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This note was originally published at 8am on March 04, 2014 for Hedgeye subscribers.

“Russia is a riddle wrapped in a mystery inside an enigma.”

-Winston Churchill

In college, I wrote my senior essay on constitutionalism in post-Soviet Russia.  It was a great topic for an Ivy League kid and I had the privilege of being advised on the paper by General William Odom, a former head of the National Security Council under Ronald Reagan, and expert on Soviet affairs.  Despite my heroic efforts at primary research, the conclusion could have been shorter than a tweet.

Simply put, the rule of law was going to take time, perhaps generations, to take hold in Russia.  Unlike the United States and many Western nations, the history of Russia, even before Communism, was one of rule “by law” and not rule “of law”.  So, in effect, any new Constitution would simply be viewed by the people as an apparatus by which they were ruled, rather than a document that freed them.

Then, as now, it is impossible to analyze Russian action solely from the lens of the West.  Actions which may same outrageous to the West may actually be very subdued to the Kremlin.  

Riddle In An Enigma - poot

A quick review of any major Western media source is that there are two schools of thoughts in analyzing the current situation.  The first is that Putin is clearly violating the sovereignty of the Ukraine and will pay for it, likely economically.  The second is that Obama has largely been incompetent in dealing with Russia and is in a box because Putin has become his partner, of sorts, on Iran and Syria.

Stepping back though, it is worth viewing this from the Russian perspective.  For starters, Crimea, which is and has been recognized as a sovereign part of the Ukraine by Russia, is also the home to Russia’s Black Sea Fleet and will be until 2042 under an agreement between the two countries.  It is also a region that is almost 60% Russian speaking and ethnic Russian.  So, clearly, the Kremlin has vested interests in the Crimean peninsula.

Meanwhile, in overthrowing President Yanukovych, the Ukrainians overthrew a Russian ally who had been moving further away from the Europe and closer to Russian, including taking a recent $15 billion loan from Russia.  The current leadership in the Ukraine also does have some far right-wing elements.  Specifically, one of the three main leaders of the protest and the new deputy Prime Minister of the Ukraine, Oleh Tyahnybok, is the leader of the far-right ultranationalist Svoboda party that was allied with the Nazis in World War II.  (Tyahnybok has at times blamed the Ukraine’s problems on the “Jewish-Russian” mafia running the country.)

Back to the Global Macro Grind...

Clearly, from a Western perspective neither of the above factors, strategic interests in Crimea or extreme nationalists in the new Ukrainian government, justifies an invasion into sovereign Ukraine. Hence, the West is in uproar and among other things is threatening to pull out of the Sochi G-8 conference this summer and implement economic sanctions.  For his part, Putin has towed the line closely in Crimea; there have been no shots fired and little violence.  As well, so far, the Russians have not made a move into the mainland of Ukraine.

On some level, Putin also likely respects history.  Similar to Afghanistan, Crimea has been a thorn in Russia’s side historically. Russia also fought a war in the Crimea, against a British, French and Ottoman coalition, in the middle of the 19th century.  This war was an unmitigated disaster for the Russian Empire, then led by Nicholas I.  Not only did Nicholas I not live to see the end of the war, but his successor Alexander II signed the Treaty of Paris and initiated the biggest liberalization campaign in the history of Russia. 

Despite the fervor that was brewing on political TV this weekend, the perception based on a poll we took yesterday is that the situation in the Ukraine is actually favoring Putin vis-à-vis President Obama.  In fact, 78% of the respondents to our poll said Putin will come out stronger. Napoleon famously said:

“Never interrupt your enemy when he is making a mistake.”

Of course, it begs the question: who is making the mistake?

In all likelihood, the most significant reason that Russia is unlikely to escalate is an economic one.  Even as the Russian stock market is rallying this morning (perhaps an indication that the worst is behind us?), Russian asset prices have been decimated.  In the Chart of the Day, we show this with a chart of the Russian ruble, which is literally hitting all-time lows. Despite the Russian central bank aggressively raising interest rates by 150 basis points, the ruble continues to be better for sale.  Internally, a weak ruble is the worst economic outcome for Putin as it has the potential to drive inflation up dramatically. 

Externally, the most significant “river card” Russia has to play is its natural resources that much of Western Europe is dependent on.  Last year, Russia shipped 133 billion cubic meters of gas to Europe, including 40 billion to Germany, which was more than 1/3 of Germany’s supply.  Ultimately, Russia has become very economically integrated with the West and it is likely this integration that leads to resolution before escalation in the Ukraine. 

This all of course reminds me of the following joke:

A Ukrainian immigrant goes to the Department of Motor Vehicles to apply for a driver's license. 

He has to take an eye test. The clerk shows him a card with the letters: 

C Z W I X N O S T A C Z 

"Can you read this?" the clerk asks. 

“Read it?" the Ukrainian replies, "Heck, I know the guy!" 

Our immediate-term Risk Ranges are now as follows (our Top 12 macro ranges are in our Daily Trading Range product):

UST 10yr Yield 2.59-2.73%

SPX 1826-1861 

VIX 13.06-16.26 

USD 79.81-80.31 

Brent 108.78-111.21

Gold 1310-1353 

Keep your head up and stick on the ice,

Daryl G. Jones

Director of Research

Riddle In An Enigma - RUB

Riddle In An Enigma - rta2