Expect chaos in Ukraine to guide the markets for the foreseeable future

Russian President Vladimir Putin has been in charge of Russia for 22 years. With his war against Ukraine, the street fighter has misjudged the resilience of the Ukrainians and the resistance of the West. The Russian leader probably believed that the U.S. and Europe would let the invasion run its course to a reasonable extent, partly due to concerns about the economic fallout. 

Friend and foe alike were amazed at the speed and unity with which a very far-reaching sanctions package was imposed against Russia; one which has left Russia largely financially and economically isolated. Setbacks on the battlefield and the financial-economic uppercuts dealt by the West may have prompted Moscow to adjust its demands somewhat to find a way out of the ring without losing face.

Whether a peace agreement is concluded in a timely manner or not, however, Russian bombs and grenades have rammed home a lesson to the last hard-of-hearing who still believed in the purifying effect of free trade and globalization as bringers of democracy and freedom. The post-Cold War peace dividend seems to have been completely cashed. 

In this hectic, unstable world, the key question is whether Kyiv and Moscow swapping boxing gloves for a pen and an agreement really mean that peace is being given the green light.

There are three possible scenarios now:

• Scorched earth- Putin does not care one bit about the sanctions and other attempts to stop him and settles for nothing less than all of Ukraine. In this case, Ukraine will become a puppet state of Russia.
• Divided earth- Putin ceases his offensive, with the West and Kyiv accepting Russian control over all of Donbas and Crimea and a promise that Ukraine will never join NATO.
• Inearth- Destroyed Ukrainian cities, thousands upon thousands of civilian deaths, many Russians killed, economic depression and almost complete international isolation go too far for the Russian people and part of the elites, culminating in a revolt that may not only end Putin’s regime, but also his life. Many in the West would be rejoicing, but the phrase “be careful what you wish for” applies here. Losing this war would delegitimize the entire regime and system. Since Putin has turned Russia into a completely top-down society — with the pillars of a healthy, resilient state either removed or completely corroded by corruption — chopping off the beast’s head could lead to dangerous death throes.

Financial markets are very upbeat about peace prospects. This optimism is premature. Eventually, we will end the second scenario with a frozen conflict, but for now, we should beware of too much euphoria about an end to the war:

• Over the last few weeks, countless analyses have frequently mentioned the word rationality, or rather the absence of it, with regard to Putin. However, it is perhaps far more appropriate to view the man through a radicalization lens, in the same ways that terrorist acts are analyzed. Seen from such a perspective, it is easier to account for Putin’s actions.
• In order to successfully conclude negotiations, both parties must have at least a partially overlapping worldview. In recent years, this seems to have been increasingly less the case between the West and Putin.
• Putin really sees himself as the man who stands between chaos and order in Russia. If he is convinced that he is the only one who can accomplish such an almost sacred task, then the limits to what he is willing to do will also fall far beyond the scope deemed realistic by Western politicians.
• The parallels with the First World War are troubling. At the time, it was Austria-Hungary — the weaker partner — rather than Germany that put the disastrous cat among the pigeons; the action could be viewed as a last-ditch desperate act to save the crumbling empire. This time around, it is once again the underlying party in the alliance of, in this case, China and Russia, that declares war. What happened over a century ago shows that desperate times call for desperate measures. Putin could reason that “a war of choice has become a war of necessity.” 

• Following on from this, the risk of miscalculations remains. As Tom McTague described it in The Atlantic: “The danger is that escalating Western support for Ukraine — fueled by Putin’s barbarism, Ukrainian success, and Western optimism — will combine with the regime’s growing weakness to create the conditions for miscalculation born of desperation.”

If negotiations go awry and the conflict escalates further, we can expect strong movements in the financial markets, as the damage so far has been relatively minor (not for the Ukrainian and Russian markets, needless to say) and there is still scope for pricing in more negative developments. In a scenario in which Putin continues to bomb cities, sanctions are expanded and supply lines continue to be disrupted, the next movements are obvious:

• EUR/USD would resume its movement towards parity;

• The markets will start pricing with more caution on the part of the European Central Bank;

• The spread between German 10-year interest rates and those of Eurozone countries labeled weaker will increase; 

• European shares will continue to underperform;

• Gold could far exceed $2,000; and

• The oil price will probably break through $130 a barrel again.

As mentioned, I see the crisis gradually shifting towards a frozen conflict. Once certainty about this scenario increases in the markets, we will see roughly inverse movements to those outlined above. However, this does not mean that it will all be peace and calm again for the financial markets. In the medium to long term, the stability in the markets is unlikely to return any time soon.

Andy Langenkamp is a senior political analyst at ECR Research which offers independent research on asset allocation, global financial markets, politics and FX & interest rates.