Ukraine has been devasted, but its people fight on; Russia has failed so far, but the world still dances to its tune. How can one make sense of a seemingly senseless war? Alastair Irvine takes stock of the geopolitical, economic and investment consequences one year on. 

Introduction 

“You take your time making your decisions: a week; a month, six months. In the meantime, we’ll just carry on dying”.

 

In as many words, so said a calm and impressively quiet President Zelensky to the gathered NATO leadership playing Panzer Poker, as much between themselves as with Putin, at the US airbase at Ramstein in Germany a few days ago. In the debate whether to donate heavy armour, and whose, to Zelensky’s war effort his eloquence spoke volumes; that it needed saying at all reveals all the tensions simmering below the surface.

 

A year ago, I published an extensive analysis, “Anatomy of a Crisis: Russia, Ukraine and the West” about how in 2022 it was possible to be on the brink of Russia invading Ukraine, a sovereign nation with western security assurances, and provoking the biggest military conflict in Europe since the end of the Second World War. Today, as we approach the invasion’s first anniversary, amid a proxy war between NATO and Russia with all its global geopolitical, economic and investment consequences, it is an appropriate time to take stock.  

February 2023: still fully engaged militarily. Not Putin’s plan at all  

Alongside their assault kit and weapons, Russian airborne forces flying into Ukraine on the morning of 24 February 2022 had their full ceremonial uniforms packed in their bergens, ready for the expected early victory parade in Kiev. Putin, his generals and his intelligence experts expected the Ukrainians to fold, not fight.

 

But this was no Blitzkrieg. A lack of strategic planning; an underestimation of the Ukrainian ability to react, reorganise and Zelensky’s determined, grim will to resist after the initial shock; what proved to be fatally flawed Russian operational tactics under remarkably amateurish leadership showing up the poor quality of Russia’s regular forces; early preparatory military support to Ukraine in terms of hardware and training principally from the US and the UK; these combined to deny Putin the quick and easy win he expected. It re-defined and contained the Kremlin’s strategic possibilities. The early failure to take key cities including Kyiv, Kharkiv, Lviv and others, and to neutralise the government including the plan to assassinate Zelensky, effectively determined that the conflict would be one that was enduring, grinding and attritional rather than conclusive. The invasion itself was zero surprise to the Ukrainians: they knew without any doubt it was coming; it was only a question of precisely when, where and how the various anticipated air, land and possibly amphibious thrusts from the Black Sea would be executed by Putin’s forces; their own very effective secret service, and their military intelligence both within and outside Ukraine, were being actively supported by intelligence gathered and passed on by NATO, all helping Zelensky’s’ preparation to blunt the onslaught.

 

Putin’s limited territorial gains have been confined mainly to the south-east of Ukraine and a long distance from the border with NATO countries. It has been a significant success for Zelensky that he has been able to prevent Putin going west and closing off the border with NATO member states. All the arms and ammunition Zelensky has been receiving from the West have been transported across the porous frontiers with Ukraine principally through Poland and Romania; it is also where over a period of more than six months, tens of thousands of Ukrainian military conscripts have been exfiltrated as if on a conveyor belt on their way to NATO rapid basic training camps (as reported in the press, more than ten thousand have been trained in the UK alone) before being infiltrated back to their homeland to go and fight.

 

The progress of the war itself is well documented, to which we have little to add. But the questions we are most often asked are two-fold: first, where do we go from here; and second, how does this end? We have no crystal ball (as former Chief of the UK Defence Staff, Gen Sir Nick Carter said, unless you can get inside Putin’s head, what is completely irrational to us may be quite rational to him from his own perspective and proceedings take an unexpected turn, viz the invasion itself which most intelligence agencies in the West knew could happen but their governments and others concluded would not, or could be averted) but with that caveat, hopefully what follows gives food for thought. 

Diverging war aims. What do NATO members want?  

In “Anatomy of a Crisis” one of the key factors we identified as giving Putin the confidence to embark on his ‘special operation’ was the obvious disunity within NATO. The clearest manifestation was the complete collapse in international cooperation in Afghanistan and the ignominious flight from Kabul in August 2021. In a political attempt to break the US defence hegemon, but more importantly to exert its independence as a globally recognised power, the EU also had publicly aired deluded ideas about its own unilateral defence strategy on the European continent. If the alliance was under significant self-inflicted stress before, at least Putin’s invasion has reminded NATO’s membership of why it exists; the result has been a general reconvening of minds and some restoration of purpose behind the coalition. However, while the alliance might rail against the injustice of Putin’s actions and most NATO members are providing war support to Ukraine, whether directly with military hardware, training and intelligence or indirectly with financial assistance to a country whose economy has just taken a 30% hit, significant divisions remain about what the desired conclusion should be.  

US and UK in broad alignment

The US wants Putin defeated or at least his war effort degraded (in the American military lexicon, “attrited”) to the extent he is never able to do the same to any other country as he has done to Ukraine. The UK shares that broad aim but more specifically wants all Russian forces militarily expelled from Ukraine. Explicitly neither is prepared to fight directly with Russia to achieve it (hence the jibe, “NATO will fight to the last Ukrainian”). But both governments concede that in trying to re-reset the clock and evicting the Russians, however desirable total expulsion might be, Ukraine’s pre-2022 invasion border is the most realistic, recognising pragmatically that the Crimea will most probably remain Russian.  

