10 Unintended Consequences Of A Protracted Russia/Ukraine War According To JPMorgan

On Wednesday, J.P. Morgan Strategic Research (these are the guys who actually have some good ideas, and are not propaganda broken records who only purpose is to get retail investors to buy whatever their prop traders have to sell) hosted a webinar featuring leading experts from the “think tank” community, who previously served in US and European policymaking positions, to discuss the possible scenarios that could play out from Russia’s invasion of Ukraine (replay link here).

Speakers concurred that the war could be protracted with the possibility of further sanctions, led by the US, although a ban on oil and gas exports from Russia is unlikely to materialize given Europe’s dependency. While not an imminent scenario, speakers did not rule out the possibility of the threat and potential use of tactical nuclear weapons. The speakers also discussed the efficacy of sanctions, the longer-term unintended consequences and the implications for US-China relations.

Below are the top ten takeaways by JPMorgan’s strategist from the webinar:

Top 10 takeaways on possible scenarios and unintended consequences from Russia’s invasion of Ukraine

1. Russia and Ukraine remain far apart on achieving a ceasefire based on Russia’s conditions. The speakers agree that the war could be protracted for several months or more, not weeks, with partitioning potentially necessary to end this “war of attrition.” For Russia, it is not a matter of whether Russia will continue in its attack but what price it is willing to pay to defeat this outside “existential threat.” Putin continues to portray the invasion of Ukraine as a domestic conflict, not a foreign war. The coordinated approach by the West against Russia has elevated the invasion of Ukraine to a proxy war with the West in Putin’s narrative to the Russian population, and he is “willing to wage a war to the last Ukrainian.” The Russian goals remain unchanged and include:

  • Recognition of Crimea as part of Russia and the “Donetsk and Luhansk People’s Republics” as independent entities.
  • Declaration of Ukrainian neutrality, although inclusion into NATO or NATO and the EU could be addressed later.
  • Demilitarization of Ukraine, but military assistance by third parties remains unclear.
  • “Denazification” of Ukraine which could be interpreted as a purge of the Ukraine political system of what Russia perceives as “far-right elements” that remain unfriendly to Russia.

A retreat for Russia would mean accepting defeat and threaten the core of Russia’s political regime, which has collapsed twice in the last 100 years. For Ukraine, it would be difficult politically to accept a peace agreement that would satisfy Russia. The “ugly” settlement, where no side gets what it wants, could involve neutrality of Ukraine with some form of security guarantees with the option of EU integration later. The precedent of the 1955 Austrian State Treaty was referenced as an example where the representatives of the Soviet Union, Great Britain, the US, and France governments signed a treaty that granted Austria independence. It also arranged for the withdrawal of all occupation forces, with the understanding that the newly independent state of Austria would declare its neutrality, creating a buffer zone between the East and the West. While Austria is an EU member, it has declared non-alignment with military alliances and is not a member of NATO. The idea of demilitarization is probably a non-starter as Ukraine needs to be able to defend itself. Russia will likely get recognition of its position on Crimea while some solution needs to be found regarding the two so-called republics.

2. Putin retains solid support with the military and domestic population despite the severity of financial sanctions and heavy military losses. A recent poll showed that 58% of Russians approve of the invasion of Ukraine and 23% opposed, but one speaker sees two-thirds of the population continuing to support Putin. The support from Russia’s military for Putin does not appear likely to falter over the near term despite heavy casualties as the anger is directed at the US and NATO. The severity of the sanctions are perceived by many Russians as “unjust interference” by the West, which has turned Russia into an outlaw and have negatively impacted every Russian citizen, from infants to the very elderly. The decision to freeze central bank assets and confiscate property without a court order is perceived as “uncivilized.” Beyond the economic war, the crackdown on protests and bans on independent media coverage have led to a rise of misinformation.

3. The coordinated western response to Russia’s invasion of Ukraine is perceived as an ‘existential threat’ by outside forces that could merit the tactical threat, if not the actual use, of nuclear weapons. One speaker believes there is little to no risk of Russia using chemical and biological weapons as chemical weapons provides no military advantage and biological use is too indiscriminate. However, interpretation of the Russian doctrine does permit the use of tactical nuclear weapons to address ‘existential threats.’ While not seen as imminent, there is scope for miscalculation in the communication that could lead to unwanted reactions and responses, including nuclear alerts. The long-term consequences could reverse decades of progress in stemming the proliferation of nuclear weapons as Russia’s arsenal of nuclear weapons may be seen as effective in acting as a deterrent for NATO to be drawn into war. Military planners in countries around the world are now likely to see this as a clear signal regarding the benefits of nuclear weapons.

