VTI - Ukraine: The Gray Swan

2023-11-16 15:21:56 ET

Summary

• Today, we shine the light on Ukraine, which is nearing its 21st month of conflict and remains the largest land war in Europe since WWII, despite fading from the headlines.
• The conflict in Ukraine, which has claimed hundreds of thousands of casualties, still has the potential to escalate into a larger conflict with ramifications for equities and the global economy.
• Russia has effectively worked its way around Western sanctions and is now more firmly on a war footing, outproducing the West in key war needs.
• We outline three potential scenarios the war in Ukraine could take next, along with their potential ramifications for the market and investors in the paragraphs below.

War is what happens when language fails .”? Margaret Atwood.

It is hard to believe that we are one week away from the 21-month anniversary of the invasion of Ukraine. The initial stage of the conflict rattled investors and the energy markets. However, this war has long since faded from the front pages even as the conflict had claimed hundreds of thousands of casualties and caused untold property damage and human suffering.

However, the situation is one of several geopolitical situations investors currently need to keep a wary eye on. Events in Ukraine still have the ability to escalate into a larger conflict which would have many ramifications for equities and the global economy. Given how closely followed the conflict has been, it hardly can be called a Black Swan at the moment. We will call it a potential Grey Swan as the war still has the ability to develop into a major headache for the global markets and economy.

I spent 30-40 minutes early Thursday morning reading the most comprehensive article on the conflict in Ukraine I have seen to date. The piece is some 20 pages long, with dozens of cited sources within it. It breaks the war into three phases. The first part covers the initial invasion when the Russians had committed just under 200,000 overall personnel to the advance. The next section discusses the second phase of the war, from the time Ukraine recovers significant territory later in 2022 through the failed springtime counter offensive by the AFU here in 2023, which has largely concluded. The final piece of the article highlights where the conflict stands now and what are the likely next steps in the largest land war in Europe since WWII.

Some key conclusions. After a hard initial six months, Russia has mostly worked its way around Western imposed sanctions effectively. The economy hasn't tanked as many pundits predicted. In fact, the country is seeing positive GDP growth.

Russia is now more firmly on a war footing, and production of key war needs like artillery shells, drones, and tanks have picked up dramatically. The nation is far outproducing the collective West in all of these categories currently. Russian forces in Ukraine have also just over doubled since the initial phase of the war, with ample additional reserves in Russia.

This is not the case on the Ukrainian side which still doesn't not have the capacity to produce modern weapons like tanks and remains reliant on sourcing from their Western allies. In addition, Ukraine has no navy to speak of or an effective air force. Manpower has been dramatically depleted, both by casualties on the battlefield as well as emigration out of the country. The average age of the Ukrainian soldier on the battlefield is now north of 40 years old. These items are critical, as an initial war of maneuver has turned firmly into a war of attrition. This kind of conflict greatly favors the country with the most arms and personnel.

Ukraine's much anticipated offensive only penetrated some 10 miles at its deepest. Many of its best equipped and trained brigades were degraded substantially during the assault, both in weapons and soldiers. Unfortunately, instead of being able to rest and refit these key military formations, they are being locked in continued combat within ' positioning ' battles. The most key of which is around the strongly held Ukrainian stronghold of Avdiivka. A fortress that is now surrounded on three sides by Russian forces who now have line of sight on the small corridor being used to resupply some 40,000 Ukrainian troops there. This allows substantial amounts of artillery to rain down on supply convoys and staging areas.

The loss of Avdiivka would likely mean the loss of all of the Donbas, as it anchors the last good defensive line in the region. This event is likely to happen early in 2024. A key question is whether Ukraine will be able to get the bulk of its troops out of the region before Avdiivka falls or whether the country loses these forces to attrition and/or surrender. The fall of the Donbas likely leads to three potential scenarios, all of which I think are important to investors and the market.

1. Ukraine and the West accept the inevitable, which is Russia will keep Crimea, influence and/or control of the four eastern oblasts in the country and the land bridge between these two regions. Obviously, this would be a huge foreign policy setback for the current administration whose polls started to sink dramatically after the Afghan withdrawal debacle in the summer of 2021. Peace would also likely be a slight negative for arms suppliers like The Boeing Company ( BA ) , Lockheed Martin ( LMT ) and RTX Corporation ( RTX ) . Albeit they would have years of production runs to replace the Javelins, HIMARs, fighting vehicles, Patriot missiles, tanks the U.S. and its allies have sent to Ukraine. This would replenish the older stocks of weapons sent to the conflict zone with modern replacements. This scenario is probably a positive for Blackstone Inc. ( BX ) and its ilk as the focus in Ukraine shifts from supplying arms to reconstruction activities. The loss of the Donbas would initially cripple Ukraine further economically, given the region contains a huge amount of the country's mining, mineral, energy and agricultural assets.

2. The first scenario is based on the U.S., Kyiv and Moscow agreeing to peace talks, obviously. However, all parties have different and significant reasons not to engage in settlement discussions. If the Russians successfully take the rest of the Donbas, they could also decide to push further into the country. Risks of this increase should the battle for Avdiivka turn into a rout for Ukrainian forces. The most logical next step would be for Russian forces to take the port city of Odessa which would cut off all access to the Black Sea for Ukraine. This would also substantially limit Ukraine's ability to hit Sevastopol, Russia's huge naval base in Crimea. This scenario would greatly increase Russia's leverage in any peace talks and be an even greater humiliation for the collective West. The winners and losers from this event playing out would be similar to the previous scenario. In addition, this path probably leads to a significant spike in energy prices, at least temporarily.
3. The final path assumes Russia expands its holdings in Ukraine, possibly taking Odessa, but instead of triggering peace negotiations, the conflict expands to include NATO force and potentially further risk WWIII. Obviously, were this to occur, volatility in the markets would shoot up tremendously. It is also hard to see this type of escalation not leading to a fairly quick trip into bear market territory for stocks. As this would be a real 'Black Swan' that is certainly not priced into equity prices currently.

Just food for thought for investors today and a reminder they need to continue to keep a watchful eye on events in Ukraine.

I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones .”? Albert Einstein.

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