Germany, France and Italy too with each other but not with the Anglo-Americans  

Germany, France and Italy still prefer a political solution with Putin: in their view, outright defeat will be counterproductive, he should be allowed to “off-ramp” (i.e. be allowed a face-saving path out). A unilateral Russian withdrawal followed by a negotiated settlement involving the partition of Ukraine and non-aggression security guarantees to Russia from NATO would in their view pave the way towards restoring peace in Europe. They see it reopening the possibility of a more harmonious and constructive relationship with Moscow, no doubt with re-establishing future energy supplies and revitalising Germany and Italy’s chemicals, capital goods and car exports to Russia in mind. Essentially, this is the same position France and Germany took when negotiating the ineffective Minsk agreements in 2015/16 in the aftermath of the 2014 Crimean annexation and to try and end the civil war in the Donbas, a position which completely ignored the wishes of Ukraine.  

Front-line hard-core opposition  

The Baltic States, Poland, the Czech Republic, Slovakia, Romania and Moldova, all sharing a border with or in close proximity to either Russia or its puppet satellite Belarus or with Ukraine want Russia put in a position where it can never threaten their own sovereignty in future; they are not only aligned with the US and the UK but are inimical to the Franco-German stance. Hungary remains close to Moscow and in the autumn, 100% reliant on Russian gas, signed a new supply agreement with the Kremlin. But the others remain hawkish with no compromises. Finland (it has an 830-mile border with Russia) who alongside Sweden is a prospective NATO member (though the membership of both, particularly that of Sweden, is still being blocked by Turkey over a dispute about Kurdish rights) and both countries having for years been officially neutral, is increasingly of the same mind.  

Ukraine crystal clear: Ukraine 1, Russia 0  

Ukraine itself is utterly unequivocal: it wants all Russian troops expelled unconditionally from all Ukrainian territory including the Crimea, and the more Russians who are killed in the process, the fewer there are left to have a possible third go at appropriating Ukrainian territory in the foreseeable future. Like the Russians, the Ukrainians have no interest in gentlemanly warfare: this is an existential conflict for Ukraine with no quarter given. It is kill or be killed. To be clear, Ukraine is fighting not merely for survival but to win, to repeat, unconditionally.   

Reading the tea leaves: curious observers and other interested parties 

What dogs the alliance is how to square this circle of polarised, competing and muddled aims. Further, as was only too visible at Ramstein, among a group of 30 democratic leaders holding talks under the glare of the world’s press, any disagreements are significantly magnified and give the impression of washing one’s dirty laundry in public. From their own perspectives and in their own national interests, defence strategy analysts not only in Moscow, but also in Beijing, Pyongyang, Tehran, Taipei, Canberra and other capitals such as Tel Aviv and Riyadh are constantly picking over the bones of such forums to draw their own conclusions among the shifting sands of western thinking as to how NATO or the US might react to future conflicts, whether as an adversary or as an ally.   

The UN: a misnomer about which the less said the better  

If NATO has at least come together and is some way to finding its roots again, in this context the United Nations can be dispatched and summed up swiftly in two words: ‘useless’ and ‘irrelevant’. That Russia remains a full voting member of the five-nation Permanent Security Council alongside the US, the UK, France and China (collectively the Second World War Allied Powers) says it all.  

Crossing the invisible line: the fear of escalation  

This is a war by proxy. No dispassionate, rational commentator or policymaker in the West can possibly disagree with that statement. The question is (and it was the one most obviously and publicly preoccupying Germany’s Chancellor Olav Scholtz), where for Russia is the red line that says in supporting Ukraine in the way NATO has so far done, primarily with defensive systems (including the most modern and sophisticated), at what point is the line crossed towards offensive weapons which then propels the war into a direct confrontation between Russia and NATO states, effectively the harbinger of a semi-global shooting war involving much of the Northern Hemisphere? And in the event Russia declares such a conflict a reality, given the degradation of its conventional land forces and helicopter fleet in the past year (it is worth noting that its fixed wing air force remains largely intact and its navy almost entirely so despite losing its Black Sea flagship), realistically what can it do about it in response?

 

But it is this grey area between proxy support and direct confrontation which keeps returning to the NATO discussions. At Ramstein it was about a change of gear from supplying armoured personnel carriers to the delivery of aggressive main battle tanks; last March, it was about Poland, Romania and the Czechs wanting to supply Soviet era jet fighters to Kiev, comparable with Ukraine’s existing fleet, a course of action firmly rejected by Washington and London. President Zelensky’s “Wings for Freedom” tour to London, Paris and Brussels making a powerful case for combat aircraft to be provided has turbocharged the debate and seems sure to find support but will again test national levels of enthusiasm.  