4. The transatlantic relationship between the US and Europe has been strengthened and given rise to bipartisan centrist forces in both the US and Europe. Russia’s invasion of Ukraine has brought the West together. The unity of the US and Europe in addressing Russia’s invasion should not be underestimated, although there is recognition that Europe’s dependency on Russian oil and gas cannot be reduced rapidly. Beyond the transatlantic relationship, support for Ukraine has strengthened bipartisan centrist political forces in the US and Europe. The decision by Germany’s Green Party-led coalition government to increase Germany’s defense budget to 2.8% of GDP, well above the NATO commitment of 2% of GDP, points to the speed and magnitude of the political transformation underway in Europe. This is being mirrored to a degree in the US as the aggression against Ukraine has prompted the Biden administration and businesses to take action hat would not have been seen as possible a month ago and with bipartisan support. This includes the ban of US imports of Russian oil and the announcements by over 400 private sector companies to stop doing business in Russia. In addition, there has been $800mn of security and humanitarian aid sent to Ukraine including 800 anti-aircraft missiles, 9,000 anti-armor systems, 7,000 small arms and ammunition, and reportedly armed drones.

5. Further financial and individual sanctions forthcoming with the realization that Europe will need time to reduce its gas dependency of Russia. The decision by the US to ban Russian oil imports has occurred alongside the Treasury Department issuing updated guidance on authorizing transactions with Russian entities for energy supplies. While this may seem contradictory, the Biden administration made a clear commitment to European partners that in order to enact some of the stiffest sanctions the world has ever seen, it will also help ensure Europe will continue to have sufficient energy supply. The oil ban will not be applied globally and the US Congress is unlikely to push for harsher sanctions at this stage. A month into the war, there is recognition of the need to move more slowly on reducing Europe’s dependency on Russian gas and that the goal to eliminate imports is long-term in nature. However, deeper financial and individual sanctions are likely to be imposed. The White House announced today, March 24, more than 400 additional individual sanctions, which includes sanctions on 328 members of the Russian State Duma, a dozen Russian elites including the head of Russia’s Sberbank and 17 board members of Sovcombank, and 48 Russian defense companies. The US Treasury has also issued guidance on the restriction of gold transactions with the central bank of Russia.

6. Russian retaliatory measures to sanctions still a possibility. On March 23, as USDRUB remains at all-time highs, Putin has demanded that “unfriendly countries” use rubles to buy Russian oil and gas. While on March 21, the White House issued its strongest warning yet about a potential cyber-attack from Russia against targets in the US, indicating that businesses should harden cyber defenses in response to intelligence indicating “preparatory activity.” Speakers also warned of the risk that Russia might expand the conflict geographically to Poland and Romania, which are actively engaged and shipping weapons to Ukraine. Reports of a storm damage to the Caspian Pipeline Consortium (CPC) have led market participants to wonder whether it was a form of retaliation against Russia. The CPC—one of the world’s biggest oil pipelines which ships around 1.2 mbd crude from Kazakhstan to global markets—was reportedly damaged on Tuesday likely impacting 1 mbd, or roughly 80% of export volumes, for up to two months. The supply interruption comes on the eve of the NATO meeting on March 24, where EU members are expected to discuss imposing sanctions on Russian’s oil sector, raising fears that Moscow was prepared to retaliate against western sanctions by curbing its own energy supplies.

7. Mixed views on the effectiveness of sanctions on changing behavior with existing sanctions unlikely to be rescinded over the near term. The severity and coordinated approach to applying sanctions on Russia will be seen as a litmus test to the effectiveness of sanctions and whether the desired results will be realized. The longer-term unintended consequences include higher inflation, risks to food security, disrupted supply chains and de-globalization. There is little prospect for the existing sanctions to be reversed quickly and speakers noted that sanctions are much easier to introduce than remove as it is often difficult or impossible to build a consensus for rescinding a sanction, even when some progress has been achieved. As an example, the sanctions imposed in 2014-2015 due to the annexation of Crimea and the war in Donetsk and Luhansk remain in place since the Minsk agreement was never implemented. It is too early to say what would be required for the US and its international allies to be willing to rescind sanctions.

