The End of Putin
The war in Ukraine is an unbelievable tragedy. The Ukrainians are fighting our war, and need our support. A friend of mine is in Kiev right now, he works for the Ukrainian Central Bank. He’s woken up daily by sirens and the explosions of ballistic missiles. At the end of this post, I’ve added a link to donate. I’ve done so myself, maybe you find a moment to do so, too
Things evolve rapidly. When I sent a post around this time last week, media outlets such as Bloomberg ran headlines such as “Kiev to fall within hours”. I highlighted the chance that amidst brave Ukrainian resistance and a demoralised Russian army, such a quick ending was far from certain. I also pointed out that defence budgets would likely be boosted considerably and nuclear would be back on the table for Germany. Both have been confirmed or discussed within the week. And as predicted, commodity prices have gone parabolic, putting enormous pressure on already elevated inflation
The development begs the question, what’s the endgame of all this? While economic matters - to some degree - follow mathematical certainty (e.g., add $3 trillion stimulus and get inflation), predicting the events in Ukraine comes with a large error range, especially as much is decided by one individual. Either way, I believe it’s likely that all roads in this conflict will lead to Putin’s demise, be it soon or dragged out. The case is laid out below
There are three dynamics that pull towards Putin’s fall, with accelerating force. Let’s walk through them:
1) The war against Ukraine is unwinnable. Why?
First, Ukrainian resistance is fierce, and Ukrainians are fighting on their home turf, where they know every street and every corner
Second, the Russian army is ill-prepared and demotivated. The reports of deserting troops, abandoned equipment or supply and communication issues are endless, even in light of biased Western coverage
Third, this is has turned into a proxy war between Russia and the West. Ukrainians are the soldiers, but the West with its substantial resources provides weapons and intelligence
Fourth, the nature of war has changed. With new weapons such as the Javelin anti-tank missiles, large Russian vehicles are sitting ducks, and supply lines very hard to maintain
Fifth, to occupy a hostile country of 44 million people, a much larger force would be needed. With the current 150k soldiers, the ratio of occupant to population is 3.4 to 1000. In comparison, the Allied forces occupying Germany in 1945 had 89.3 to 1,000, or NATO forces in 1995 Bosnia 17.5 troops to 1,000 inhabitants
There is no way Putin can win this war, all he can achieve is destruction and scorched earth
2) The economic pain from sanctions will break the Russian economy. Why?
First, the financial sanctions devalued the Rouble and cut off export markets. This means a drastic GDP decline and equally drastic domestic inflation over the coming quarter
Second, with sanctions on critical spare part imports and logistics firms refusing service, supply chains will be ripped apart. Examples: Airbus and Boeing halted the supply of spare parts to Russia. Most Russian planes are Airbus/Boeing, spare part inventory is typically 2-3 weeks, so very soon most Russian planes will stop flying. Necessary Western spare parts for oil production are restricted, which means eventually production declines. Maersk has ceased non-essential Russian operations, which shuts down imports such as basic electronics etc.
Third, Western companies have shut down their Russian operations, from Ikea to Volkswagen or Ford. Not only will their products not be available anymore, but also their employees are sent home and temporarily out of work
Without a change in course, Russia’s economy will hit a wall within the next quarter
3) With every passing day, international backlash grows. Why?
First, the omnipresence of phones and social media ensures real-time reporting like never before. The barrage of increasingly disturbing images increases Western resolve, both to bear the domestic cost of sanctions as well as to step up military support
Currently, the EU wires Russia ~€600m daily for gas. How many more images of destroyed towns and dead civilians until Europe says “enough” and stops the purchases, accepting the enormous industrial pain?