Panzer panacea? Or charity shop armour  

Inevitably in a dynamic and confused conflict in which casualties and equipment losses are being incurred every day and neither side has any interest in publicising its own state-of-strength ledger, gaining an accurate picture of what has been lost to date is difficult. However, piecing respectable sources together it appears that Russia has lost in the region of 1000-1500 tanks (possibly half its entire operational fleet) while Ukraine has lost in the region of 400, a meaningful but lesser proportion of its own, all of them Soviet-era T-64 and T-72s.

 

With a shopping list of 300 replacements from NATO, what has been agreed is a total of around 130 being pledged to Ukraine. While certainly welcome from Zelensky’s point of view, even if not fully satisfied, the result presents him with a formidable logistical and maintenance challenge. His crews are familiar with armour but are at home with a fairly homogenous fleet of ex-Russian vehicles. They are entirely unfamiliar with the bewildering array of different western types about to be delivered each of which will require a uniquely tailored training construct: UK Challenger 2; Leopard 2 from the likes of Germany, Poland, Finland, Estonia and others; M1 Abrams from the US, all of them currently on the wrong side of the Atlantic; and shamed in to having to join in too, France is being pressured to sending Leclerc main battle tanks, a position so far unresolved.

 

Apart from having armour, tracks and guns, there the similarities end: they have no common parts or spares between models; they might all be armed with 120mm guns, but while most are smooth-bore barrels, the British Challenger’s is rifled, meaning different ammunition; coming from different armies, even the same models do not necessarily share the same radio communication nets meaning there is no assumption they can talk to each other; and finally, the Abrams has a unique and complex turbine propulsion system powered not by diesel or petrol, but by kerosene jet fuel. To keep them operational, each of these models is going to require its own bespoke supply chain, field servicing and maintenance organisations, massively expanding the complexity of the rear-element and front-line support systems, known as the B-Echelons.

 

Logistically, the same applies to a multitude of models of infantry armoured personnel carriers, again from a wide array of countries, all requiring their own individual maintenance packages.

 

The tanks have to be delivered, spares and ammunition constantly replenished; the crews have to be retrained, not only on their vehicles but also tactically about how best to use them in conjunction with infantry to maximum effect and to minimise losses; new support chains have to be put in place. The progress of the war so far shows that Zelensky’s troops are highly adaptable and innovative and this logistical conundrum will not be insuperable. But this is not simple, rapid plug-and-play warfare.  

Laying bare the operational challenges of warfare believed redundant 30 years ago  

As the military escalation develops, if putting main battle tanks in the Ukrainian front line and maintaining their operational effectiveness presents challenges, doing the same with sophisticated and immensely complex foreign aircraft would create a new dimension of difficulty.  

Western defence procurement 

While to a degree restocking Zelensky’s forces with effective and upgraded hitting power, what is revealed is that there no inexhaustible supply of sophisticated military hardware. In “Anatomy of a Crisis” we dissected the considerable shortcomings of military procurement, focusing in particular on the UK. But what the Ukrainian war has shone a light on is the extent to which the defence manufacturing industry in the West, including the US, is paradoxically structured to peace-time conditions. It is simply not geared up to immediate wartime exigencies or meeting the needs of a prolonged conflict, nor is it likely to be easily scalable.

 

Industrialised warfare was born in the First World War. After a few false starts thanks to the extent to which it was run down during the inter-war years of global disarmament until the advent of the Axis dictators shocked the system back to life again, it rapidly scaled new heights of mass production and sophistication in the Second World War in a period of immense and concentrated acceleration in the development of military technology.

 

Compare and contrast with today: in September 1944 at its peak production, in the UK the “Lancaster Group” of companies centred on A V Roe (Avro) and its affiliates and satellites was producing 280 4-engined heavy bombers of just that one type per month for the RAF; the first batch for a delivery of 620 Eurofighter Typhoon 2 jets took manufacturers in four countries exactly 10 years to complete from 1998, each aircraft’s full assembly being measured in weeks and months rather than days. With warships the lead-times are even longer: HMS Prince of Wales, the Royal Navy’s latest aircraft carrier (which has spent 6 of its 15 month operational life to date in dry dock under repair) took more than 10 years from her keel being laid to her being operational; her predecessor namesake, the 43,000 ton battleship of World War 2, was laid down in January 1937 and she was commissioned exactly four years later and was in battle with Bismarck in May 1941 (and in December 1941 alongside the old battle cruiser Repulse as part of Force Z, both ships were at the bottom of the sea off Malaya having been simultaneously sunk by Japanese torpedo bombers—PoW’s operational life was a mere 11 months). That same battleship was built at Birkenhead, together with other famous wartime ships including the 16inch-gun battleship HMS Rodney (survived the war) and the carrier HMS Ark Royal (sunk) at the Cammel Laird yard, now part of BAe Systems; as noted by Wikipedia that yard alone built nearly 200 ships in the 6 years of WW2, something the entire British ship building industry today is incapable of coming close to.

