On July 17th, a Malaysian Airlines Boeing 777 passenger plane was shot down over Ukraine, killing all 298 persons aboard. As evidence mounts, it appears that a Russian SA-11 anti-aircraft missile was used in the attack. The evidence suggests that Russian-backed rebels fired the rocket, inadvertently attacking the civilian aircraft.
In this report, we will discuss the recent escalation of tensions in Ukraine that led to the mistaken attack on flight MH-17. We will examine the use of proxies in warfare between nuclear powers, both the costs and benefits. In terms of cost, the problem of “blowback” will be analyzed, with a focus on how this situation affects Russian President Putin. As always, we will conclude with an analysis of market ramifications.
Escalation in Ukraine
Since the beginning of this year, conditions in Ukraine have been steadily deteriorating (see WGR, Reflections on Ukraine, 3/10/2014). The basic problem is that Ukraine is absolutely critical to the geopolitical stability of Russia. Zbigniew Brzezinski, President Carter’s former National Security Advisor, once remarked that Ukraine was a key element to Russia’s imperial ambitions. Putin has moved to regain control over Russia’s “near abroad” as shown by his invasion of Georgia in 2008 and Russia’s persistent interference in Ukraine’s affairs going back to the “Orange Revolution” in 2004. For the past decade, Ukrainian officials have been under constant pressure from Russia to pull away from Europe and the West, and ally with Russia. The country itself is divided, with the eastern regions favoring an alignment with Russia while the western portions would rather improve relations with the West.
In November, then Ukrainian President Yanukovych unexpectedly decided not to sign an EU trade agreement that had been previously negotiated. Instead, Yanukovych decided to join Russia’s Eurasian trade union. The decision appears to be a blatant financial decision—Russia offered Ukraine more aid and lower natural gas prices to reject the EU offer. Western-leaning Ukrainians began protests against the Yanukovych government, which escalated into an ouster of the president.
Putin was furious at this turn of events, insisting that the new government was illegitimate and refusing to accept the outcome of the elections that followed. In late February, Russia took forcible control of the Crimea, annexing the region. He also began to support unrest in eastern Ukraine, which is mostly sympathetic to Russia. In rapid fashion, eastern Ukraine became ungovernable.
Since taking office in early June, President Poroshenko, the newly elected leader of Ukraine, has steadily begun to take more aggressive steps to quell the unrest in the eastern regions. Heavy artillery and attacks from aircraft have intensified. Initially, these more intensive attacks worked against the rebels. However, it has become clear that the rebels have acquired weapons of equal sophistication. The rebels claim to have shot down at least 17 Ukrainian air force planes and helicopters.
One of the concerns of the West was how this seemingly “ragtag” group of rebels was able to quickly learn to deploy and use this new weaponry. At a minimum, the Russian military probably had to train the rebels, and it isn’t inconceivable that the Russians actually operated the systems.
The tragedy of July 17th appears to be the result of giving very sophisticated weaponry to rebels who lacked the infrastructure to use it properly. The SA-11 is capable of bringing down aircraft at a range of 80,000 feet. The Malaysian aircraft was flying at 33,000 feet, a level that was believed to be comfortably above the range of deployed weapons in the region. However, it was clear that the airline was not aware that the SA-11 was “in theater.” Usually, when operated by a state military, such anti-aircraft weapons are tied to a radar system to prevent an inadvertent attack on civilian aircraft. In this case, it appears that rebels saw a plane in the sky (at 33,000 feet, it would look like a small object with a contrail) and assumed it was a Ukrainian military transport plane, similar to others the rebels had brought down. Unfortunately, this was not the case. And so, 298 civilians died, almost certainly by mistake.
War by Proxy
If Brzezinski is correct and Ukraine is clearly important to Russia, why doesn’t Putin simply invade? The simple answer is that nuclear weapons have changed warfare.
In theory, when two nuclear powers go to war, unconditional surrender is impossible. This is because the losing side, seeing defeat and annihilation, would launch a deadly nuclear strike against its enemies. If Hitler would have had access to nuclear weapons, it is unlikely that WWII would have ended with him committing suicide in a bunker. Instead, he likely would have launched nuclear weapons directly at Moscow, London and Washington. As missile and warhead technology has evolved, the ability to launch retaliatory strikes makes a direct war even less likely.
