GW&K Investment Review 1Q 2022
Now what? It feels as though Russian President Vladimir Putin has overplayed his hand and made a drastic mistake. He has unleashed death and destruction on the Ukrainian people and paid for it with the lives of thousands of Russian soldiers. To what end?
He could easily have negotiated a settlement that resulted in a Ukrainian government unaligned with NATO, or one that declared neutrality within the European theatre. If Putin believed that the country would fall and accept the Russian way of life, he was too late—a generation of Ukrainians have felt the spirit and freedom of the West and are not willing to go back to the stark and dark years of Russian oppression.
There is so much irony in the unintended consequences of the invasion. Before the offensive, in the midst of a peaceful Europe, NATO was dying. Defense expenditures of member countries as a percentage of GDP was growing less and less. But now the alliance has awakened. I can’t imagine a worse outcome for Russia than to have Germany rearm. For years, Germany had been willing to retreat from the arms race given their long history, but now the economic powerhouse of the continent has reengaged.
Credit must be given to the U.S. and most of the world for creating a line in the sand. Not only have governments been supportive of Ukraine, but maybe more importantly, the private sector has pulled the plug on Russian commerce. The free world, public and private, is as united as it has been since World War II. This was not Putin’s plan.
As an isolated dictator Putin has made a huge mistake, a not so infrequent result for those who rule with absolute authority. Whether it be Hitler invading the Soviet Union and creating a war on two fronts, which in the end was his downfall, or Saddam Hussein convincing the world he had weapons of mass destruction, which we now know he did not, even the most ruthless of despots fail without a team of strategic advisors. The old Soviet system had a Politburo and internal rivals, but, like Stalin, Putin is alone at the top and it seems his decision to invade went unchallenged. The Russian army is top heavy and unable to adjust to events on the ground. Putin believed that simply throwing waves of soldiers and armaments into the arena would win battles. But we have seen in other military theaters how dramatically the style of fighting has changed. Technology, force coordination capabilities, and contingency planning are all key to success. A lumbering army approach, as in World War II, is antiquated.
By now, it seems clear that Russia will not defeat Ukraine. These people are not going to give in or give up. It could be another Afghanistan for the Russian army, but it seems more likely that there will be some kind of settlement. Body bags have a way of forcing resolutions, as we saw in Vietnam. The cost to the Russian economy is real and probably unsustainable. While Putin made the mistake, the West now needs to figure out a way that he can save face. He believed he needed to stop Ukraine from joining NATO. That’s easy—Ukraine does not join NATO. Maybe a few of the eastern provinces join the Russian sphere. The world needs to find the right formula for the war to end. Maybe a UN armistice line will be required. Ukraine, Russia, and NATO need to find a negotiable solution.
Then there are the other issues staring investors in the face—interest rates, inflation, and China’s policy toward the conflict. If the war ends and the price of oil and gas retreats, it will take a lot of pressure off the economy and monetary policy. I always have argued that rising commodity prices produce deflationary pressure as consumers see their available discretionary spending get squeezed. Unlike other goods and services, it is difficult to substitute for oil and gas. We can drive less or adjust thermostats, but we need what we use. The U.S. has come a long way since the 1973 oil embargo, making strides in productivity and efficiency standards, but the price of fuel is still a critical input cost for the economy.
If the war doesn’t end quickly, rising energy prices combined with rising interest rates will have a meaningful impact on economic growth. The Federal Reserve is quite aware of these compounding factors and will likely raise rates slower if oil and gas prices climb from here.
One last thought: I believe the Chinese government will give lip service to Putin but will stay out of Russia’s fight. China needs Russia to be an opponent of the West so Beijing is not isolated, but they will not throw away 40 years of progress and risk U.S. economic retaliation for sending arms to Russia. The Chinese population has reaped the benefits of Western trade and although the U.S. and China are the two largest global economies, theirs will be a commercial and technological battle, not a clash between militaries.
My conclusion is that the West has woken up. An armed land war, almost inconceivable a few months ago, will remind the world of its terrible costs. I thought COVID had taught us that we were all in this together; Putin didn’t get the message then, but he has now. The world will tolerate competing economic combat, but with exception of local skirmishes, hot wars are off the table. Nations across the world will unite against the aggressors. What a great lesson, which gives me real hope that some good will come from this mess and that the European people can once again enjoy the benefit of global trade, technology, and ingenuity.
In short, this too shall pass. Keep the faith and stay invested.
Harold G. Kotler, CFA
CEO, Chief Investment Officer