 

Why labour this point? Simply because today, we know that missile manufacturers such as Raytheon, Shorts, Thales and others supplying anti-tank and anti-aircraft systems to Ukraine are at absolutely full stretch to keep up with demand. Existing stocks have been plundered from governments’ national weapons stores and replacements are heading straight to the fighting front. Keeping Zelensky supplied has domestic consequences for those countries making the donations. Further, because weapon systems such as aircraft and ships are both sophisticated and exceedingly expensive (the unit cost of a Typhoon, €140m; the cost of a UK aircraft carrier, £3.5bn before aircraft; a new Challenger 3 main battle tank approaching £9m) and numbers are limited, a combination of the cost and the knowledge that they are difficult to replace has the potential to constrain how they will be deployed for fear of rapid and significant depletion. The tanks most countries are sending to Ukraine are a generation old (it was hotly debated that sending current models with the possibility of capture simply hands NATO’s design secrets on a platter to the Russians in a conflict in which NATO itself is not involved as a direct combatant) and from reserves (having been “mothballed” for future use in an emergency or available for cannibalisation for spares); however, were the conflict to escalate to direct confrontation, some countries might find that their armoured fighting endurance is curtailed because they have given a chunk of their reserves away and with limited ability to replace them. More acutely still, the same argument will apply to combat aircraft should NATO agree to send them. 

Defence debate. Kit: “the tank is dead! Long live the tank!” 

Putin’s armoured losses have been prodigious (so too the number of soldiers), the careless wastage a revelation to western defence analysts and military strategists. A combination of abysmal tactics and woeful leadership on the Russian side, and Ukraine’s highly competent use of the most modern hand-held anti-tank systems supplied by NATO together with cheap and very low-tech civilian drones adapted to military usage to good effect has accentuated an already polarised debate about the future of warfare, and therefore defence priorities and budgets.

 

Russia’s armoured strategy for dealing with NATO was predicated on mass-cavalry charges across the open ground of the Warsaw Gap/Polish Corridor. Whatever the losses, overwhelming numbers and sheer momentum would see it through to victory before the US had time to mobilise. Ukraine, in defence with limited resources, has played to its own strength. At the beginning of the campaign when the land was still waterlogged and boggy, Russian tanks were confined to metalled roads, nose-to-tail, able to be picked off from the flanks in the absence of effective close infantry support. Ukraine blunted the initial force of Putin’s blow and kept the Russians off-balance, drawing them in to pockets of close country and unfamiliar fighting conditions and the resulting significant losses. It was masterly reactive tactics by Zelensky (though he too has lost significant numbers).

 

Tank vulnerability, and that of expensive aircraft too to relatively cheap anti-aircraft missiles (the essential economics are a $30k hand-held missile fired by an ordinary infantryman with minimal instruction capable of destroying an aircraft worth tens of millions, and its very expensively trained pilot and crew) have given ammunition to those who believe that the reliance on costly, manned equipment is warfare of the past. The future is cyber, drones and unmanned vehicles including aircraft and ships. The other camp believes quite the opposite: Ukraine demonstrates that if one’s adversary is fully equipped with armour etc, it must be matched in numbers and effectiveness; further, machines cannot hold and consolidate territory, only boots on the ground can do that and they need support. Sitting in the middle of the debate, counting the beans and weighing up the affordability of both arguments, are national treasuries.

 

Front-line countries such as Poland are insuring against their worst fears being crystallised. Already with large conventional forces, the Poles are nearly doubling their defence spending including significantly increasing the size of their army. Germany, for so long a NATO laggard and serial delinquent, announced last March that it would commit an extra €100bn to defence (as its critics say, in reality to get it to where it should have been had it been meeting its 2% of GDP commitment all along); Berlin’s reticence since to follow through belies the initial sentiment, and Scholtz’s subsequent indolence and reluctance as he is blown about in the maelstrom of German domestic politics, trying to keep a fragile coalition of unlikely bedfellows together, suggests that words are easier than actions. Here in the UK, despite our being undoubtedly Zelensky’s most prominent supporter in NATO (certainly Boris was) and the first to commit to sending tanks to Ukraine, despite all the geopolitical strategic risks Rishi Sunak and Jeremy Hunt see no reason to change the basic stance that there is no more money for defence than was previously announced. Denounced by the Americans last week as no longer a Tier 1 army and barely Tier 2, the British Army’s numbers and equipment are still slated to be cut by more than 10% (the Defence Secretary, Ben Wallace, is mounting a late rear-guard action ahead of the budget, to what effect remains to be seen), and defence spending on conventional forces and their fighting capacity is still on the path to a real-terms decline however much smoke-and-mirrors accounting using pensions, military accommodation and other costs is cooked up to give the illusion otherwise. 

Defence debate. Strategy: “Go east, young man! Or west”

At the strategic level there are fresh questions too. For years, the US had been de-emphasising Europe as a defence priority in favour of looking after its Pacific interests. Post Brexit and before the invasion the strategic emphasis for the UK shifted eastwards too to focus on the Indo-Pacific region, the most obvious manifestation of which was the advent of the AUKUS defence treaty between America, Australia and Great Britain which immediately prompted a row over Australia’s procurement of nuclear-powered submarines as it switched contractors from French to British and American yards. Much will depend on the outcome of the Russo-Ukrainian conflict as to how future inter-related foreign and defence policies develop in a very dynamic world of both opportunities and threats, particularly as almost every country continues down the seemingly inexorable and simultaneously followed path towards carbon net-zero by 2050 and the intense global competition for scarce resources: commodities, materials, labour and capital.  

