[ANALYSIS]: RUSSIAN ROULETTE: A major risk to markets (UPDATED FEB 22)

SITUATION REPORT: 

DONETSK AND LUHANSK INDEPENDENCE

• Russian President Putin recognised the independence of two separatist-held regions of Donetsk and Luhansk (part of Donbas) in eastern Ukraine.


• Russian President Putin ordered Russian troops to Ukraine after recognising breakaway regions; troops were sent as peacekeepers.


• The recognition of the republics' independence paves the way to give the Russian-backed separatists military support and provides a pretext for Russian troops to cross the border.


• Russian President Putin said Ukraine is an integral part of Russian history and they are ready to show Ukraine what genuine de-communisation looks like, while he accused Ukraine of stealing Russian gas in the past and using energy to blackmail Russia.


• 
  Russian President Putin  thinks the West will impose sanctions anyway, while he added that Russia has the right to take retaliatory measures and has every right to protect its security which is what they will do.


• Russian Energy Minister said Europe will be unable to replace large volumes of Russian natgas with other regions' LNG.


• Under the new agreement with separatist leaders, Russia has the right to build and establish military bases in eastern Ukrainian regions.


• Ukrainian representative to the UN said their border have been and will remain unchanged regardless of the steps announced by Russia. They requested to activate security and cooperation mission in Ukraine to prevent any future escalation.

WESTERN REACTION

• An emergency UN Security Council meeting was conducted overnight (requested by Ukraine).


• 
  US President Biden signed an executive order prohibiting new investment, trade and financing to the DNR and LNR regions of Ukraine, while he will soon announce additional measures which would be separate and in addition to the swift and severe economic measure it has been preparing.


• Furthermore, the White House said the US will announce fresh sanctions against Russia on Tuesday in which it will coordinate with allies on the announcement.


• US Ambassador to the UN said Russian order to deploy peacekeepers in eastern Ukraine is nonsense and Russian recognition of eastern Ukraine is clearly the basis for an attempt to create a pretext for a further invasion of Ukraine.


• 
  The UK will announce Russia sanctions on Tuesday and the UK government said sanctions will go further if invasion happens, so will not go as far as the full package prepared, according to The Guardian.


• "The EU is likely to impose limited sanctions — such as listing more individuals and cutting trade with the separatist “republics” — largely a symbolic move given those regions are already sanctioned.", three diplomats told Playbook.


• UK sanctions on Russia will include the defence industry, oil and gas companies, banks, financial institutions and chemical companies, according to Sky News Arabia


• 
  Dutch PM Rutte said a limited package of EU sanctions agreed against Russia and that the sanctions will target those responsible for the move to recognise the independence of Ukraine rebel regions.


• Austria said the EU sanctions package on Russia includes the Nord Stream 2 gas pipeline, according to Reuters. 


• EU heads said they will react to Russia's recognition of Ukraine separatists with 'firmness', while EU's Von Der Leyen said the recognition of the two separatist territories in Ukraine is a blatant violation of international law, the territorial integrity of Ukraine and the Minsk agreements.


• 
  Consultations are going on at the top level of the EU institutions, while there will be consultations with US and UK on whether tonight should be the trigger point for sanctions, according to WSJ.

EASTERN REACTION

• "China calls on all parties relevant on the Ukraine situation to continue dialogue and consultation and seek reasonable solutions to address each other's concerns on the basis of equality and mutual respect", according to The Global Times.


• Senior Chinese Diplomat Yi said China is concerned about the evolution of the Ukraine situation.


• Japanese Foreign Minister said they will coordinate with the international community on sanctions against Russia.

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UPCOMING EVENTS

• UK PM Johnson will conduct a COBRA meeting at 06:30GMT on Tuesday.


• EU ambassadors meet at 08:30GMT in Brussels today to discuss Russian sanctions. EU affairs ministers will meet from 09:00GMT for the General Affairs Council, where they will continue the discussion, according Politico.


