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Anatole Kaletsky: Markets already see a Putin win

Oscar Wilde described marriage as the triumph of hope over experience. In finance and geopolitics, by contrast, experience must always prevail over hope, and realism over wishful thinking.

A grim case in point is the confrontation between Russia and the West in Ukraine. What makes this conflict so dangerous is that U.S. and EU policy seems to be motivated entirely by hope and wishful thinking. Hope that Russian President Vladimir Putin will “see sense” — or at least be deterred by the threat of sanctions to Russia’s economic interests and the personal wealth of his oligarch friends. Wishful thinking about “democracy and freedom” inevitably overcoming dictatorship and military bullying.

Investors and businesses cannot afford to be so sentimental. Though we should never forget Nathan Rothschild’s advice at the battle of Waterloo — “buy on the sound of gunfire” — the market response to this week’s events in Ukraine makes sense only if we believe that Russia has won.

The alternative to acquiescence in the Russian annexation of Crimea would be for the Ukrainian government to try to fight back, either by military means or by pressuring the Russian minority in the rest of the country. That, in turn, would almost inevitably imply a descent into Yugoslav-style civil war — with the strong possibility of sucking in Poland, the North Atlantic Treaty Organization and the United States.

The West has no intermediate option between accepting the Russian invasion and full-scale war because it seems inconceivable that Putin would voluntarily withdraw from Crimea. Having grabbed Crimea by force, to give it up now would almost certainly mean the end of Putin’s presidency. The Russian public, not to mention the military and security apparatus, believes almost unanimously that Crimea is “naturally” part of Russia, having been transferred to Ukraine, almost by accident, in 1954. In fact, many Russians think, rightly or wrongly, that the entire Ukraine “belongs” to them. (The word “u-krainy” in Russian means “at the frontier,” and definitely not “beyond the frontier.”)

Under these circumstances, the idea that Putin would respond to Western economic sanctions, no matter how stringent, by giving up his newly gained territory is pure wishful thinking. Throughout its history, Russia has accepted economic hardships unimaginable to Western observers in pursuit of geopolitical goals. Thus the idea, which circulated in financial markets on Tuesday, that Putin was suspending military action because of a 10 percent fall in the Moscow stock market that day was, putting it mildly, naive.

The reality is that Putin backed himself into a corner by invading Crimea. This seemingly clumsy manoeuvre, however, far from being the foolish tactical blunder derided in Western media, is actually a textbook example of strategic real politik.

Putin has created a situation in which the West’s only alternative to accepting the occupation of Crimea as a fait accompli is war. Since a NATO military attack against Russia is as inconceivable as Russia’s withdrawal from Crimea, Putin’s redrawing of the Ukraine’s borders seems bound to prevail.

The only question now is whether the Ukrainian government will calmly accept the loss of Crimea, or try to retaliate against Russians within its new borders; thereby offering Putin a pretext for invading the rest of the country and precipitating all-out civil war.

This is the question investors must consider in deciding whether the Ukraine crisis is a Rothschild-style buying opportunity or a last chance to bail out of equities and other risky assets before it is too late. The balance of probabilities in such situations is usually tilted towards a peaceful solution — in this case, Western acquiescence in the Russian annexation of Crimea and the creation of a new national unity government in Kiev that is acceptable to Putin.

To resolve the confrontation, such a government would probably have to guarantee the official status of the Russian language and preserve Russia’s effective veto over Ukrainian relations with NATO and the European Union. This is indeed the most likely scenario, and the one most investors and businesses are effectively assuming will happen by the end of the week.

The trouble is that the alternative, a civil war in Ukraine, while far less likely, would have far greater impact on European and global economies, on energy prices and on stock-market prices around the world that are setting record highs.

Looking back through financial history at comparable episodes of severe geopolitical confrontation, stock-market investors have usually done well to wait for clear evidence of a decisive outcome before plunging in.

In the 1991 and 2003 Iraq wars, for example, investors did well to “buy on the sound of gunfire,” but only after the outcome of the engagement was clear. In 2002, the Standard & Poors 500 index fell by 25 percent during the run-up to war. It only turned decisively in March, when the U.S. attack on Iraq began, gaining 35 percent by the end of the year.

Similarly in 1990 and 1991, it was only six months after Saddam Hussein’s invasion of Kuwait, when victory for the U.S.-led forces in Iraq had become inevitable, that equities advanced strongly. They gained 25 percent over the next four months.

A better analogy for the current confrontation may be the 1962 Cuban Missile Crisis. After a summer of nervous speculation in which stock markets around the world fell by 20 percent, President John F. Kennedy confronted Russian leader Nikita Khrushchev with a nuclear ultimatum to remove Soviet missiles from Cuba. Within a week, Wall Street started rising and ultimately gained almost 30 percent in six months.

But the 1962 rebound only started once it became clear that Khrushchev was backing down and Kennedy had won the war of nerves. A logical explanation for this week’s stock market movements is that investors now see a similar outcome in Ukraine.

But this time with Russia as the winner.

Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.

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Posted: March 6, 2014 Thursday 04:24 PM