What's the Endgame in Ukraine?

Guild Investment Management  |

Euro QE is set to start in March. So it’s off to the races for European stocks, right? Well, maybe not just yet.

Market nerves have been frayed this year for two main near-term reasons. First is the uncertainty surrounding the fate of Greece after its election of a radical government and the rejection of its ongoing bailout deal. We continue to believe that both sides have the same basic concern -- how to sell any potential deal to their electorate -- and we continue to believe that a deal will get made, although it may last only until the fall. Over the weekend, we read comments from France’s finance minister that the differences between the two sides are “a matter of words.” However, there will certainly be volatility and a psychological overhang until a resolution is made that saves face for all involved.

The other worry for markets has been the collapse of a September cease-fire agreement and the deepening of hostilities in eastern Ukraine between the Ukrainian government forces and Russian-backed rebels. As we discuss below, we continue to believe that a peace will be reached -- at least, a peace that’s “good enough” for markets to acclimate to it. The renewed cease-fire deal reached after marathon negotiations in neighboring Belarus may last for some time, but will likely unravel when Vladimir Putin decides to take the next incremental step towards his longer-term objectives.

Even with the good news of Euro QE, these two problems have made tough going for stock markets in both Europe and the United States.

Russia, Ukraine, and Europe

As we have noted before, the situation in the Donbas (eastern Ukraine) makes perfect sense in the context of Russian and Ukrainian history. We believe this history is guiding the realpolitik of European leaders like Germany’s Angela Merkel, who, to many American eyes, seem to be “throwing Ukraine under the bus.”

Many American citizens and politicians have a black-and-white view of the world, with democracy on one side (represented by the U.S. and Europe) and tyranny on the other (represented in this case by Russia). Hence the popular image of Vladimir Putin as a sinister puppeteer or chess player that’s been on the cover of every western news magazine for years. The Russian view is different, and even though we disagree with it, we think it’s critical to understand it.

There’s no doubt that Putin is a tyrant, and there’s no doubt that he has engineered the development of a kleptocracy in Russia that keeps the funds flowing to himself and his cronies. Nevertheless, he resonates with Russian voters, even while his policies are dragging the country into economic ruin. He knows how to appeal to the historical sense of his people.

It’s All a Western Plot

Yes, there is a westernized, liberal elite in Russia’s big cities; but underneath, and throughout the country, there is deep sympathy for the idea that the West is still the enemy. For hundreds of years, Russia has craved the wealth of the West, and at the same time been repulsed by the Enlightenment values (or, in their view, lack of values) that made that wealth possible. Russian philosophers and artists railed about the decadent West in the 19th century. And now, even the long tragedy of Russia’s life under Communism is read by many as a “western captivity.” They believe Marxism was a “western poison,” part of an age-old plot to degrade and destroy “Holy Russia.” In its further reaches, this ideology becomes a kind of messianic nationalism.

So it’s easy for a demagogue like Putin to convince the Russian people that Ukraine’s turn to the West was engineered from the outside by Western agents. (Missteps and ill-considered comments by U.S. diplomats unfortunately added fuel to that fire.)

Angela Merkel grew up in Communist East Germany, and Vladimir Putin was trained there as a KGB agent. Although they represent polar opposites in politics, they understand one another very well.

Merkel well knows the suspicion and fear that underlie Russia’s view of Europe. Many former Soviet satellites have been integrated into NATO, nations with a long history of oppression by the Soviet Union and by the Russian Empire before it -- countries such as Poland, Latvia, Lithuania, and Estonia. That integration is a fait accompli. We believe that if push came to shove, NATO would defend them -- and we think that for now, Russia has accepted their loss as an unfortunate but unavoidable fact.

Ukraine, though, is different. The ties that bind Ukraine and Russia are of another order -- a fact Putin exploited during a triumphant speech after he seized Crimea. He identified Crimea as the birthplace of Russia.The origin of Slavic Christian civilization in what is now Ukrainian territory means that Russia and Ukraine are existentially and inextricably bound in Russian historical imagination and national feeling.

Coming to Terms With Reality

For Western-minded Ukrainians, that is a tragic reality. For western Europeans, it is troubling and difficult,but not tragic. We believe that European leaders, Angela Merkel chief among them, tacitly acknowledge Russia’s claim that Ukraine should remain within its sphere of influence.

Whatever stable or unstable peace evolves on the ground will be a cover for that basic acknowledgement.Perhaps it will be a “frozen conflict” like Georgia’s. Perhaps more likely, it will be a constitutional settlement, where the Donbas remains part of Ukraine on paper, but is fundamentally independent -- and where its presence in a loose Ukrainian federation permanently prevents Ukrainian accession to NATO. The shape of that constitutional settlement has only been hinted at in the agreements brokered in Minsk, so we have yet to see.

That would suit Vladimir Putin just fine -- and we believe European leaders will ultimately accept it. We are not happy about this prospect for the people of Ukraine, for whom this is one more episode in their own long historical tragedy. Nor do we have high hopes that the current ceasefire will be enduring, because in any caseit is only a stepping stone for Putin to get what he wants.The more obvious it becomes that Ukraine will not succeed in its westward turn, will not be integrated into Europe, and will be prevented from joining NATO, the more stable the situation will become. The current Minsk protocol gives a timeline in which such a constitutional settlement could be reached by the end of 2015. It remains to be seen whether Putin thinks calm, or further fighting, will best further his ends.

This is how we think the Ukrainian situation will ultimately be resolved. However, this does not mean that Russia will then cease to be a destabilizing threat for Europe. As long as Vladimir Putin holds the reins -- and probably longer -- Russian fear and aggression will be a source of instability and volatility on Europe’s eastern flank. We do not yet know how responsible European nations will shift their posture in response.

Investment implications: Historical precedent suggests that Euro QE will be a big positive for European stock markets. Uncertainty surrounding Greece and Ukraine, however, continue to depress market psychology. Ukraine’s fate is tragic, but we believe a settlement will be reached that de facto locks Ukraine into the Russian sphere of influence. As that occurs, and as the Greek situation clarifies, European stocks may become attractive for several months. However, fighting in Ukraine is likely to continue, with lulls while negotiations occur, until Russia can secure a situation on the ground that truly blocks Ukraine’s further military and economic rapprochement with Europe. Investors with tolerance for volatility can seek to profit from Euro QE through ETFs that track the various European national and international indices. A useful resource for investors is the ETF screening site ETF Database; a list of ETFs for European equities can be found here. We favor exposure to northern European countries with more constructive macroeconomic policies; investors with more risk appetite could consider exposure to peripheral European economies. As we always note, investors should be sure to hedge their exposure to the Euro, which can be easily done through an ETF such as the ProShares Short Euro (EUFX) .

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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