Special market update: Putin’s recognition of Donbas  

Posted 22 February 2022

Putin’s Donbas move triggers ‘starter’ sanctions

Russia’s aggression towards Ukraine reached a new level overnight after Russia’s president Putin officially recognised the two self-proclaimed separatist ‘republics’ in Ukraine’s Donbas region. Most importantly, he  ordered official troops to move in for what he declared to be ‘peacekeeping operations’. This has triggered the West to announce a stepping up of sanctions. Meanwhile Ukraine’s president Volodymyr Zelenskiy said Putin had merely “legalised” troops already present in the republics.

At the time of writing on Tuesday the media reaction to the escalation of the conflict has been more alarmed than that of stock and other asset markets. This ties in with what we published last week about historical observations of the impact of regional wars on stock markets. Price moves tend not to be particularly pronounced once hostilities have actually started. Indeed, downswings occurred when tensions were building up beforehand and hostilities have more often marked the beginning of a medium-term upswing in markets.

The explanation for this apparently uncaring market action is that economic activity beyond the area of conflict usually continues as before. However, in this specific instance,  there is a risk of energy supply disruptions to the pan-European region in the form of Russian gas, or at least that energy prices will remain high for longer or rise higher than had been anticipated in 2022’s general economic recovery scenario. This would explain some of the recent weakness in stock markets as they had priced in further increases in the cost of gas and oil putting a dampener on the 2022 economic upswing.

We suspect that if Putin’s latest move had indeed constituted a full-on invasion of Ukraine – as some of the news media seemed to suggest – then the market reaction would not be as benign as it was this Tuesday morning, with only the price of oil and gas in Europe trading notably higher than yesterday.

The subdued market reaction tells us that there is a recognition or at least suspicion that with this latest move, Putin may have revealed his true goals/intentions in this conflict; namely, explicit control of the Russian speaking parts of the Donbas region after Russian supported separatists seized the area in 2014. A military protectorate may not be an outright annexation like the Crimea, but few would draw a distinction. This would be similar to the outcome of the 2008 conflict where Russia succeeded in turning the two Georgian regions of Abkhazia and South Ossetia into such military protectorates.

It also suggests that there is an assumption in markets that Putin has once again been successful in outmanoeuvring western interests and achieved his aim of extending Russia’s area of influence and control at an acceptable cost to his country. This assumption is based on previous indications by the Biden administration that they would not deem a move in the frozen conflict in the Donbas as a trigger for imposing the full force, of what would be very painful sanctions on Russia.  

This relative market optimism is heartening, and some may even describe it as wishful thinking, given it is not at all certain that Putin will be content with what he has gained so far. Whether the US and European governments will indeed refrain from imposing significant sanctions and whether the Ukrainian government will accept Russia’s occupation of part of its rightful territory, rather than strike back is unclear. Its basis is the assumption of rational actors on both sides, which at a time when the pressures of the pandemic are easing should want to shy away from risking the economic recovery and contain the economic fallout to what is deemed an acceptable minimum.

Our view is that the above is a possible outcome, but that it is too early to expect this conflict to be beyond its peak. We recall that in the run up to Greece’s 2012 sovereign debt crisis there was also a widespread market expectation that political actors in Greece and the EU would act rationally from an economic point of view, and not let the situation deteriorate to the point where the Greek public no longer had access to their bank accounts. In the end, what was deemed unthinkable was allowed to happen in order to pave the way for a lasting resolution to the debt crisis.

We believe we are faced with a similar situation today, except that one of the main actors in the current conflict – President Putin – is much harder to gauge, even if it has to be said that up to now, in apparently achieving his aims he looks to have been clever and rational, rather than dogmatic or irrational.

As a result of the fluid situation, we are for the time being satisfied that our central investment position, aligned with a continued, albeit more gradual global recovery during 2022 remains sound in the prevailing political and market environment. However, should Russia aim for a significantly bigger landgrab than the already rebel occupied areas of the Donbas and/or the reaction of the Ukraine and the West’s sanctions become more severe, we will re-evaluate our investment portfolio positions. On the other hand, if Russia signals that they are content with what they have achieved, along the lines of ‘we believe our brothers and sisters in the Donbas are now safe’ could trigger a genuine relief rally.

The situation remains fluid and uncertain, but as it currently stands, we are seeing an almost equal probability for our next move to be an increase in our pro-cyclical recovery position or a more defensive reduction in our overall risk exposure should the geopolitical situation deteriorate rather than improve from here.  

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