8. Mixed views on the implications for China, but US policy will focus on reducing dependency on China for its supply chain and critical infrastructure. There will likely be further fragmentation of supply chains and deglobalization as a result of the harsh sanctions imposed. One speaker predicts that the extraordinary degree of resolve from the West against Russia will likely coalesce into a unified approach in dealing with the rise of China in 5G and China’s growing profile within the European technology and energy sectors. There will likely be some compromise necessary to advance the recently passed House legislation, America COMPETES Act of 2022, aimed at increasing US competitiveness with China and boosting US semiconductor manufacturing versus the Senate version passed last June. Timing for debate remains uncertain, but the House will likely be forced to compromise given the number of additional provisions that were added which were not in the Senate bill. While there is House and Senate support for advancing the Creating Helpful Incentives to Produce Semiconductors (CHIPS) for America Act, which supports the US semiconductor manufacturing sector, there is less agreement on the foreign policy provisions to strengthen US export controls of capital and materials going into China. Another speaker believes that the US has reduced its focus on its pivot to Asia outlined during the Obama administration as it has been forced to shift attention to conflicts in the Middle East and now Europe. The conflict in Europe will be yet another challenge for the US in allocating resources to develop a comprehensive strategic response to China’s emergence in Asia.

9. Higher commodity prices to prevail. Our Commodities Strategy team’s baseline scenario now assumes that while Europe will, over time, limit energy imports from Russia, finding alternative sources immediately will be fraught with challenges. We believe that only European countries with 30% or below of import dependency will be able to diversify away from Russian oil, resulting in a 1 mbd of permanent loss. Trade flows may change with China and India likely to ramp up Russian crude imports. The 1 mbd drop in Russian export flows leads us to raise our 2022 Brent spot price forecast to $104/bbl, but in the short-term, prices can go as high as $120 to $130/bbl through April and May unless the EU decides to completely ban Russian volumes then prices could go as high as $185/bbl by December. Oil prices should finally dip below $100/bbl in 2023. Russian gas flows to Europe have increased since the invasion and Russian metals exports continue to flow. Agricultural trade flows however, remain disrupted despite reports of some grain shipments leaving Russia. While the Russian fertilizer export ban poses risks to global supplies and crop yields, China, India, Brazil and Pakistan are considered friendly countries and are likely to have access to Russian fertilizer exports to meet the needs of crops in upcoming seasons. While the world is short on commodities, China is not given they have started stockpiling commodities since 2019 and currently hold 80% of global copper inventories, 70% of corn, 51% of wheat, 46% of soybeans, 70% of crude oil, and over 20% of global aluminum inventories.

10. Lower global growth and higher inflation but policy support from China and higher prices for commodity- exporters provide select market opportunities in EM equities. Our near-term growth forecasts continue to move lower as we respond to the Russia-Ukraine war and the latest news on COVID-19, and we now project 1H22 global growth (2.3%ar) dipping below potential. We also raised our forecast for 1H22 global CPI annualized inflation to 7.1%, a multi-decade high, and a 3.2%-pts annualized upward revision to our 1H22 inflation forecast. We now forecast a 10.9% contraction in GDP growth for EMEA EM in 1H given the expected 24% contraction in Russian growth over the same period, while the CE4 countries will experience a 1.8% contraction in GDP growth. However, we remain bullish on EM equities since policy support in China, which is in direct contrast to Fed tightening, should be positive for the 35% of the EM benchmark that is China. There are also large EM markets such as Brazil, Saudi Arabia, South Africa, and Indonesia that are major commodity exporters and stand to benefit from commodity price spikes. We recently downgraded India equities to UW as a hedge to commodity risks, notably higher food prices. We are OW China, Brazil, Indonesia, Saudi Arabia and Thailand. We continue to believe in Value over Growth and EM equities are the cheapest part of the global equity universe. We are OW key value/commodity sectors in EM, specifically Energy and Materials. Saudi Arabia is now CEEMEA’s biggest stock market and the 6th biggest in EM but more than 60% of EM investors have not bought a single share despite the Saudi Arabia market continuing to outperform the benchmark. With the Russian stock market closed for nearly a month, Saudi Arabia, which trades about $2bn daily, is a good opportunity in EM to buy into higher oil prices.

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