Russia, Ukraine Crisis Ignored by Financial Markets?

(MENAFN- DailyFX) RUSSIA, UKRAINE, US DOLLAR, MILITARY STOCKS, RUSSIAN RUBLE, crude OIL, NORD STREAM 2 - TALKING POINTS

• Russia-Ukraine tension embroiling the US - fears of military encounter rising
• Russian Ruble and non-military stocks may fall if geopolitical pressure surges
• media headlines aside, what are markets telling us about investors' outlook?

Tension between the United States and Russia has been escalating as Russian troops and tanks continue to build up along the Ukrainian border. Despite the seemingly rising temperature, investors have continued to shrug off the prospect of military escalation between the two nuclear powers. Is this cavalier stance setting markets up for a nasty surprise?

For the past 30 years or so, the Ukraine has been the subject of strategic interest for both the US and Russia. Its geographic positioning makes it a key strategic chokepoint for both powers. Moscow and the US-led NATO alliance both view Ukraine as a key strategic buffer zone containing each other's influence and would-be territorial ambitions.

Political instability has plagued the Ukraine, between the Orange Revolution and the mass unrest that followed, to the annexation of Crimea. President Vladimir Putin continues to follow a foreign policy approach of regional reinforcement - much like China in South-East Asia - to secure its regional interests and influence. Ukraine plays a key role in this vision.

Domestically in Russia, this echoes sentiment viewing Ukraine as historically linked to its large Eastern neighbor via the 'Kievan Rus' heritage as well as USSR membership. For Mr. Putin, reclaiming and expanding Russia's sphere of influence - especially in the Ukraine - strongly resonates on a national patriotic level. This along with Russia's military and strategic stance means that Moscow is likely prepared to vigorously defend its interests here.

Will Russia invade the Ukraine? The short answer is“most likely, no”. Mr. Putin is testing Washington's resolve, and that of President Joe Biden. His administration's pullout from Afghanistan was seemingly driven – at least in part – by an underlying strategy of reallocating resources to combat China's growing economic and political influence, regionally and internationally.

With that in mind, Mr. Putin might have some leverage in that Washington may not want to embroil itself in a conflict that distracts it from tackling China. As a result, Moscow may take a more aggressive approach to gauge how far the US is willing to go to defend Ukraine - and by extension - Europe as a whole.

What makes the situation tense is the timing: Russia has a small window - roughly between February and March – for a possible invasion. The military equipment necessary includes tanks and armored personnel that can only cross the border when the ground is frozen for a few weeks. After that, a muddy season follows that would make any ground military incursion significantly more difficult.

Trading Strategies and Risk Management

Global Macro

Recommended by Dimitri Zabelin

Start Course

To avoid a face-to-face military encounter, the US has threatened to impose crippling sanctions tougher than those deployed after Crimea was annexed. Mr. Biden wants to make the economic cost of invading the Ukraine so high that it would outweigh the political benefits Mr. Putin would extract from moving in.

The sanctions in question could include measures along financial, technological or trade channels, or indeed some combination thereof. In the finance space, seizing and freezing Russian assets and going after the country's large financial institutions might spook investors, prompting capital outflows that drive down the Russian Ruble. The aim here would be to apply an economic squeeze that turns Russian public opinion against the Kremlin's actions. A similar method was used against Iran prior to the landmark nuclear deal in 2015.

For more insight on how politics impact markets, follow me on Twitter @ZabelinDimitri

Technology-related sanctions may include cutting off key inputs - such as semiconductors - that are required for advanced military hardware, like jet planes. Furthermore, Washington could go so far as to restrict Russian access to any microelectronics that rely on US patents or designs. This would likely amplify existing global supply chain problems, with multi-iterated consequences.

And finally, a third method could be the blocking of deliveries of key consumer goods such as refrigerators, cars and iPhones. If a crippled currency and shortages of in-demand products trigger a domestic backlash, political pressure may push Russia to reconsider the cost of its military endeavors in the Ukraine.

To supplement these tactics, Washington may supply weapons to Ukrainian insurgents to fight Russian occupying forces. This is known as the porcupine strategy: make it as painful (militarily, politically, and economically) as possible for one state to“consume” – i.e. occupy – another one. The US now has to weigh these options amid ongoing negotiations.

One senior Russian diplomat said that talks with the West were approaching a“dead end” amid discussions on concessions. One major obstacle is Putin's demand that NATO deny membership to the Ukraine and all former USSR-member republics. This would be in addition to removing all weapons and troops currently deployed and controlled by the US in the post-Soviet states.

However, Putin has to be careful not to overextend his hand. Too many demands with such steep prices may cause the US to call Moscow's bluff. At this point, the Russian President may be forced to follow through, which may cause more upheaval than previously intended. In the interim, the Russian Ruble, US Dollar and military-industry stocks will be closely watching the stand-off for clues about next steps.

In the event of a military clash, military-industry stocks such as Raytheon and Lockheed Martin are likely to diverge upward while broader equities and the Russian Ruble suffer. Such names have sharply risen while non-conflict-oriented equities have dipped amid broader risk aversion during times of geopolitical turmoil over the past 3 years.

Chart created using TradingView

The chart above shows instances of how heightened tension between Iran and the US catalyzed a defense stocksbuying spree. Given the size of both Russia and the United States' military power, even the hint of armed conflict is likely send these shares surging. The Russian Ruble, on the other hand, would probably plunge given the prospect of Washington's sanctions.

Written by Dimitri Zabelin for DailyFX

MENAFN20012022000076011015ID1103566779