What If Ukraine Wins?

When the Russia-Ukraine conflict first broke out, world markets were in a complete shock. Equities fell and commodities rose as geopolitical tension became the dominant price driver.

As fighting dragged on from weeks to months, other important factors took over. Besides the traditional supply and demand variables, we have witnessed a record shattering inflation rate, aggressive rate hikes by the Fed and ECB, and growing worry of a global recession.

While geopolitical risk has been put in the back burner, it never went away. In recent days, Ukrainian forces launched a military offensive and retook Kharkiv, a Russia-occupied stronghold in eastern Ukraine.

Would this be a breakthrough in the 200-day war? How would it impact world markets? Should we adjust previously employed strategies given this new development? To answer these questions, let’s first revisit our Three-factor Asset Pricing Model:

Asset Price = Intrinsic Value + Market Sentiment + Crisis Premium

Where,
• Asset Price – Expected Price of an asset at time t,
• Intrinsic Value – Trader defined fair value. It could be estimated by fundamental supply and demand factors or technical indicators. If you don’t have one, simply use the market price. This is our baseline price.
• Market Sentiment – Bullish or Bearish sentiment. This can be considered the supply and demand of investor money. More buying pulls the price up above the intrinsic value. More selling pushes the price down.
• Crisis Premium – When a crisis breaks out, it could introduce an “Event shock” to the market. It is a dummy variable, with 1 denoting a crisis, and 0 indicating the lack of it.

In our exploration of event-driven strategies on binary outcomes on June 16th (https://www.tradingview.com/chart/ZW1!/YtyfCg3f-In-Search-of-an-Edge-for-Non-Professional-Traders/), we defined the Russia-Ukraine Conflict by two possible outcomes: War and Peace.

War includes all scenarios that the Ukraine conflict would continue or intensify.

For the second outcome, how could peace be restored? It could come as a Russian victory (Win), a peace deal between Russia and Ukraine (Draw) or a Russian defeat (Loss). The recent Ukrainian military advances raise the possibility of an armistice.

Would we see a reversal of the initial crisis shock if peace is in reach? Let’s examine the following commodities.

Wheat
In 2021, Russia accounted for 17% of global wheat export, while Ukraine had a 11% share. CBOT Wheat Futures shot up 75% two weeks after the conflict started. The price shock was a market response to “perceived” loss of 28% of global wheat supply in a worst-case scenario. Market panic tends to over-shoot. Irrational price movement could be totally out of proportion of the actual supply loss.

As the conflict continued, Russian wheat found new markets in China and Iran, despite an international sanction in place. In August, Ukrainian grains resumed shipping through the Black Sea thanks to a Russia-Ukraine deal brokered by Turkey.

Wheat price pulled back to below $8 a bushel as investor realized that this big portion of wheat supply is not totally wiped out even the fighting never stopped.

CBOT Wheat is quoted at $8.69 a bushel last Friday, almost at the same price level when the conflict started. Where will it go next?
• If fighting intensifies (War), wheat price could possibly go higher on the back of high energy price and high interest rate.
• However, if a peace deal is struck (Peace), release of huge supply from both Russia and Ukraine could send wheat price sharply down.

We employed a Strangle Option Strategy on CBOT Wheat Futures in June, which carried an out-of-the-money (OTM) Call option and an OTM put option. We expected a big price move as imminent, but its direction uncertain. It appears that we are in a similar situation again.

Natural Gas
NYMEX Henry Hub Natural Gas Futures was trading at approximately $4.50 per MMBtu before the conflict. It went up 70% in the following two months and was more than doubled to $9.2 by early June.

After recession fear sent natural gas price down to $5.5, it has come back up above $8.00 as Russia cut off natural gas supply from the Nord Stream 1 pipeline. This triggered a major energy crisis across Europe.

What would happen next?
• War: Natural gas price will surge higher. Liquified natural gas from the US is more expensive, and not adequate to replace the Russian supply. Europe will be looking at an extremely cold winter.
• Peace: Sanctions will be ended. The huge oil and gas supply from Russia would flow back to global market, sending energy price sharply down.

Similar to CBOT Wheat, we may consider a Strangle Option Strategy on NYMEX Henry Hub Natural Gas Futures, and to buy OTM call option and OTM put option simultaneously. This trade is based on our expectation that a big price move is imminent, but its direction is uncertain.

Euro-USD Exchange Rate
Interest rate parity (IRP) states that the interest rate differential between two markets is equal to the differential between the forward exchange rate and the spot exchange rate. As Federal Reserve started raising interest rates in March, Euro has seen the biggest depreciation against the dollar in 20 years.

The battle between USD and Euro may also be viewed as a game of relative strength.
• US could raise interest rates faster than Europe;
• US could control inflation better than Europe;
• US unemployment could be lower than Europe;
• US economy could perform better than Europe, soft landing vs. hard landing;
• Energy crisis could worsen in Europe as winter approaches.

A peace deal could change everything. It would validate the strength of European nations in support of Ukraine. Market confidence and bullish investor sentiment would be powerful enough to reverse the steady decline of Euro currency.

Peace, Euro up. War, Euro down. It looks like a Strangle option strategy to me again.

The Equity Market
Up to this point, I have been fairly bearish about US Equity Indexes. Based on the Discounted Cash Flow (DCF) asset pricing model, I expect Fed Rate Hikes and High Inflation to suppress stock valuation.
• High interest rate increases the discount factor WACC (Weighted Average Cost of Capital), the denominator of the DCF equation
• High inflation increases production cost and reduces sales volume, which results in smaller free cash flow (CF), the numerator of the same equation
• The combined effect is a lower stock valuation

Small-cap stock indexes such as the Russell 2000 could be in a dire situation when the fear of recession becomes a real one. Smaller companies tend to have higher cost of capital and could suffer bigger profit loss compared to the Blue Chips.

New developments in Ukraine could mean an end of the war. In our three-factor model, the crisis premium could go to zero.

Typically, only one factor dominates the market at any given time. In this case, a bullish sentiment could take over. It could drive stock price higher. Investors in a celebratory mood simply discount all the bad news for a while.

Geopolitical dynamics is a game changer that investor can’t afford to ignore. Recent development in Ukraine has put a new layer to the series of discussions around “The Great Wall Street Repricing”. If you have made directional bets, this may be a good time to take cover.

Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. Tradingview users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.