Reflections on Ukraine

Over the past five weeks there have been a number of significant events that have occurred in Ukraine. A president has fled, a revolutionary government is forming and Russia has taken de facto control over the Crimea. The events themselves are momentous but the broader effects are of significance as well.

In this report, we will offer three reflections—Putin’s Gambit, The U.S. Adrift and A Dangerous New World. Although any of these three could be a topic in themselves, we will shorten these issues to offer a single “journey” through the current crisis. As always, we will conclude with market ramifications.

Putin’s Gambit

For Vladimir Putin, the West has been humiliating Russia since the Cold War ended. Soon after the U.S.S.R. collapsed, a series of Western economic consultants converged on Russia. Their recipe for recovery was a form of shock treatment where state-owned enterprises were rapidly privatized. Due to the lack of legal and regulatory protections, workers who had received equity tended to sell their shares cheaply to more wealthy individuals. These buyers evolved into the “oligarchs” who became fabulously wealthy on the back of privatization. The general consensus among Russians is that these oligarchs made their money by taking advantage of their connections. For Putin, these oligarchs allied with Western interests to strip Russia of its wealth and give it to unsavory individuals who then spirited their gains out of the country. The destruction of the economy culminated with the 1998 debt default.

Although Russia claims there were promises not to expand NATO, the former Eastern Bloc states clearly wanted to join the defense organization as insurance against a Russian resurgence. Poland, Hungary and the Czech Republic joined in 1999, while Estonia, Latvia, Lithuania, Slovenia, Slovakia, Bulgaria and Romania joined in 2004. Albania entered the group in 2009 along with Croatia. This expansion into the former Eastern Bloc nations was seen as an encroachment into Russia’s area of interest.

In 1999, the mortification continued as NATO, bypassing Russia’s veto on the U.N.S.C., attacked Serbia over Kosovo. Russia has traditionally seen itself as the protector of Slavic Orthodox groups in Eastern Europe. For the West, primarily led by the U.S., to attack Christians to protect Muslims in Kosovo was direct evidence that Russia’s interests were simply being ignored.

The Rose Revolution in Georgia in 2003 and the Orange Revolution in 2005 were further evidence the U.S. was pressing into Russia’s “near abroad.” Russia’s European plain has few natural defenses. Throughout Russian history, the country has protected itself by expanding into the regions surrounding the central core to force invaders to traverse longer distances to reach critical areas.

After the fall of the Soviet Union, the U.S., along with supporting the expansion of NATO, was active in the former Soviet states, establishing bases for intelligence gathering and military cooperation. When governments aligned with Russia in Georgia and Ukraine were overthrown by revolutions in 2003 and 2005, the Bush administration viewed these events as evidence that democracy was “on the march.” For Putin, this was evidence that the U.S. and the West were steadily reducing Russia’s buffers, ostensibly to lead to the destruction of Russia.

Even outside Russia and its near abroad, Russia saw America’s behavior as reckless and unilateral. Bush’s war in Iraq, lacking U.N. approval, was not ridding the world of a supporter of terrorism from Putin’s perspective. Instead, it was the act of a superpower that had no constraints. The removal of Gadhafi in Libya and the plans to bomb Syria were further evidence that the U.S. had evil intent.

During the Cold War, both superpowers fought wars but developed an understanding of the interests of the other and would tend to avoid direct provocation. Clearly, establishing this understanding took time—the Cuban Missile Crisis shows this process was not the norm in the early stages of the Cold War. But by the 1970s, both nations tended to treat each other with a wary respect. This respect, from Russia’s perspective, ended in 1991.

For Putin, who has been quoted as saying the end of the Soviet Union was a “…geopolitical catastrophe…,” these humiliations were not the only concerns. Putin has also expressed grave misgivings with Western intellectual developments. Over the past decade, Putin has become increasingly nationalistic and traditional, supporting the Russian Orthodox Church, opposing homosexual rights and stifling dissent.

For the past 300 years, the West has become increasingly tolerant. The Enlightenment principles of free speech, freedom from religious persecution and individual rights trumping the state have steadily expanded. Although this trend has generally been seen as favorable, it carries a significant danger.

Essentially, all systems of morality and ethics are based on a set of primary principles. These tenets are, in the final analysis, believable, but not verifiable. For example, the basis of utilitarianism is “the greatest good for the greatest number.” Although this sounds self-evident, note that “good” is never defined and probably not measurable.

