loss of power and an insult to their honor.
- Putin realizes, correctly, that Ukraine is on a trajectory to eventually become a NATO member, it has applied to join and, unless he acts, it will likely be accepted into NATO in the next 1-2 years.
- Having a full Ukraine as a NATO member is the worst outcome for him and he does not want to be remembered as the Russian leader who lost Ukraine. Hence, he would like to redraw the border of Russia with NATO in a way that is more favorable to Russia.
- Wintertime is the optimal time for Putin to act since he has maximum leverage on Europe, as it is heavily reliant on natural gas supplied by Russia for electricity and heating.
- Putin knows that invading Ukraine will result in harsh sanctions against Russia, but those economic costs will be more than offset by higher oil, gas and commodity prices.
- Russia’s economy is highly dependent on exports of commodities with revenues from sales of crude oil, petroleum products, and natural gas accounting for about a half of Russia’s federal budget.
- He has likely secured China as a bigger customer for an additional 10 billion cubic meters of Russian natural gas, replacing most of Europe’s demand.
- I estimate that Putin is intent on capturing a significant portion of Ukraine territory enabling him to negotiate from a position of maximum power.
- However, Putin does not want to get bogged down in a long war and a long-term occupation that would require fighting local guerrillas (like Russia experienced in Afghanistan), so he has an incentive to quickly enter peace negotiations with the West.
- I estimate that he will agree to, in his “generosity”, to withdraw from the Western part of the country in return for an agreement constructed roughly as follows:
- Allowing Eastern Ukraine to become an “independent” state
- Lifting of international sanctions and normalizing trade
- Resumption of Nord Stream 2
- Agreement on population transfer, enabling East Ukrainians to move to the West and vice versa.
- Western Ukraine will be allowed to join NATO shortly after becoming free again.
- Eastern Ukraine will remain a proxy Russian State providing Russia with a buffer to NATO and additional access to the Black Sea.
- To the Russian people, Putin will become a national hero who has rescued the ethnic Russian population of Eastern Ukraine. By standing up to America and the West, Putin would be viewed as the leader who has returned Russia to its rightful place as a leading world power.
Let’s not forget, this war will be a horrendous humanitarian crisis, in which thousands will lose their lives. Hence, I expect Putin will wait and invade after the Beijing Winter Olympics conclude on Sunday, Feb 20th, so as to not offend his friend and ally Xi Jinping.
This will be a test of US and Western resolve to protect their interests. The implications are long term, especially for Taiwan and in other areas around the world. Hence, it is a high stakes game!
Based on how well Putin’s strategy works, Xi may decide to make his move on Taiwan sooner…
Inflation and Interest Rates
Federal Reserve officials at their meeting last month discussed an accelerated timetable for raising interest rates, beginning with an anticipated increase in March amid greater discomfort with high inflation.
The minutes of the Jan. 25-26 meeting, which were released Wednesday, also showed officials continued their deliberations over how aggressively to shrink their $9 trillion asset portfolio. The move is another way for the Fed to tighten financial conditions to cool the economy.
Yesterday, JPMorgan Chase & Co. economists said the Federal Reserve is likely to raise interest rates by 25 basis points at nine consecutive meetings in a bid to tamp down inflation. The bank is joining Goldman Sachs Group Inc. which is forecasting seven hikes this year, up from its earlier prediction of five.
On inflation, the economists said a “feedback loop” may be taking hold between strong growth, cost pressures, and private sector behavior that will continue even as the intensity of current price pressures in the energy sector eventually fade.
Hence, Wall Street investors are moving towards our “Volcker Pessimistic Scenario” in which inflation persists and requires a much stronger Fed response. Raising interest rates to a point where they’re above the rate of inflation, as Volker did in 1979.
Is a Recession Coming?
The personal consumption expenditures price index, which the Fed uses for its inflation target, probably jumped 6% in January from a year earlier, according to the median of a Bloomberg survey of economists. The core measure, which excludes food and fuel, is forecast to climb 5.2%.
Less than a month before the Fed’s next policy meeting, a sharper-than-projected advance in the price gauge could turn up the heat for a half-point increase in the benchmark interest rate.
As short-term rates rise, investors are closely watching the spread between the 2 to 10-year Treasuries. Inversion of this part of the term-structure has preceded every recession over the past 50+ years. As you can see recessions (grey areas) follow within 6-24 months of inversions, marked in red.
The spread is tightening between the 2 and 10-year, reflecting changing expectations about the Fed’s actions and the economy. Markets are reflecting the fact that the Fed will need to be much more aggressive in fighting inflation. This will cause the economy to slow down and will likely dip into a recession.
Conclusion
As can be seen in this chart, during past rate hike cycles, most commodities have risen sharply higher.
Source: Marex
Combining this pattern with a war in the Ukraine and subsequent sanctions, I expect this time around we will experience an even more extreme commodity price inflation. Hence, we took positions in several commodities we expect to rise because of the conflict.
As evident by the poor stock market performance year-to-date, especially in high valuation stocks, investors are expecting tighter monetary policy and rising interest rates which have already started to compress valuations.
If my predictions hold, a war in the Ukraine will start in the next few days and will likely be the catalyst to trigger further valuation compression. War will drive oil and commodity prices higher resulting in continuing inflationary pressures. The Fed will have to tackle this situation heads-on by tightening monetary policy further putting pressure on asset prices. Which means this coming week will be extremely volatile, and markets may fall sharply. I would not be surprised if we retest the January lows.
In the next few weeks, we may reach peak hysteria, stocks will likely get oversold, hitting low valuations which may be a good entry point back into the markets. We will be following market action closely and looking for opportunities.
My heart goes out to the millions of Ukrainians who are about to face a terrible war. Let’s hope it is not as bad as I imagine it could be.
Please let me know your thoughts, I’d be happy to continue the conversation.
All the best,
Tal