Risk Commentary
Shock and Awe; Fear and Loathing
Shock and Awe
While Ukraine has made significant gains over the past couple of months, Putin has the ability and the motivation to reverse the Ukrainian gains and achieve a good portion of his objective. Lobbing a nuclear weapon into Kiev would suffice and would probably qualify for Colin Powell’s “Shock and Awe” suggestion for winning wars. However, such an action would attach to Putin a permanent label of a rogue world leader, and for many placing him in the same category as Hitler, Stalin, and Saddam Hussein. Furthermore, there is the risk that NATO responds in kind or the Ukraine special forces exact retribution via the release of a dirty bomb in Red Square, poisoning water supplies or a variety of other unsavory actions. Alternatively, there is the option that Putin unleashes a limited or “tactical” nuclear bomb. While this is possible, the effect might not reach the level of “shock and awe” and might contaminate Russian soil in the process. None of these outcomes are particularly satisfying to Putin, but neither is the current state of affairs, which brings us to our next major thought.
Fear and Loathing
In the words of Machiavelli, it is more important that a leader be feared (and perhaps loathed) than to be loved. It appears that Putin and most of his predecessors have followed this approach with the result that the strong man obtains and retains power. The issue for Putin is how to recover from a failing situation. Weighing in his mind is probably the fate of prior Russian leaders who paid a heavy price for a failing war. Czar Nicholas lost power (and his life) as a result of failures during World War I and Gorbachev lost power after Russia’s failure in Afghanistan. With the mobilization of 300K soldiers, it is hard to characterize the war as a minor skirmish especially given the current level of casualties, which are estimated near 45,0001.
Exit Ramp
The trick for Putin and his advisors is how to either turn around the failures in Ukraine or exit gracefully. Our view is the most likely course is that Russia will wait to see how the additional troops fare and hope for some kind of stalemate. From the all-important logistics perspective, areas in the South look increasingly vulnerable because of restricted supply lines, but the East (Donbas) should be manageable. The partial destruction of the Kerch bridge linking Russia and the Crimea will pressure logistics and might make Russia’s holding the Crimea untenable. (The additional troops might further complicate matters as more troops require more logistical support.)
Once each side is exhausted (or there is a clear winner) negotiations will commence whereby Russia is likely to receive some concessions in exchange for other consideration. For example, perhaps Russia is able to keep a port in Crimea, but supply Ukraine with long-term natural gas. This all seems palatable, but the more immediate challenge is likely to hit with the arrival of the colder weather.
The EU Freeze
Dealing with restricted natural gas is manageable when ambient temperatures are above freezing. However, come mid to late January, the EU might be in a painful state. The cost of natural gas is a concern, but perhaps more distressing is the availability. Modern economies are simply not used to suffering without heat, which is likely to occur in some areas. The below graphs are sobering:
Figure I: Gas Prices in Northwest Europe (EUR/MW-hr)
Figure II: Prices for Natural Gas by Region (USD/millions of BTUs)
Sovereign Debt
It is unusual for a government to reverse a core policy, especially when the government is fairly new and trying to establish credibility. Well, that is exactly what the UK’s Truss government did this year with the cutting of top marginal tax rates, and within days, reversing that cut. The concern is that the UK is not serious about cutting government debt. Truss was emulating Margaret Thatcher and Ronald Reagan with the cuts, but apparently the greater concern was the loss of tax revenue. Time will tell whether Truss is successful, but it is hard to view the recent action as credibility enhancing. Alternatively, many might conclude anything was better than the prior administration.
Energy Battles
The Biden administration was handed a set-back with the decision of OPEC to cut daily petroleum production by 2 million barrels per day as of November. The current administration was hoping for increased production to ease global concerns and to reduce the coffers of Russia. Unfortunate for the current administration is the fact that the cuts come on the heels of the midterms, with the likely outcome being some additional pressure on the incumbents. The core problem appears to be the administration’s attempt to distance itself from MBS [Mohammed bin Salman] who has been accused of supporting the killing of a dissident. Our expectation is that there is little that can be done to materially change the outcome of the midterm elections.
Swiss-mis
Switzerland appears to be a country made for banking, with its unassailable geography, favorable regulatory environment, proximity to major wealth centers, and history of market acceptance. However, as can be seen in the below chart, Credit Suisse (“CS”) was trading at merely 20% of book value (see the below chart from macrotrends.net). From an economic perspective, this is shocking; it suggests that CS is not even worth the shareholders’ equity on its balance sheet, let alone a premium for future earnings. Obviously, the market believes the book value is inflated (estimates are several billion will need to be written off from Archegos Capital Management) and that there are little future earnings expected. Meanwhile, CS is looking to spin-off its investment banking arm. Our view is that the market is evolving and that even august institutions such as CS need to be cognizant that they can offer something that is valued by the market and where they have a competitive advantage.
Figure III: 5-year Stock Price, Book Value per Share and Price to Book Ratio
Tempering Monetary Actions
The FED has increased funds rates by 75 basis points three times this year. However, a 225-basis point rise (i.e., 75 bps times three) translates into a $695B2 increase in interest expense (although there is not a direct correlation) which is close to the $704B spent on the military3. Hence, the FED is likely to temper additional rate increases.
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[1] https://www.npr.org/2022/08/24/1119202240/ukraine-russia-war-by-numbers
[2] https://www.pgpf.org/national-debt
[3] https://executivegov.com/articles/u-s-defense-budget-2022-how-much-does-the-united-states-spend-on-its-defense-budget#:~:text=According%20to%20the%2061st%20NDAA,budget%20in%20terms%20of%20percentage.
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