Second, as commodity prices go parabolic and global economic activity slows, it’s in particular China that’s hurt, as China is both commodity-hungry and its economy based on exports. More so, Chinese companies adhere to Western sanctions out of fear for retribution
An alliance with Russia that balances US hegemony is in China’s interest, but to choke the world economy is not. Unsurprisingly, there has been a change in tone. Chinese state media published the content of foreign minister Wang’s call with Ukraine, where he stated he was “extremely concerned” by civilian casualties
The Western World has come to see this as a battle between good and evil. Red lines have been drawn, and the resolve to push back grows. For China, the fallout is increasingly costly and undesirable
In summary, with every passing day, the forces against Putin strengthen while his own position deteriorates. But after the initial failed coup de main, his objectives are further out of reach
This brings me to the range of outcomes for this conflict. They can be split into rational and irrational:
The rational choice:
Reflecting on the assumptions above, it would be best for Putin to reach an agreement with both the Ukraine and the West effectively as soon as possible
The West would need to contribute to this solution by allowing Putin to sell a truce as achievement (e.g., Ukraine won’t become part of NATO, certain weapons won’t be placed there, the Azov battalion is disbanded, sanctions are reversed)
Still, Putin’s domestic position would be severely weakened. Why? Dictatorships are based on fear. If the leader shows weakness, the fear subsides and the leader will be challenged. The Russian elite will see a de-facto lost war as weakness and soon challenge Putin
The irrational choice:
This would be to continue down the same path. There is no positive end-game for Russia, this is a path to self-destruction. How long this can be sustained depends on at what point Putin’s domestic support breaks
This breaking point is very hard to gauge from outside, it could be soon, or it could be only when the economy is entirely on its knees. If history is any guide, few scenarios exists where it isn’t eventually reached. Too many actors close to power will have too much to gain from an overthrow, while a discontent public provides the justification
In a country without free press, it’s impossible to judge public sentiment from the outside. However, some signs indicate that public support may be lower than Russian media outlets make you believe: (1) As discussed, morale amongst Russian soldiers is very low. They are a representative sample of the domestic population. If everyone’s behind this, why are they so desolate? (2) Putin’s inner circle is accustomed to a Western lifestyle, with possessions from London to the Cote d’Azur. Are they willing to lose it all for Putin’s crusade? Abramovich certainly is on edge, judging by his moves around Chelsea FC
I cannot predict which route Putin will choose. After feedback from Macron’s conversation (“Worse is yet to come”) and the setup of humanitarian corridors for civilians to flee, it seems the route taken is to win or die. Still, I would not rule out a ceasefire. The next few days and weeks will give more indications
For the West, the economic pressure is enormous. The conflict has exposed the huge vulnerabilities in the commodity supply chain, with ESG-policies an influence (see previous post “The ESG Time Bomb”). Meanwhile inflation continues to rage
Recent pre-conflict inflation data all surprised to the upside. Eurozone February inflation came in at 5.8%, and rental growth in the US re-accelerated in February (see post “It’s all about Housing” for the relationship between rents and CPI)
Despite sanction-exclusions, Western commodity traders have self-sanctioned and ceased dealings with Russian counterparts. This is equivalent to a massive supply-shock across many commodities, from oil to aluminium, coal or wheat. In many of these markets, Russia holds a 10-40% market share
It’s simple: If 10% of supply is taken out and demand remains the same, prices increase until demand abates
Because commodities are essential for many everyday activities, demand destruction only occurs at much higher prices (In economic terms, most commodities are inelastic)
It’s not only commodities, supply chains are also affected by the conflict. Examples: Russia’s Air Bridge Cargo is one of the world’s largest cargo airlines and now out of the market. 14% of global shipping workforce are Russian or Ukrainian, Ukrainian parts are missing in BMW’s cars etc. The freight/shipping/supply effects seem drastic and still underreported
If the conflict isn’t resolved soon, the world economy and especially Europe will go into a severe recession. There simply won’t be enough product around
As mentioned before, this will come at a time where central banks can’t bail out with money printing. Inflation is already too high
War and inflation historically go hand-in-hand. Inflation means nothing but scarcity of resources relative to demand. In the past, this created the incentive to reach for supply by military means
It would be better if the Fed reigned in demand by higher interest rates, rather than crazy-high commodity prices creating demand destruction. The former is an orderly, healthy process. The latter is chaotic and angry
It’s not only humanitarian aspects that put pressure on NATO to play a more active role. If supply disruptions become more palpable, expect the West to get more aggressive (a no-fly zone would be the first step)
I continue to repeat what I’ve stated since beginning of year: Cash is King
We’re in an inflationary world where interest rates will go up and asset valuations go down, coming from very elevated levels
Now the risk of a supply-shock recession has been added to the mix
Even if the conflict gets solved soon, its aftermath of de-globalisation and home-shoring will provide more inflationary pressure, and thus higher rates
For the medium term, the following trends are worth noting, in addition to what I highlighted last week:
Western oil production will likely increase. It’s now a matter of national security, trumping ESG considerations. Cf. the CEO of US-shale player Pioneer, he described a “mindset change” with regards to more production this past Wednesday. This is bullish for oil services [ETF: OIH]
There will be more genuine efforts to actively reduce carbon-intensive demand. It was noteworthy that the IEA’s proposals to reduce dependency from Russian gas included putting domestic thermostats one degree lower. This would save the equivalent of 10bcm/~10% of current shipments from Russia. However realistic, it reflects a new line of thinking
If the conflict continues, carbon certificates will be in the crosshairs to reduce industrial cost. EU-ETS certificates fell 30% after Italy’s Confindustria called for a temporary suspension of the scheme. As mentioned, I see carbon-certificates as key alternative to ESG-policies, so I hope this won’t happen
DONATIONS FOR UKRAINE:
I understand that the origin of this conflict is not as clear-cut, and Western involvement in Ukraine’s affairs may have contributed to the escalation. But war is war, the Ukraine has been attacked and innocent people are dying. This is a human tragedy, and it’s clear who fired the first shot
I’ve donated to Ukrainian Armed Forces. I can also recommend donating to Unicef Ukraine