As the West has evolved into a widening tolerance of acceptable behaviors, it tends to beg the question of “what is not permitted”? If all desires are considered acceptable, then by what basis can individuals determine ethical behavior?

Putin sees the West’s rejection of religion and acceptance of “deviant” behavior as decadent and having the power to undermine Russian society. And so, he has steadily moved to oppose what he considers non-traditional behaviors, such as homosexuality. He also arrested the members of the rock band “Pussy Riot” for allegedly singing blasphemous lyrics inside a church. And, as one would expect, Putin has moved to generally stifle dissent, putting the value of the state over the individual. For Putin’s Russia, anyone expressing a deviant position isn’t just opposing the norm; they become an enemy of the state.

For Putin, the West is an economic, geopolitical and social threat. He wants to prevent these threats from entering his world by expanding his area of influence. The first action is to expand Russia’s influence into the former Soviet states. This means rolling back Western influence in these states. The current crisis in Ukraine is tied to this goal. There are two methods Putin is using to achieve this aim. First, he is using Russia’s energy resources to force compliance; when a state defies Putin, he tends to cut off their natural gas or oil. Second, he takes brazen acts against these states, similar to the apparent annexation of the Crimea or the 2008 incursion into Georgia, to prove that the West will not come to their rescue.

It is important to note that Ukraine, though not part of NATO, signed the 1994 Budapest Memorandum where the U.S., Russia and the U.K. guaranteed Ukraine protection in return for giving up Soviet nuclear weapons on their soil. The recent Russian incursion into the Crimea appears to be a direct violation of that accord; to date, neither the U.S. nor the U.K. have come to Ukraine’s aid, at least in ways that will restore the country’s territorial integrity.

As we have noted before, Ukraine is critical to Russia’s European influence. Without Ukraine, as Zbigniew Brzezinski recently indicated, Russia is a minor Asian power. With Ukraine, Russia can project power into Europe.

The other major goal that Putin seems to be trying to achieve is pure retaliation for the perceived humiliation Russia has suffered since 1991. Putin sees the U.S. as weak and vacillating; his aim is to reduce its influence and power in the world, even at some considerable economic cost. He perceives Europe as divided; although Germany could be a formidable opponent to its geopolitical aims, the rest of the continent can be manipulated with energy and money.

The U.S. Adrift

Although the Obama administration appears to have been caught off guard by developments in Ukraine, diplomatic cables revealed by Wikileaks indicate that both Ukrainian and U.S. diplomatic and government officials were worried about Russian military action against Ukraine as early as 2009. Russia’s leases on the military bases in the Crimea are due to end in 2015 and, by all accounts, Ukrainian officials were not inclined to renew these agreements. Ukrainian officials also expressed grave concerns about America’s commitment to Ukraine’s security. The decision to not build anti-missile sites in 2009 intensified these concerns. The looming loss of these base leases could have been part of Putin’s motivation to move into the Crimea.

In contrast to Putin, who seems to clearly know what he wants to accomplish, successive U.S. administrations since the end of the Cold War have been unable to develop a consistent foreign policy theme. The building of a central organizing principle for foreign policy isn’t a simple exercise. During the Cold War, it was obvious the U.S. had to contain the Soviet Union and prevent the spread of communism. It wasn’t an easy task, but it was a clear one. There were other goals and issues, but without addressing that particular factor, nothing else really mattered. The need to contain communism and the Soviet Union automatically prioritized American foreign policy goals.

The need to contain communism led the U.S. to support unsavory dictators and essentially support the creation of al Qaeda. It also led to the long-run disarmament of Japan and Germany and, for the most part, led to a world that did not suffer another world war.

Since the Cold War, the realist “Hamiltonian” archetype that dominated that period has fallen from favor for a mix of “Jeffersonian” and “Wilsonian” models. During the 1990s, the U.S. didn’t face a direct threat similar to that of the Soviet Union. Saddam Hussein was a constant irritant and the U.S. had a couple of foreign debt crises to resolve. But, in general, the 1990s were a period of military demobilization and the spread of market capitalism and democracy (the so called “Washington Consensus”). There were diversions. The military action in Kosovo made little strategic sense. The terrorist attacks in 2001 shifted the Bush administration from what appeared to be a Jeffersonian stance (he campaigned on a “humbler” foreign policy) to an aggressive Wilsonian position. Although international terrorism was a threat to Americans, it was never powerful enough to overturn the U.S. government. The terrorism focus, which led to two intractable wars, was not a long-term basis for foreign policy. All the administrations since 1990 have been involved in the Middle East, through a series of failed peace agreements between Israel and the Palestinians, the persistent worries about Iran’s nuclear program and the general instability in the region, best expressed by the “Arab Spring.” Again, the issues in the Middle East are important but not enough to dominate the geopolitical focus.