• Russian President Putin's decree on the regions' independence is expected to be ratified by Russia's parliament on Tuesday.

TROOPS AND DRILLS:

• It is reported Russia has amassed over 150k troops alongside tanks, airpower, artillery, and rocket batteries on its 1,200-mile border with Ukraine.


• Reports suggest Russia has three main routes for an invasion: 1) the Northern Route via Belarus, 2) Central Route via Donetsk or 3) the Southern Route via Crimea.


• Russian Deputy Foreign Minister called reports of possible US THAAD missile systems being supplied to Ukraine as a provocation, via Reuters citing Ria.

Analysis details (05:00)

BACKGROUND IN BRIEF:

• Ukraine became independent in 1991 when the Soviet Union (USSR) dissolved with the end of the Cold War. Ukraine has been tilting to the West since, as it sought to distance itself from Russia, with a NATO (North Atlantic Treaty Organization) membership also floated.


• Russian President Putin is seeking to regain influence over the former Soviet state. Ukraine insists that Russia cannot prevent it from building closer ties with NATO if it chooses. The US and some other NATO players have shown Ukraine support whilst simultaneously attempting to deter Russia. Moscow blames NATO for undermining the region’s security.


• In 2014, Russia illegally annexed Crimea – an area presented as a gift to Ukraine under the USSR. Meanwhile, the Donbas region (the eastern Ukrainian provinces of Donetsk and Luhansk – near the Russian border) has seen conflict since 2014 after Russia sent troops to support Russian separatists. An agreement was made in 2015 which helped ease the major conflicts but failed to politically unite the sides – with small flare-ups continuing since.


• The Donbas region is seen as a proxy for the tensions. Early last year there have been instances where the 2015 ceasefire was broken. The EU and US have imposed a string of restrictive measures in response to Russia's actions in Crimea and eastern Ukraine.

POSSIBLE ESCALATION:

A senior US official said the US and European responses on Ukraine may not be identical.

WAR: Rabobank believes there is a higher risk of military action than markets are pricing. “Crucially, Russia’s actions would unilaterally redraw the map of Europe, risk refugee flows west, and have enormous market implications.”, the bank says.

SANCTIONS: Analysts at JPM highlight potential sanctions against Russian oligarchs, Nord Stream 2, Russian financial institutions, Russian sovereign debt, Russia’s energy sector, the SWIFT payments and RUB convertibility. JPM suggests that there has been concern over the collateral damage to the global economy and Russian citizens, albeit the likelihood of sanctions has lately increased. Recent reports have suggested that President Putin himself could be a target of potential sanctions.

CYBER ATTACKS: The threat of cyber warfare cannot be discounted. Ukrainian government agencies were recently attacked by a group of hackers some say have links to Russian secret services, although this was not confirmed. The Department of Homeland Security also warned that Russia could launch a cyberattack on the US in retaliation for any defensive moves of Ukraine.

MARKET IMPLICATIONS:

ENERGY: Russia holds over 30% market share in Europe for both natural gas and oil. To alleviate some of this threat, the US said it is engaging with LNG suppliers to manage storage and diversion to Europe if needed. However, Saudi Arabia, Kuwait and Iraq would struggle to cover the shortfall in crude supply created by a blanket ban on Russian energy exports as they have already allocated their annual term supplies, according to Argus sources.

• 
  OIL: Analysts at Rabobank suggest war could see oil hit USD 125/bbl amid elevated risk-premia and higher transit costs, whilst sanction (assuming all countries stop purchasing Russian oil) could see prices rise to USD 175/bbl. JPM believes oil could spike to USD 120-150/bbl in the event of sanctions.


• 
  GAS: The Nord Stream 2 underwater pipeline (linking Russia and Germany) will likely be caught in the crossfire. The pipeline is awaiting certification for use. While current supplies will not be affected, the risk to future supplies will substantially increase. This, alongside low European natgas stocks, could significantly increase European gas prices and seep into global oil markets, according to JPM. Note: China and Russia agreed to a 30yr gas deal via a new pipeline and settled in EUR.

METALS: Russia holds a large market share of total exports in nickel (~49%), palladium (~42%), aluminium (~26%), and platinum (~13%), whilst it also exports steel (~7%) and copper (~4%). A supply disruption will naturally lead to higher prices. Some desks however argue that sanctions would be more detrimental to the global economy given how integrated the above metals are to everyday goods, whilst a rush to stockpiles will further aggravate the ongoing supply chain problems.

INFLATION/GROWTH: With Russia being a large contributor to energy and metals, officials are beginning to sound concerned over the potential inflationary impact from escalations. IMF's First Deputy Managing Director warned an escalation in the Russia-Ukraine conflict could result in a 'bigger, broad-based increase in commodity prices, and could increase risks of entrenched inflation expectations, feeding into wage-price spirals”. ECB Governing Council member Simkus also suggested the Russian related tensions are a bigger cause for uncertainty than Omicron. JPM warned a spike higher in oil and subsequent inflationary pressure would be deleterious to growth.

STOCKS: Traditional risk-off selling could be expected in the event of a war. That being said, in the midst of earnings season and the central bank pivot, equities could be distracted (at least briefly) from events in Ukraine depending on the severity and duration of the situation. Sanctions meanwhile will likely be contained to Russian equities. Austria-based banks are the most exposed to Russian claims, according to Nomura. 

FX: In the event of a war, desks suggest traditional risk-off is expected with safe-haven flights into the JPY and CHF. EUR meanwhile will not be well-placed given Europe’s likely involvement. The RUB and UAH will likely slump. Meanwhile, additional sanctions will likely see the RUB under pressure, but Rabobank believes this could tactically benefit Russia as “it would give it room to cut the US dollar prices of its exports for those willing to deal with it … This could potentially exacerbate the sharp price bifurcation in global commodity”, Rabo says. Nomura says "Based on our assumptions, the relative outperformers beyond the USD are likely to  be CHF and JPY (relative safe havens) and CAD (from higher commodity  prices). We think EUR , INR and PHP will experience the most negative impact." In terms of FX hedges, Nomura suggests that in their view, "hedges in EUR/JPY via 2w digital puts (anything below a  strike of 128) would be a good hedge (or tactical) position against possible military  action by Russia,"

RATES: A risk-off scenario from war would likely lead to lower yields and a flatter curve in the immediacy, whilst longer-term impacts from the inflationary effects could then take over. In the event of sanctions, some argue that sanctions on large Russian banks could see credit spreads blow out.

AGS: Russian and Ukrainian grains exports (wheat, barley, corn) account for around 24% of the global total, whilst fertilizers out of the region also represent a large global export share. Supply interruptions will naturally bolster prices.

CENTRAL BANKS: In terms of the three major central banks, Nomura argues that due to the lower trade link, the Fed would be least affected by Russia/Ukraine in policy discussions. The ECB will likely be the most cautious, followed by the BoE. 

RUSSIA’S SECURITY PROPOSALS: 

Despite the string of diplomatic meetings, the security proposals are at the center of Putin’s interests.

• Russia previously emphasised that it is to formulate its stance after the US responds to Russia’s security proposals.


• On December 17th, Russia released draft agreements on the security guarantees that Moscow expects to receive from Washington and NATO. The proposals oblige NATO to stop its eastward expansion, drop plans on granting Ukraine membership, and call for restrictions on the deployment of weapons including nuclear.


• On December 15th, the Russian Deputy Foreign Minister said if the US and NATO do not provide them with guarantees around security, it may lead to confrontation; and a lack of progress on this would lead to a military response.

FUTURE RISKS: 

The Russia-Ukraine developments will be closely watched as a proxy for the China-Taiwan tensions. China will likely calibrate any move depending on the fallout from the Russian situation.

22 Feb 2022 - 06:25- EquitiesGeopolitical- Source: Newsquawk