How to hedge Ukraine

Via Macquarie legend Viktor Shvets:

Politics are struggling to contain geopolitics = disruption

• In the ‘90s, Zbigniew Brzezinski (former National Security adviser, and one of the best known experts on Eastern Europe), said – ‘Without Ukraine, Russia ceases to be an empire, but with Ukraine suborned and then subordinated, Russia automatically becomes an empire’. He also argued that ‘Russia can be either an empire or democracy, but it cannot be both’. Since then, Russia has decided to become an empire, and as Brzezinski observed, without Ukraine, it cannot be one. Even Solzhenitsyn (Soviet dissident and the author of Gulag) advocated establishment of what he called ‘historic Rus’ or union of Russians, Belarus and Ukrainians. It echoes Putin’s recent essay. One can debate the validity of these views, and while Russians are weary of commitment and casualties, they regard Ukrainians & Belarussians as brothers who should be friends, and part of the family. Whether in the Tsarist or Soviet days, Central Asia and the Caucuses were treated as colonies while Baltics were akin to an alien window to the West. But Ukraine and Belarus were and are different.
• What does this historical detour imply? 1. Sanctions are unlikely to yield useful results. This is not about pain in the pocketbook or GDP, and besides, after Crimea, Russia has essentially disconnected itself. It has repaid most of its foreign debts and rebuilt FX reserves. Russia has internalized its economy, making strides towards self-sufficiency, especially in agriculture. It has also reoriented towards China, and both countries are now developing alternatives to SWIFT. At the same time, Russia remains a key supplier of commodities (oil, gas, aluminium, titanium, etc), with EU being especially vulnerable. The lever
that could hurt is to block Russia from any product containing US technology, but this would hit countries from Germany and Sweden to Korea and China. 2. A credible Western military response could make a difference, but there is currently none. EU and NATO are divided, and the US has already ruled out ‘boots on the ground’ and is only supplying limited defensive equipment. While the Ukrainian army is now much stronger, it is not a match for Russia, and its East-West geographic and cultural cleavage still persists. 3. From Russia’s perspective, arguably the best outcome is to replace the current Ukrainian government, and the latest news suggests that Russia might be contemplating this option. While reducing damage, it could provoke a civil war that might still require a significant Russian commitment. 4. West offers little. Democracies tend to over-negotiate in search of a win-win compromise. But in geopolitics (as practiced by Russia and practitioners of realpolitik), there are no win-wins.
• Bottom line: we think sanctions are unlikely to make much difference and while many of Russia’s demands are (in our view) unrealistic, questions of Ukraine, Belarus and Kazakhstan will not go away as these are integral to the way Russia perceives itself. Investors are bad at assessing geopolitics, explaining why German equities boomed all the way to Stalingrad or failure to anticipate World War I. Politics are supposed to look after geopolitics and 8 or 9 times out of 10 this is the right answer. But tail risks (e.g., Ukraine, Middle East, or tensions in the South China sea) are becoming highly disruptive, and politics might no longer control geopolitics. This might even overshadow the Fed.

What will war do? Goldman is sanguine:

Geopolitical tensions in Ukraine have raised the risk of disruptions to commodity flows. While we take no view on potential further escalation, we would expect three likely impacts. First, the 2014 precedent suggests sanctions to limit on current Russian energy exports would be unlikely, as the negative impact on Russian oil revenues would be limited by its ability to redirect most flows and would further come at the cost of higher oil prices globally with finally the risk of retaliatory gas shortages in Europe. Second, while some physical disruptions could nonetheless occur, we would expect the impact from a gas or oil pipeline outage to remain modest given Russia’s ability to reroute flows away from Ukraine, which it has already started doing for gas this month. Third, potential longer-term energy sanctions would likely focus on the Nord Stream 2 pipeline
and expanding on the 2014 restrictions on foreign involvement in Russia’s shale, offshore and Arctic upstream activities, exacerbating the structural under-investment already shaping oil and gas markets given Russia’s large untapped natural resources.

While our base-case remains that disruptions are unlikely to occur, the price risk to exposed commodity markets is nonetheless skewed to the upside relative to 2014 given tighter inventory levels. On headlines of further escalation or a physical supply outage, we see the greatest upside risks for European gas prices of c. 12 EUR/MWh (given the still critically tight inventory situation), followed by wheat and corn (as Ukraine has become a significant exporter). We expect the impact on oil prices to be modest at c. $2/bbl (given the likely only limited loss of un-reroutable pipeline volumes), with dirty freight markets likely to rally significantly instead (given the ability to redirect flows to the seaborne market).

Finally, we expect gold to remain unfazed, just like in 2014. Importantly, in the absence of escalation and cold weather, the growing risk premium in European TTF gas prices (vs. JKM) that is attracting spot LNG cargoes for February and March, will help end winter with sufficient supplies (and sequentially lower prices). In oil, however, we believe that current prices rightfully only reflect a negligible risk premium, reinforcing our conviction for sequentially higher prices instead.

I think oil will be stronger than that, at least initially. The entire commodity complex will likely blow off. We are already seeing it iron ore even though Ukraine is a relatively minor exporter at 35mt.

But I wouldn’t hedge it via commodities. Nor via gold. Not with the Fed tightening in the wings. Such an environment could very quickly turn from geopolitical to economic shock and equity prices (followed by commodity prices) crash on recession risk.

With that backdrop, the US dollar recommends itself as the best Ukraine hedge, at least until the Fed rolls over.

Houses and Holes

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