Ukraine’s costly war of attrition still weighs on outlook

Attrition and conscription

In the field, the Russian army continues to systematically bombard Ukrainian towns in the east and south of the country, as well as launch missile strikes on civilians, including the Black Sea city of Odesa, and has recently taken the region of Luhansk (see maps). The Russian army has settled on tactics that concentrate firepower while better coordinating air and ground attacks. The front lines are increasingly turning into a war of attrition as Russia engages in long-range shelling, firing as many as 50,000 artillery rounds per day. Ukraine can only respond with around one-tenth of that volume of firepower. At that rate, even a recent US commitment to supply 220,000 shells to Ukraine would only put Ukraine’s artillery on an equal footing for a few days. Much depends on the balance between Ukrainian and Russian losses, and the West’s ability to accelerate supplies of ammunition and longer-range weapons to Ukraine. 

The US and UK estimate that the Russian army has suffered between 16,000 and 20,000 soldiers killed in the first three months of combat. Russia has recorded around 4,000 military deaths by name. That compares with 15,000 killed during the Soviet Union’s nine years of fighting in Afghanistan until 1989.

The army is offering bonuses to join up as it tries to plug the shortages created by the Ukraine war. In the absence of a formal declaration of war, Russia cannot call for broad mobilisation. Russia’s conscription system requires men aged between 18 and 27 to spend 12 months in the military, and recruits around 130,000 men through mid-July. Under Russian law, conscripts cannot serve in front-line roles before they have had four-months of military training. The Kremlin has promised conscripts will not be sent to Ukraine, although there are reports of such soldiers fighting there. In May, Russia ended its age restriction that prevented nationals over the age of 40 from enlisting, to boost specialist technical, medical and engineering skills. However, stories have emerged of generals called out of retirement to plug the combat losses in Ukraine.

An expanding NATO

At the international level, there is no lack of commitment, and many signs of the evolving geopolitical priorities. Last week, G7 leaders promised to support Ukraine “for as long as it takes” and a NATO meeting set out a new ‘strategic concept’ that removed wording dating from 2010 describing Russia as a ‘strategic partner.’ Instead, Russia is now “the most significant and direct threat to Allies’ security and to peace and stability in the Euro-Atlantic area.”

One of President Vladimir Putin’s stated objectives for invading Ukraine was to halt NATO’s expansion on Russia’s borders. That looks to have backfired, although it may support his domestic narrative that the country is threatened by the alliance.

The leaders of Finland, Sweden and Turkey signed an agreement that may pave the way for the two Nordic nations to end decades of neutrality by applying to join NATO. Turkey still insists that it may block accession to the 30-nation body, alleging that Finland and Sweden support Kurdish terrorist groups.

NATO plans to put 300,000 troops on alert, compared with today’s 40,000 quick response force, with a focus on deployments focussed on the Baltic states. The US is seeking to reinforce its presence with a promise to base 100,000 troops in Europe “for the foreseeable future,” including a permanent garrison in Poland, a first, plus fighter aircraft based in Germany, the UK and Italy.

Defence spending worldwide will inevitably rise to meet the evolving strategic demands. NATO guides members to spend the equivalent of 2% of GDP, though most have fallen short of that in recent years. The US’s defence budget has already risen in absolute terms, by USD 17 billion to USD 722 billion for 2022, or 3.1% of GDP, and the Biden administration has requested USD 737 billion for 2023. Most other NATO members are reversing their ‘underspend.’ Even Germany, which has historically spent less than 1.5% of GDP on defence, reached a parliamentary deal last month to finance a EUR 100 billion military modernisation, and to lift the average to more than 2% in the coming years.

Oil’s not well

Energy supplies remain a key economic and political casualty of the war. The EU has managed to reduce its need for Russian gas, as Germany anticipates that Russia may cut off gas supplies completely by the middle of this month. The bloc is also discussing plans – opposed by Hungary – to phase out Russian oil imports by the end of 2022.

Oil prices will likely continue to trade in the USD 100-to-120 per barrel range for the rest of 2022, depending on the pace of the slowing global economy. We expect strategic stock releases from the US and International Energy Agency to be adequate to meet demand in the near term. The key will come towards the year’s end, once the impact of the strategic stocks has faded and depending on demand from China’s expanding economy. OPEC (the Organisation of Petroleum Exporting Countries) has only limited additional oil capacity, with just the United Arab Emirates and Saudi Arabia able to increase supplies.

On 26 June, Russia defaulted on around USD 100 million of its sovereign debt due for settlement in May when the grace period for repayment expired. Russian Finance Minister Anton Siluanov called the situation a “farce” engineered by the West, since Russia does not lack resources to pay, but international sanctions make it impossible to transfer the funds. The country says that it wants to pay off the USD 40 billion that it owes foreign creditors in roubles. Ratings agencies Fitch, Moody’s and Standard and Poor’s have all stopped offering credit ratings for Russia since the war.

While insignificant as a global financial event, since investors have slashed exposures to Russian assets in the wake of sanctions, the technical default illustrates Russia’s increasing isolation from Western markets.

As economic activity slows in response to tighter monetary policies, equity markets have suffered as investors weigh the increasing likelihood of a US recession. We estimate the risk of a mild US slowdown in 2023 at 70%, with the Federal Reserve’s benchmark rate peaking at 3.5%-3.75%. We attribute a 30% probability to the risk of a more severe recession, where the Fed needs to move its policy rate to 4-5% to fight inflation. There is little time left for the US monetary policy to balance slowing its economy as it contains inflation, all the while avoiding a downturn. Only four scheduled Federal Open Market Committee (FOMC) meetings remain until year-end: 26-27 July, 20-21 September, 1-2 November, and 13-14 December.

In this challenging and volatile investment environment, we continue to favour a neutral portfolio position in equities, and keep an asymmetric return profile using options strategies. Since the start of the war in Ukraine we have used put spreads on US and European indices to help shield portfolio performance, and we have rolled these forward through September, while also expanding their coverage of overall equity holdings from 13% to 22%, for a euro-denominated balanced portfolio.

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