Random Thoughts on the Russian War in Ukraine (Hint: It’s Not Going Well for Russia)
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The following is a loose collection of random thoughts and observations on the Russian invasion of Ukraine. Rather than a coherent article, I offer some insights that have emerged as the war has dragged on.
I wrote two very timely pieces last week: one on housing and one on the Russian invasion of Ukraine. This is the latter; the housing piece is very long, so it will be broken up into two articles. Part one of the housing article will go out this week. But I wanted to share with you this piece on Ukraine today.
What follows are some very, very random, loosely connected thoughts. This is not an article. An article has a beginning and an end, with a conclusion. These random thoughts don’t follow that pattern. I am just trying to think through complex issues early in the morning and sharing with you my thoughts.
War in Ukraine outcome
I am cautiously optimistic on the outcome of the war. To win a war you need both will and means.
The Ukrainian will to win increases with every mass grave of murdered civilians uncovered with every liberated Ukrainian village. For Ukrainians, this war is no longer about territory but about survival as a nation – its invader believes Ukraine doesn’t have the right to exist (I wrote about that here).
The means of the Ukrainian army have increased substantially over the last few months. In addition to receiving more modern equipment from NATO, when they pushed the Russian army out of Kharkiv Oblast, the Ukrainians enjoyed a larger weapon transfer from the Russian side to the Ukrainian side than NATO had provided to date. Also, Ukrainians know how to use this equipment and can start using it immediately.
I heard a statistic. I couldn’t verify it, but the numbers made sense. In the early stages of the war, for every tank or other piece of heavy equipment the Ukrainian army lost, it captured three pieces of heavy equipment. In early summer this ratio fell to 1:1 (when Ukraine lost ground in the East). But in August it rose to 7:1 and it might have been as high as 17:1 in September/October.
Before the war, the Russian army was feared to be the second most powerful army in the world (after the US). Over the last eight months we discovered that it’s the second most powerful army in Ukraine.
Putin still has several strategies in his arsenal:
First, win the war by force – this one is not working out so well.
Second, scare the West economically. So far this has not worked. Europe filled up its gas reserves and through economizing, it thinks it can get through the winter.
The last card Putin has left is the threat of nuclear war. From what I’ve read, tactical nuclear weapons will accomplish very little from a military perspective, but they do have a significant psychological impact. The West has drawn a red line, telling Putin that if he uses nuclear weapons, we’ll destroy the Russian army overnight using conventional forces. The Russian army is barely defending Kherson; it is not a match for NATO.
To show how serious we are, the US has moved the 101st Airborne Division to Europe – the last time it was there was 80 years ago. I am not sure if Putin is bluffing, but NATO is not. We are sending a message to other nations, including Iran and North Korea. Also, China is watching this very closely.
The mobilization Putin has enacted may destabilize his regime. As I was growing up in Russia, my parents were terrified of my brothers and I turning 17 and being drafted into the Russian army. The Afghan war was over; Russian parents of boys did not fear for our lives but for our sanity. Being drafted into the Russian army then was like serving a three-year prison sentence. Older soldiers constantly abused younger ones.
I can only imagine the agony Russian parents go through, fearing that their sons will be drafted and, without proper training or equipment, sent to the frontlines within two weeks to become cannon fodder for Ukrainian artillery. Russia has never valued human life (this is something in common with China).
The Afghan war lasted nine years. It resulted in the death of 15,000 Russian soldiers. In eight months in Ukraine, Russia has already lost 71,000 lives. One thousand died in a single day last week.
With every grieving parent, the Russian political system becomes a little bit less stable. It is impossible to tell if or when a spark sets the system on fire, but we are observing something like this in Iran. A young woman died in police custody, arrested for violating the Islamic dress code for women. Her death has sparked protests in Iran for more than a month. It took a long time for the system in Iran to come to this boiling point, but suddenly it has.
Large-scale protests in Russia could happen tomorrow or years from now, but the chances of it happening are exponentially higher with parents living in fear for their sons’ futures. And the chances rise higher and higher with every grieving mother. The people who are the most scared of the Russian army today are young Russian men and their parents.
I have many reasons to be thankful to my father for immigrating to the US 31 years ago, and today I have a new one: I don’t have to worry about my 21-year-old son, Jonah (who was born in the US) being drafted to die in this senseless war.
The Russian economy
This war has set the Russian economy back forty years. On the surface this Russia looks very different from the Russia of the 80s I remember. This one has beautiful, modern supermarkets which still, to my surprise, are full of food. Due to sanctions and the voluntary withdrawal from Russia of Western companies, Russia will eventually freeze in time. I’m thinking of Cuba when I say this. Cuba looks today the same way it did in 1959 when Castro came to power and the West imposed a trade embargo.
