‘Darkness’

It was impossible to escape dire headlines on Thursday. Neither was it easy to scan social media feeds without coming across a lament for the plight of citizens in Ukraine, who faced the terrifying prospect of an invasion by one of the world’s largest militaries.

Getting a read on equities was an exercise in futility. Liquidity is poor (I imagine it deteriorated further amid the panic) and, as Nomura’s Charlie McElligott wrote, “the ongoing short gamma / extreme short delta dynamic in US equity index and ETF options will continue to feed into market overshoots, with spot nearing ‘max short Gamma’ locations across the board.”

If there was a saving grace for stocks, it was that exposure was already de-risked materially. Systematic positioning came into the crisis cleaned out, nets sat near ~one-year lows and, as Charlie went on to note, there’s been “remarkably persistent short-dated downside buying and dynamic hedging with grossed-up shorts.”

US stocks ended sharply higher after another large intraday reversal fueled by hedge monetization, profit-taking in VIX upside and what McElligott described as “some” appetite for playing offense.

Still, the situation was perilous. And the commentary generally reflected as much. “With Vladimir Putin ordering a full-scale invasion of Ukraine, raising the specter of a dire humanitarian crisis in Europe, Western powers are poised to impose the most punitive sanctions to date on Moscow in an effort to effectively sever the country’s access to global capital markets” RBC’s Helima Croft wrote, in a note called “Darkness Falls.” “Though President Putin stated that his special military operation would be in eastern Ukraine, the grave warnings of the US intelligence community about a much wider military offensive have been borne out with explosions occurring in multiple cities, strikes on critical infrastructure and troops pouring into the country from three fronts,” Croft said, in the same Thursday piece.

Once again, I’m compelled to reiterate: Western intelligence wasn’t lying to the public, nor were the warnings “hysteria,” as the Kremlin repeatedly charged. The White House’s strategy of bombarding the public with as much intel as it was feasible to release robbed Putin of the opportunity to engineer a false flag. Ultimately, he appears to believe he didn’t need one. He simply announced an invasion. Minutes later, the strikes began. He lied right up until the last minute, suggesting the “operation” would be confined to the Donbas.

The Kremlin seems to believe $630 billion is enough to ride out the sanctions storm (figure below). I tend to doubt that, but it depends on the scope of the measures.

“The response from the EU and US will not focus on a military response, but on driving a liquidity squeeze as much as possible on Russia to target their ability to finance the military,” Rich Kelly, TD’s head of global strategy, wrote, warning of “very illiquid markets in anything seen as even tangentially related to Russia until investors can assess the full spillover effects of those sanctions.”

Commenting on the collapse in Russian equities witnessed Thursday, Kelly noted that local shares now trade at an unprecedented 80% discount to EM peers. On that score, at least, the current crisis is worse than Crimea (figure below).

The US-traded Russia ETF was beset Thursday, commensurate with the turmoil on/in the MOEX and ruble.

RBC’s Croft again highlighted the risk to non-energy markets. “As Russia and Ukraine combined account for 25% of global wheat exports and Ukraine alone for 13% of corn exports, the food price inflation risk stemming from this conflict appears acute,” Croft wrote. The figure (below), shows the breakdown.

RBC proceeded to caution that Russia’s Black Sea naval deployments might represent a “considerable risk [to] Ukraine’s ports,” which could become “inoperable if active fighting commences.” Almost all of the country’s grain is ferried by sea.

As Nomura was keen to emphasize Thursday, the risk of production disruptions in Ukraine is now very real, and Russia is the world’s largest exporter of fertilizer. Its share is even bigger if you include Belarus.

The conflict has made an already dangerous situation worse vis-à-vis surging global food prices (figure above).

Readers often ask what non-military measures could be taken to cripple Putin. TD’s Kelly described the figurative nuclear option, along with its drawbacks, in the same note cited above. “SWIFT disconnection is the most severe of the options on the table,” he wrote, adding that,

A disconnection of Russia from SWIFT would basically isolate the country and its businesses from Western markets. Russia, however, has already developed its own financial messaging protocol through which already about 1/5 of banking transfers are executed. Obtaining the approval for a disconnection would require an ample majority in the board of SWIFT which is dominated by European players. On the other hand, European countries need access to the Russian banking system to transfer payments for oil and gas supplies and will, therefore, be extremely reluctant to force Russia out, even in a worse case scenario that doesn’t involve the EU and NATO militarily against Russia. Market implications: Total untradability of Russian assets. Oil, gas and other commodity prices increase permanently.

Although the Baltic states want Russia’s SWIFT access cut, the EU was “unlikely at this stage” to take that step, according to sources who spoke to Reuters.

“Other EU member states are reluctant to make such a move because, while it would hit Russian banks hard, it would make it tough for European creditors to get their money back and Russia has in any case been building up an alternative payment system,” the linked article said.

Coming quickly back to equities, one CIO told Bloomberg that in her view, “We’re not at a point where you can just jump in because everything is so cheap.” That’s an understatement, although I’ll confess to buying some US tech shares today — Comms Services was down ~25% from the highs.

As for the notion that Putin cares about Russia’s reputation in the energy market, RBC’s Croft didn’t mince words. “Some market participants contend that Russia would not want to risk their position as a reliable supplier,” she wrote. “But since they have just plunged Europe into the gravest security crisis since WW2, we do not think we should be naive about the willingness of the Russian leader to play the commodity export card in pursuit of his revanchist agenda.”