Ukraine’s Fog of War and the Correction

Filtering information is one of investors’ most important tasks. It is hard enough in the best of times, but right now, the fog of war is making it all but impossible—and we aren’t talking about the myriad reports of fake images and video footage coming out of Russia and Ukraine. The fog is also engulfing a lot of the economic commentary, obscuring a clear assessment of developments’ impacts over the weekend and on Monday and stoking a lot of this time is different-style commentary. But as tough as it may be to see, we don’t think much has changed for investors since our discussion of sanctions late last week. The latest measures still don’t inflict enough damage to wallop global markets.

Yes, we know the US, UK and EU agreed to expel some Russian banks from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network, which facilitates international financial transactions. We know this theoretically complicates Russian banks transacting with the developed world, effectively freezing commerce and overseas assets even for entities that aren’t under sanctions. And we know several Western leaders have referred to this, however unfortunately, as the “nuclear option.” Now they are patting themselves on the back, promising their actions will create a deep Russian recession.

Perhaps. But there are reasons to doubt this outcome will be so clear. That isn’t an ideological statement, mind you, nor a political one. Rather, our job is to assess these things coolly and rationally, as markets do. Those who argue the SWIFT expulsion will kneecap Russia’s economy point to the deep economic pain in Iran after US sanctions effectively barred all Iranian banks from SWIFT. Thing is, those sanctions included measures targeting Iran’s oil and gas exports, which is what actually crippled Iran’s economy. So far, the West has done no such thing to Russia—the SWIFT ejection applies only to some (heretofore unspecified) banks, meaning there are other banks that still have access and can process oil and gas transactions. Some officials told the press Monday that they are doing so to avoid interfering with the oil trade.

This, of course, is to ensure Russian oil and gas continues flowing to Continental Europe, which relies on that supply. But it also ensures the source of half of Russia’s government revenues is alive and well, which limits a lot of the potential economic damage. Beyond that, SWIFT isn’t technically a money transfer system; rather, it is a messaging system. Messages accompany wire transfers, a key component in informing the receiving bank of the intended recipient and other key information. SWIFT is overwhelmingly the most commonly used messaging system globally. But it isn’t the only game in town. To maintain access to international markets, Russian banks could use antiquated analog technology like Telex. Or they could use Russia’s relatively new SWIFT alternative, enabling them to use banks in China and elsewhere as conduits. Annoying thing about sanctions: There will always be nations willing to help a pariah state skirt them for a small fee. 

Fine print should render the weekend’s other big measure much weaker than advertised: the ban on transacting with Russia’s central bank. The idea: strand Russia’s huge foreign currency reserve war chest abroad, so that the Central Bank of Russia (CBR) can’t use it to prop up the ruble. Propping the ruble would require the CBR to sell its foreign currency assets and buy rubles on the international market with the proceeds, which is now theoretically off the table. This, too, will allegedly trigger a Russian currency collapse, bank run and deep recession.

That is a possible outcome, of course. But is it likely? Due to Europe’s aforementioned reliance on Russian fossil fuels, there is an exemption for all entities processing payments for imported Russian oil and gas. That means Russia doesn’t need to repatriate its overseas assets to get the hard currency necessary to stabilize the ruble. It can just sell a boatload of oil and gas, then convert the euros and dollars it receives as payment to rubles—through a third-party nation, if need be. Incidentally, this argues against oil and natural gas prices soaring from here. If anything, Russia’s need for hard currency could motivate it to ramp up supply, helping prices stabilize.

Another thing: Russia has diversified its foreign currency holdings significantly in recent years. Russia’s US Treasury holdings have gone from over $100 billion in 2017 to too small to report by 2020.^[i] The dollar was about 46% of its war chest in 2017, according to the CBR’s data.^[ii] As of last June, the latest figure available, it was down to 16%.^[iii] It could be lower still by now, if the CBR took pre-emptive measures ahead of the long-planned invasion. Meanwhile, the yuan is now 13% of its reserves, and gold is up to 22%.^[iv] Between the diversified reserves and the steady incoming stream of hard currency as payment for energy, we think Russia probably has more firepower than most commentary suggests.

It is true that markets had a sharply negative reaction to this weekend’s developments. Russia’s stock market was closed, but Russian companies listed on the London Stock Exchange tanked. So did the ruble, although the CBR’s huge rate hike seemed to help at least temporarily. Yet be very, very careful about extrapolating one day’s market movement into a financial crisis. Just putting our thinking caps on, but we have a hard time seeing why the partial SWIFT ejection or forex lockup would trigger an honest-to-goodness bank run—like, the actual Panic of 1907 kind of bank run, not a few dozen people in line at an ATM because they read a scary article. Neither factor affects domestic banking transactions. Russia’s economy isn’t dollarized. The CBR can provide unlimited liquidity in rubles if need be. We aren’t arguing this will be painless, but those claiming a bank run will bring Putin’s downfall and the war’s end risk believing in a fantasy—not least because they are perhaps being a bit too naïve about who would take over.

Every stock market correction (sharp, sentiment-fueled drop of -10% to -20%) has a this time is different scare story. That tone and narrative is why people have such a hard time staying cool and rational and believing market history can be a useful guide. When the stories are laced with wartime propaganda, it is probably five times as hard. For investors, it is vital to take a deep breath and put on your skeptic glasses. Read the fine print. Leave feelings out and assess the facts. In this case, we think you will see the facts support our opinion that this conflict remains too geographically limited, and the major players too small economically, to wallop global markets.