Yes, Russians will miss McDonalds and Coca-Cola, but that is not a great loss; it’s probably good for their waistlines and overall health (more of them will be spared from diabetes). But the modern world runs on technology – semiconductors, software, complex manufacturing – and Russia has little of it. Today you cannot build a car or washing machine without semiconductors. This is why Russian auto production is down by half since the war started and washing machine production dropped from 600k units a month to 100k.
A wild card here is China. China has some technologies that Russia needs. For instance, it has antilock brake and airbag technology that Russia needs to restart factories that were “sold” for 1 ruble to Autovaz by Western companies when they left Russia. Russia needs oil drilling equipment, and spare parts for their planes. Will China risk sanctions from the US and Europe by exporting these things to Russia? I don’t know. After Visa and Mastercard cut off Russia from their networks, basically preventing Russians from using rubles outside of Russia, China stopped onboarding Russians to their credit card network. The Western economies combined are 20x larger than Russia’s economy.
However, the US just banned sales of advanced semiconductor technology to China. This ban sounded like the opening shot of a new Cold War with China. US companies are prohibited from selling not just certain microchips but also their latest versions of chipmaking equipment. A US citizen may lose his citizenship if hired by a Chinese semiconductor company. Our relationship with China is not getting friendlier, which naturally pushes China towards Russia.
The Ukraine war and sanctions turned Russian weapon exports into a thing of the past. First of all, sanctions have crippled Russia’s ability to produce enough weapons to fight its war. Modern missiles require semiconductors, which Russia has a hard time getting (though I have a feeling they’ll smuggle some in).
Second, today Russia needs every weapon it can get its hands on to replace the ones it lost over the last eight months. It has already resorted to using tanks from the 1970s. Finally, this war has been a sad infomercial for Russian weapons. India used to import half of its weapons from Russia. Now, the US and Europe will likely become the sole providers of weapons to India – another tailwind for defense contractors (we own plenty of those). After the war is over, Russia will be selling its weapons to rogue regimes like Iran and North Korea, but the market for its weapons has shrunk considerably since February 24th.
Until the war, the Russian economy was doing fairly well. Russians shouldn’t thank their leaders for this, but give a warm hug to their neighbor to the East. China’s insane growth (by any modern standard) drove demand for all commodities (China is a commodity-poor nation). Prices of most commodities have gone up a lot, and one-trick commodity pony Russia benefited from it. Putin jumped right aboard and took the credit for the economic rebirth of Russia. (Any smart politician does that. I see American politicians do it all the time – just follow the Twitter accounts of the last three presidents.)
However, other than mastering the production of commodities and food with the help of Western technologies, Russia has achieved very little over the last three decades since I left it for the US. Russia even imported from Germany the steel it used to make its tanks. Sanctions will likely have a significant crippling impact on the economy. We ain’t seen nothing yet.
Starting in December, Europe and the US will stop buying Russian oil. There will be a cap placed on its price – I hear it will be $60/barrel. If India or China pays more than the cap, it will face secondary sanctions from the West. India and China will embrace this chance to buy oil at below-market prices.
It is unclear what will happen to Russian production of natural gas. Most of it has been pipelined to Europe. This gig is over. The majority of oil and natural gas extraction in Russia takes place in very cold (permafrost) areas. Once you stop production, the wells freeze and it takes an enormous effort to restart them. Russia will still be selling oil, but it will have to accept any price it can get. But what is it going to do with its natural gas? Even if it builds another pipeline to China, that will take years.
Also, Western oil companies have left Russia. In addition to providing capital, they brought technology and knowhow. Both are now gone. Russia is the third largest producer of oil, behind the US and Saudi Arabia, producing 11 million barrels a day. The recession that we are going to find ourselves in will reduce demand for petrochemicals, though not by much. (Historically, recessions have reduced the rate of growth of demand for petrochemicals but did not lead to declines.) The supply of oil and natural gas from Russia will not be growing and will likely be shrinking. Europe will have a challenging winter, but it appears that the Russian economy will be challenged just to survive.
The Future of Russia
The political setback from this war has been even greater for Russia than the economic toll – it has rolled back the clock 80 years. Overnight, the country has started to resemble Stalin’s Russia. Any unkind word about the war or the Russian army lands people in jail. It is a matter of time before people start telling on each other and Russia starts reopening gulags.
History provides conflicting lessons on how long Putin will stay in power. Castro and Sadam Hussein were in power for decades. Castro peacefully died in his bed, and Sadam would have ruled Iraq for another 30 years if the US had not “liberated” it.
Vitaliy Katsenelson, CFA is CEO of IMA – a value investing firm in Denver.
How can you safely invest in a market this speculative? Check out his free series on The 6 Commandments of Value Investing.
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