The market’s closed this morning in observance of President’s Day, but that doesn’t mean traders are completely tuned out. The Russia/Ukraine situation, which has completely stolen the Fed’s thunder as a rate hike approaches in March, went from bad to worse following an alleged clash at the border.
Russia says five Ukrainian “saboteurs” were killed by border guards today as they attempted to breach Russian lines. The Ukrainian government refuted the claims, saying that not only did no such attack occur, but that there weren’t even any Ukrainian military assets operating in the area.
Russia then doubled down on its allegations, adding that one Ukrainian prisoner of war was taken in the skirmish and several armored vehicles were destroyed.
Shortly thereafter, leaders of the two pro-Russian separatist factions – the Donetsk People’s Republic (DPR) and Luhansk People’s Republic (LPR) – asked Russian President Vladimir Putin to formally recognize the independence of both territories (Donetsk and Luhansk).
Members of the Russian Security Council called upon Putin to do so as well in a meeting televised by the Russian state media.
Putin responded that he would reach a decision on the matter by the end of the day.
But less than an hour later, an official from Russia’s state media network said that Putin had already made up his mind to recognize both Donetsk and Luhansk as independent territories.
We mentioned in Friday’s commentary that Putin’s endgame likely involved absorbing Donetsk and Luhansk as part of a “peacekeeping” strategy. Nobody really knows whether Ukrainian forces actually attempted to cross the Russian border this morning. From Ukraine’s point of view, such a move would be a fruitless endeavor. Ukraine would have little reason to cross Russian lines at the moment.
In all likelihood, it was a “false flag” attack orchestrated by either pro-Russia forces (at the direction of the Kremlin) or NATO-allied intelligence in an attempt to spark a conflict between Russia and Ukraine. The former would potentially give Putin a casus belli (or “just cause”) to carve off Ukraine’s Donbas region for himself. The latter would warrant a major Western military presence right alongside the Russian border, which the US seems very interested in.
Oanda strategist Edward Moya stated the obvious in a Friday note to clients.
“Investors are having a hard time holding onto risk as the likelihood that the standoff between the West and Russia will ultimately lead to some ground conflict,” Moya said.
“Wall Street will remain jittery until we see a major de-escalation.”
Instead, the threat of war has only escalated since Moya’s note went out.
Richard Bernstein Advisors CEO Rich Bernstein was one of the few analysts over the last few days that managed to keep his eye on the ball.
“Whether it’s geopolitics, whether it’s the labor market, whether it’s supply disruptions — no matter what you look at, everything is pointing to inflation being front and center,” Bernstein said.
A Russian incursion in southeastern Ukraine (but not a full-scale invasion of the country) would likely serve as the bearish “appetizer” to a “main course” crash if the Fed hike rates more than expected next month. Fed Chairman Jerome Powell wants to get inflation under control, but to do so, he’d have to take rates to prohibitively high levels.
Powell might actually do it, but there’s a far better chance that he won’t. Investors are more likely to see a few small rate hikes followed by a capitulation once things go bad. Stocks would continue to march higher in this situation, but probably not as fast as inflation, resulting in only nominal gains (and real losses) for long-term holders.
It’s a grim future to think about, but one that the market arguably deserves after almost 14 years of uber-dovishness. And should Russia cross the border this week, starting a minor conflict in Ukraine, the next short-term (bear) market cycle may begin as well.