So, the history of the Cold War is one of proxy wars. From Korea to Vietnam, the Israeli wars, and Afghanistan, there was a tendency for the superpowers to support their allies to win control over an area. Proxy wars allow the larger powers to engage in a conflict while maintaining some degree of plausible deniability.
This doesn’t mean that the use of proxies is without issues. The proxies were often difficult to control. In Vietnam, the South Vietnamese regime was often unreliable and its governance made it unpopular with the populace. The North Korean regime has been difficult for the Soviets and the Chinese communists to control. Israel was a reliable ally during the Cold War but its continued occupation of the West Bank has, at times, undermined American efforts to operate in the region. The jihadists in Afghanistan proved to be very effective against the Soviets but would also fight amongst themselves. The Contras engaged in drug trafficking. Israel supported the rise of Islamic groups to undermine the Palestinian Liberation Organization (PLO). One of these groups is Hamas, whom Israel is fighting in the Gaza Strip today.
The goals of proxies and their supporters don’t always mesh perfectly. However, most of the time, war by proxy is far preferable to direct conflict between major powers. After all, direct conflict might end in nuclear war and, perhaps, the end of human life on earth.
However, there are cases when the proxies become a problem for their supporters. The U.S. was able to arm and train jihadists in Afghanistan against the Soviets with great success. However, this support laid the groundwork for the rise of Osama bin Laden and al Qaeda. This group was responsible for a series of significant terrorist attacks against the United States, including 9/11. Was supporting the jihadists worth it? Brzezinski has argued that it was—Soviet communism represented an existential threat, whereas jihadist terrorism will probably never be as significant of a danger to the U.S. Although he is probably correct, it is safe to say that the costs of using these proxies were quite high.
Proxy wars are, by design, covert. The sponsor wants to maintain plausible deniability so as not to provoke a direct war with another major power. When proxies go “bad” and their actions adversely affect the sponsor, such outcomes are technically known as “blowback.” We would argue that the rebels’ action that brought down the Malaysian airliner is an example of blowback for President Putin. He now faces a difficult decision.
He can continue to support the rebels who are effectively making it difficult to govern Ukraine and are furthering his aims to gain control over the country. However, if support is maintained, at a minimum, he runs the risk of international isolation and enhanced economic sanctions. At worst, the U.S. could begin selling arms directly to Ukraine and put American trainers in the country to teach the Ukrainian military how to operate the weapons systems. Although such action is unlikely under President Obama, the next president will probably be more aggressive on foreign policy issues.
At the same time, even if sanctions are the only tool deployed to punish Russia for its continued support of the rebels, such actions can be quite effective. Ending Russia’s ability to clear dollar transactions would cripple its ability to sell oil and other commodities. Unless Russia is willing to hold a wide variety of currencies in reserve with few investment alternatives, losing dollar access would be very damaging (see WGR, The Dollar Weapon, 7/14/2014). As sanctions tighten, one could reasonably expect a drop in foreign direct investment into Russia and an increase in capital flight, which is already prodigious.
Or, Putin could decide that the costs of supporting the rebels are simply too high. Russia would seal the border, withdraw weapons and allow the Ukrainian military to retake the eastern regions. Abandoning rebel support would spare Russia from sanctions or worse. However, the loss of face for Putin would be a serious blow to his persona. Putin is trying to create a “Eurasian Union” that unites Russians and Slavs into a new empire and culture that is superior to the West (see WGR, Putin’s Ideologist, 4/28/2014). Ending support for the rebels would undermine this world view, even though it isn’t obvious how much support Putin has in Russia for creating this empire.
Overall, we expect Putin to continue to support the rebellion in eastern Ukraine even though the costs to Russia will likely escalate. In fact, being able to portray the West as persecuting Russians in Eastern Europe and not allowing the Putin regime to protect these Russian speakers may be worth more to him than the economic losses that come with sanctions.
It does not appear that President Obama will push for a military confrontation with Russia, so sanctions will likely be the extent of the actions taken by the West. This scenario will likely support oil prices. If Putin chooses to increase his support for the rebels and further destabilize Ukraine in response to sanctions, Treasuries and gold may also rally. We would not expect sanctions to trigger a major selloff in equities unless geopolitical conditions deteriorate into a “hot war.”
July 28, 2014
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
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.