Economic measures and countermeasures  

If the military conflict is confined largely within the borders of Ukraine (though next on Zelensky’s shopping list alongside fast jets—like a hungry Oliver Twist he’s relentless asking for more—are long-range missiles capable of striking targets up to 200km inside Russia), the economic consequences are not just regional but global. We have discussed these often in the series of regular Merlin macro updates and they can be dealt with here quite shortly.  

Gas: Europe will make it through the winter  

Having now either closed or destroyed the principal pipelines from the Russian gas fields to western Europe, and with Europe having benefited from an unusually mild winter and been able to preserve gas reserves (73% full compared with 54% for the 10-year average at the end of January; European wholesale prices are currently €58/MWh as against €340/MWh on August 26th 2022 and €81/MWh on 1st February last year before the invasion), Putin has surely shot what must have been his last bolt to bring the European economy to its knees. That is not to say he has not caused significant disruption, including directly contributing to the fall of the Italian government last summer. His has been a strongly malign influence over inflation, particularly coming on top of the inflationary pressures already becoming apparent in the wake of the pandemic and before Moscow began weaponizing global gas prices in August of 2021. But amid all the discomfort caused to western governments and the preoccupation with the political and economic fallout of the cost-of-living crisis, Europe has begun slowly to adapt to weaning itself off Russian gas: in Poland, through a new pipeline from Norway; elsewhere, but particularly Germany and Italy, through supplies of LNG supplied by ship from the US, Qatar and Libya, conferring on each provider a new level of direct geopolitical leverage and influence through their control of deliveries which they did not have before.  

Sanctions: a study in strategic and political failure  

But for all that, the sanctions regime applied by the western democracies has been an abject failure. Joe Biden and Boris declared at the outset that the escalating programme of economic sanctions would be “devastating” to Russia. They were designed at first to make Putin think twice about invading; no dice there. Then they were successively ramped up during 2022, encompassing capital markets and banking, gas, oil, fertiliser, shipping, cargo insurance on all manner of exports, the personal assets of the oligarchs frozen overseas, all with the intention of isolating Russia economically thereby draining Putin’s coffers and starving his war machine, turning domestic political opinion against him and forcing him to abandon his folly. All so far to zero effect, except to have been a significant factor behind global inflation rates not having been seen at such levels in two generations and driving many economies towards the brink of recession.

 

It is on this latter score that western governments have failed to make the political case with their electorates that the necessity of their enduring higher domestic prices is a modest cost compared with what the Ukrainians are suffering, and in order to see Russia defeated. However, it is here that the failure to win the argument with the doubters and those inclined to support Russia in the UN to throw an impermeable sanctions wall around Russia shows the weakness of sanctions as a strategy.

 

Thanks to lower imports and the way global commodity prices were squeezed up last year and the extent to which Russia found alternative customers who had not signed up to the sanctions regime (notably China and India but not only them), data just published by the Bank of Russia shows that in the year to December 2022, Russia achieved a cumulative balance of payments surplus of $227.4bn, nearly double that of 2021. The cash is still rolling in. The World Gold Council records that Russia’s official gold reserves were entirely preserved during 2022, maintained at 2,300 tonnes or 73.9 million ounces at the year-end, worth $142bn at today’s price. Putin was well prepared: that gold tonnage was strategically increased nearly three-fold to current levels between 2012 ahead of the 2014 annexation of Crimea, and 2020 as he planned his full invasion. The Russian central bank expects to record economic contraction of around 3.5% last year, well short of the double digit hit Russia was anticipated to take by defence analysts to experience when sanctions were being implemented.

 

Oil and gas prices have since retreated from their peaks, so the picture might be different this year. But there are still no signs yet that the porous sanctions wall has been plugged to the extent that sanctions are going to force a change of behaviour in the Kremlin. If Putin has shot his last bolt in Europe with gas, equally it is not obvious to see what sanctions tools the west has left in its locker that will bring Putin to heel.  

Disintermediating the US: breaking the petrodollar  

Finally in this section, we have discussed over the years the effect that oil, a universally consumed, globally traded commodity settled in dollars, has on economics: the petrodollar confers significant power to the US through the US dollar being the world’s dominant reserve currency. Breaking the petrodollar hegemon potentially liberates the market and weakens the gravitational pull of the US. For approaching a decade, China, Russia and Saudi Arabia have been colluding over how to create an alternative settlement system based on gold (China as the world’s biggest oil importer, Russia and Saudi the two biggest exporters). Saudi is a crucial player: traditionally a cornerstone ally of the West, successive US Democrat administrations ‘disrespecting’ it, as Saudi sees it, have shifted sentiment in Riyadh such that when Biden asked Saudi last year to open the taps to help bring prices back under control, the answer was a flat ‘no’. It would appear that however glacial, and by whatever means, that determination to disintermediate the dollar is enduring.  

How might this end? 

Last August, Andrew Bailey, Governor of the Bank of England, expressed the sentiment that when the “war in Ukraine is over” and we all get back to “normal”, he expects UK base rates to go back to “rock bottom”. Which begs the question: what is “normal”?

 

So where next? That answer must be seen in the context of Putin’s original casus belli in Ukraine. It can be distilled into its essentials:

 

  • he believes it belongs to Russia, and always has (he considers Ukraine no more than an artificial construct of the European Union);
  • Russia feels militarily threatened by NATO on its doorstep: Ukraine was pitching for membership, a direct provocation in his view;
  • he rejects ‘western values’ and refuses to allow their osmotic permeation from the West to pollute Russian public thinking and to undermine his system of institutionalised corruption and patronage (the kleptocracy), the bedrock of his political power: Ukraine’s potential accession to the EU was a direct threat by the back door;
  • he resents Russia’s loss of global influence and being written off (as he was explicitly by Obama) as merely a ‘regional power’.

 

It is a powerful, conflicting and toxic brew of aggression, hubris, defensiveness and paranoia.  

No going back to 2014

First and easiest is quickly to describe what will almost certainly not happen: everyone downs tools and we all go back to rose-tinted happy families pre-2014. There is no re-set button. Nobody can pretend the last decade has simply not happened in Russia and Ukraine. The consequences are irreversible.  

What is defeat? What is victory? Or are we here for the long haul?  

We described above what the UK and the US want in terms of conflict resolution. The word “defeat” is used. But what does it mean? It is not necessarily an absolute. Putin can be militarily defeated in Ukraine but Russia remains an active or latent menace, the second most powerful nuclear state on the planet. NATO has no intention of confronting Putin head on (unless Putin attacks a NATO state and Article 5 is invoked, or he uses nuclear weapons in Ukraine which would remove any of the grey, obfuscating language in the 1994 Budapest Memorandum behind which Britain and America have twice avoided their obligations to guarantee Ukraine’s sovereignty; both would be bound to respond directly). Unless there is some Machiavellian plan to keep luring more and more Russian forces into Ukraine and to let the Ukrainians finish NATO’s job destroying them until there are none left, we must assume that defeat is seen in terms of expulsion from Ukraine.

 

Were Putin ‘defeated’ in such a way, the received wisdom assumes his political days are numbered. As he isolates himself from external contact, western intelligence is finding it increasingly difficult to gain access to reliable and close Kremlin sources to establish how strong or precarious Putin’s political position is. His demise is not a foregone conclusion.

 

But were he to be deposed, there is good reason to suspect that in the game of unintended consequences, what follows him might be just as bad, if not worse. It is becoming appreciated that whatever the public feelings in Russia (and to the extent they are credible, the polls suggest the majority of Russians, especially older ones, still fully back Putin’s actions), it is the hardliners in the Kremlin and the military who are telling Putin he is not being aggressive enough. Internally, they are his biggest threat, not for his being too strong but for being too easy, and the ones who could put paid to western hopes that when the shooting stops, harmonious relations can be restored.

 

If Putin cannot afford to lose, it goes without saying that nor can Ukraine without being at best partitioned or at worst completely subjugated. Nor can NATO afford to allow Russia to prevail without the alliance losing significant face (would that rank as a defeat for NATO? Russian propagandists would undoubtedly claim as much) which could easily then encourage unwanted courses of action from China against Taiwan, North Korea against the South, and Iran as a malign influence across the Middle East and Arabia.

 

In the event Ukraine is lost, there will be immediate pressure from NATO’s eastern flank countries, including Finland, for significant militarisation to ensure none of them is next on Russia’s imperial reclamation list. The domestic political consequences for western European, British and American NATO leaders in such a situation would be challenging, to say the least, met with the likelihood of an outbreak of nationalism in the East potentially creating febrile conditions particularly for the EU.

 

With neither side able or willing to back down, the most likely outcome in the foreseeable future therefore is a long, grinding relentless conflict, one most likely to begin again in earnest in the Spring with a renewed offensive to attempt to extend Russian-held territory westwards along the southern corridor, taking in Odessa, all the way to the Moldovan border and cutting Ukraine off from the Black Sea. So long as both sides have the means to continue waging war, Ukraine backed by NATO with all its differences of opinion, and Putin managing by hook or by crook to keep generating sufficient revenues to keep funding his war machine, it will persist, potentially for years. It is possible either side is unable to continue: the biggest risk for Zelensky is that the western nations succumb to war fatigue, they become bored with constantly being harangued for more and better support and they balk at the financial cost (e.g. the Republicans in the US maintain that there must be no blank cheque for Ukraine; in the UK while remaining a public supporter, Rishi Sunak recently ordered an “audit of the war”, essentially a cost/benefit analysis of resources spent to what effect); for Putin, it is that internally he runs out of political rope and is forced into a climb-down.

 

If Ukraine wins, what then? It has already been approved as a potential accession country to the EU. However, there are divisions between EU capitals as to whether Ukraine should be given fast-track status. One camp says, if we’re happy to supply it with weapons and cash, we should be equally happy to embrace it as a member state. The other insists, with ample evidence, that however well Zelensky is doing mounting a military defence, Ukraine nevertheless remains a country mired in corruption; even amid a war and the suffering, Ukrainian oligarchs and unscrupulous politicians are still habitually on the take, getting fat and amassing fortunes out of war payments. There is also the cost of rebuilding Ukraine, running to billions of euros and dollars; who will underwrite that in a 21st Century Marshall Plan? The US? The EU? NATO? The UN? The World Bank? The IMF? Russia? What would be the consequences of bankrupting Russia in the process, when the punitive consequences foisted upon a defeated Germany in 1918 became so obvious less than two decades later? What strings would be attached, particularly by Brussels and how palatable would they be to Ukraine?

 

As for NATO, only in January Zelensky was told that the likelihood of his country being given membership remains vanishingly small.  

The realistic possibility of escalation. What might it look like? 

As for NATO crossing that invisible red line and provoking a Russian retaliation? There is certainly the possibility of escalation. Significantly weakened by Ukraine, Putin knows that his conventional forces would lose in a shooting war with NATO. He has regularly threatened the nuclear option; ‘nuclear’ ranges from tactical (i.e., relatively local but nevertheless devastating for those in proximity), along the exponential spectrum to full intercontinental strategic Armageddon: Mutually Assured Destruction. That ball is his to serve, but again NATO has the stronger deterrent hand.

 

For years Russia has been deploying subversive warfare through the FSB (the successor to the KGB) and its military dirty tricks wing, the GRU: cyber-attacks; interfering in electoral processes; targeted assassinations; facilitating migrant trafficking; the organised duping, bribing and blackmailing of officials in positions of influence in western capitals. Much more likely than resorting to crude nuclear or weapons of mass destruction would be an all-out explosion of asymmetric warfare being prosecuted by Russia against the West: simultaneous cyber-attacks on political, government, corporate and social systems; attacks on infrastructure control systems and all forms of communications; all designed to paralyse western governments and their governance and to provoke political instability and civilian unrest. Russia’s ability to pinpoint and obliterate a specifically targeted redundant satellite in space last year came as a surprise to most intelligence agencies (and all that data we fondly think of being stored on a cloud? Not a bit of it! It is all on terrestrial servers in remote airconditioned malls, many in the US; 80% of all UK internet traffic goes via the US through a sub-sea cable across the Atlantic: imagine it being severed!). Thinking the unthinkable (but then the war in Ukraine itself was regarded as unthinkable not so very long ago!), given asymmetric warfare is highly technical, secretive, subversive and behind the scenes, would Russia pursue it together with another interested and malign, under-the-radar party? The possibility cannot be discounted.  

The broader picture: the “what if” game and looking at other interested parties  

China

Even if not in the sense above, China is an interested party. It suits China to have Russia as an ally given the extent to which the West sees both as a strategic threat. Also, as was seen at Davos a couple of weeks ago, being calculatedly cynical and manipulative, having a dangerous loose cannon like Putin on the rampage can allow the conservative Chinese to present themselves to the world as rational and reasonable and open to constructive relations. China is a big importer of energy, particularly oil and gas: mopping up Russia’s surplus oil, even at significantly discounted prices, Moscow and Beijing are in a mutually beneficial relationship.

 

But the Chinese also know perfectly well that in the event Russia were to implode, it presents both immediate threats and opportunities. A Russian political collapse would not only create a vacuum domestically but would almost certainly also precipitate a level of instability spanning two continents taking in the former Soviet countries with whom Russia has a border or remains friendly, including and not confined to Georgia, Chechnya, Turkmenistan, Uzbekistan, Tajikistan and Kazakhstan. Many of these are on the path of China’s One Belt One Road project (the “New Silk Road”). Anecdotally, in the same way that Donald Trump expressed an interest in buying Greenland from Denmark, China has an opportunistic eye on Siberia, not only for its immense wealth in untapped natural resources, but also as the significant northern land mass in the Arctic Circle which becomes strategically uber-important as the ice caps melt and all-year maritime navigation over the Pole becomes possible, significantly shortening the Atlantic-Pacific trade route (on which basis the 30-mile Bering Strait separating Russia and Alaska (the USA) will join the Panama Canal, the Straits of Gibraltar, the Suez Canal, the Bab-al-Mandab Strait at the base of the Red Sea, the Straits of Hormuz in the Gulf and the Straits of Malacca as one of the major global maritime choke-points).

 

If the Russian menace has already crystallised, the West is still struggling to determine how the strategic threat posed by China will reveal itself. For another time to explore in greater depth but still needing noting here because of General Secretary Xi’s declaration of a New World Order (i.e. with China at the top), and his explicit aim of recovering Taiwan, even after the disruption of the pandemic the West is indecisive whether to approach China as a country with which to do business. Or whether ranking alongside Russia, North Korea and Iran as a pariah, should it be ostracised? We in the UK veer towards the latter view. Biden failed at the G7 following the pandemic to lead a likeminded consensus. Learning nothing from Angela Merkel’s similar dealings with Putin, her successor as German Chancellor, Olav Scholtz, endearingly believes that through constructive dialogue and trade, China can be persuaded of the benefits of ‘western values’ and steered down an alternative more amenable path. He is completely deluded. History may yet repeat itself.  

Iran

Iran cannot be ignored. A long-time ally of Russia in the Middle East, Tehran is now openly selling kamikaze drones to Moscow, the ones provenly involved in the bombardment of civilian targets in Ukraine. Iran is close to being a nuclear-armed state and all attempts by the US, the UK and the EU to deter Iran’s nuclear programme have embarrassingly failed. Iran also enjoys close mutually beneficial links with China. Iran is an enduringly and predictably malign influence at the confluence of the immensely sensitive region joining Europe with Asia and Arabia.  

North Korea

Finishing with North Korea to complete the picture: as one well-placed defence source described Kim Jong Un, “a nutter”, the type who gives you sleepless nights. Unpredictable, almost impossible for western intelligence agencies to assess in any concrete way, he keeps surprising everyone with his missile technology development: nuclear, ballistic, cruise, tactical, hypersonic; he is not supposed to have any of them and yet demonstrably has all of them and to an increasing degree of capability. Not only South Korea but all of Japan and now the western US seaboard are within his range. Hopefully, he will not find the urge to play with his toys in anger; he is the one least likely to provide any warnings when they fly out of the pram.  

The investment perspective  

I make no apology for this being a long analysis: it is a complex, multi-layered subject with many unknowns. Investors always try and bring things back to what they can see and reasonably predict, which naturally lends itself to the short-term horizon. They feel uncomfortable with factors to which they find difficulty relating or quantifying and upon which to place a value. Central bankers are dealing with great complexities but ultimately have tidy, organised minds; economists have a penchant for neat, orderly spreadsheets and prefer the immutability of economic laws. However, as I discussed a year ago in “Anatomy of a Crisis” in relation to Ukraine, what has subsequently caused profound upset to all risk markets and is still having a marked consequential effect today, had a long, slow-burning geopolitical fuse of three decades’ duration where the fizzling flash suddenly went to bang. Literally.

 

Geopolitics are usually contextual to investors: interesting but in the background. And yet for markets, the past three years have been completely dominated directly by two global exogenous shocks: a pandemic which nobody could reasonably foresee (a “Black Swan” event), and a major war in Europe with global consequences which was foreseeable but was completely ignored (a “Black Elephant”).

 

Arguably, after the hiatus last year in commodity markets and now as China frees itself from pandemic lockdown (with its own potential to upset the new rapid disinflation consensus), a continuing war in Ukraine as it exists today no longer has the ability to surprise or shock from an economic and investment standpoint in the way that it did when it began (from a moral and humanitarian stance it remains a horror, but markets see themselves as detached and rational which is assuredly not to say they are always right!); in game theory it is a “known known”. The future risks to sensitive commodity prices, exchange rates, interest rates, bond yields and equity prices come from the possibility of being assaulted by a significant change to the existing circumstances, i.e. another Black Swan or Black Elephant event.

 

To this author, against everything I have described and analysed above (and no matter how often bond experts explain it to me patiently as if to a four-year-old), there is one enduring conundrum: the yield curve. Leaving aside all the technical factors of short-term inflation, interest rate inflection points and whether the economy this year does or does not cross the line of recession, I fail to understand this: if on a two-year view you need a yield of 2.5% on a German government bond, why does a rational investor require a nominal return of even less, a mere 2.2%p.a. on a 30-year bond (and a year ago, that yield was negative implying the risk of a default being less than zero); or even 3.6% in the US on a 30 year view (where the 10-year Treasury yield of 3.5% is the proxy for the global risk-free rate, the rate of return investors require on a completely riskless investment)? The act of ‘steepening’ the yield curve almost invariably is driven at the short-end by reducing near-term yields, seldom further out along the time horizon by significantly increasing the term premium.

 

We are embarking on the race to carbon-net zero in 2050 with all its inherent geopolitical tensions as we compete for natural resources, labour and capital and jockey for competitive position economically. Do you know with that degree of certainty what will be the state of the world in 2053 and the intervening years? All I know with 100% certainty is that I will be either 91 or dead! Anything else is merely educated guesswork or pure conjecture. Very few in the markets forecast a war in 2022 in Europe which was in front of their noses; and if they did, the subsequent volatility says that even fewer did anything about it beforehand and even after the invasion they took some time to understand what was going on. In Germany in November, it was discovered that there were advanced plans for an armed coup in Berlin to overthrow the Bundestag. QED.

 

As Galbraith said, “forecasters divide in to two types: those who don’t know and those who don’t know they don’t know”. We hope we fall into the former group. We do not have all the answers but what we have attempted to do here is outline some of the potential outcomes arising from the current conflict so that were there to be a change of circumstances arising from a geopolitical development, at least pointing to some of the possibilities in advance allows time to think about how we, and you, might react were such an event to take place.  

The value of active minds – independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Fund specific risks

The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.  

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