President Obama has operated a mix of Jeffersonian reserve, avoiding conflicts or “leading from behind” with Wilsonian moralistic position. This is a rare mix; perhaps the last president to use such a mix was President Carter, who suffered some significant foreign policy reversals.

This stance is evident in the current Ukraine crisis. The president continues to frame Putin’s actions in terms of legal norms and civilized behavior. From Putin’s perspective, these terms are essentially meaningless—the West uses them to condemn other nations’ behaviors but they don’t apply when the West wants to use military action itself (e.g., invasion of Iraq or the Kosovo action without a U.N. mandate).

A Dangerous New World

America’s lack of a unifying theme in conducting foreign policy is leading the world into a dangerous situation. We work from the position that the primary reason the world does not descend into a Hobbesian dystopia is the existence of a superpower. Although the superpower does not necessarily have to be benevolent, this government does, at a minimum, enforce global order. The British Empire and U.S. superpower periods tended to produce eras of generally free trade and open sea lanes which promoted commerce and immigration.

The lack of a global superpower, on the other hand, leads to regional power configurations that tend to be unstable. Even if a region is stable, conflicts tend to arise between regional power centers. Global trade retreats because there is no superpower to enforce trade regimes and protect the sea lanes. During periods where there is no dominant superpower, economies become less efficient, inflation tends to rise and commodity prices are usually elevated because nations hoard these goods due to persistent trade disruptions and frequent regional wars which tend to boost commodity demand.Although the U.S. has no real rival in terms of global reach (China’s military would not be able to project power globally and its financial markets are not sophisticated enough to supply the reserve currency), the superpower role could simply end because policymakers cannot figure out how to execute the role without a competing superpower.

So, as the U.S. struggles to define the role, the rest of the world must adapt to this reality. Putin’s actions in Ukraine (and to a lesser extent, in Georgia) signal that American security guarantees may not matter all that much in the face of a determined regional power. Not only will this position inform nations in Central and Eastern Europe, nations in the Middle East will question whether the U.S. will protect them from Iranian aggression or in the Far East from Chinese aggression. If threatened nations determine the U.S. is unreliable, they will attempt to build their own defenses. A small or poor nation, trying to protect its security, will be likely to deploy weapons of mass destruction as an inexpensive way to ensure a regional power thinks twice before acting against it. Proliferation of these weapons will be very difficult to control if nations under threat feel they cannot rely on the U.S. to protect them.

America’s inability to define and manage the superpower role has been a concern of ours for some time. However, we did not expect to see situations that would reveal the country’s lack of planning this quickly. Thus, conditions in Eastern Europe remain fluid; one should not be surprised to see similar situations develop elsewhere.

Ramifications

Our primary investment response to the uncertainty surrounding America’s superpower role has been to own hard assets. The potential for regional conflicts, weakening confidence in the dollar and the increased likelihood of hoarding all should lift commodity prices.

Although that theme still makes sense, paradoxically, global turmoil will likely support U.S. asset prices. As unrest develops, capital flight tends to come to the U.S. as foreigners, fearful of deteriorating conditions in their home countries, move assets to the U.S. for safety reasons. Of course, multinational firms, who rely on global supply chains, will likely be vulnerable. Smaller firms could benefit. Emerging market risk could become significantly worse.

Simply put, the situation in Ukraine could be changing the investing environment away from a globalized world with a functioning superpower to something quite different. We will continue to closely monitor events, but creating a clear roadmap is difficult. If we are correct in our assessment, the investing environment could evolve in a different pattern than what we have experienced since WWII.

Bill O’Grady

March 10, 2014

¹ For details, see WGR, 1/9/2012, The Archetypes of American Foreign Policy.

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri. The firm provides professional portfolio management and advisory services to institutional and individual clients. Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication.