Ill omens
Worrying news from the Eastern fronts
Some people are scared easily and jump at the slightest noise. Others like to raise the alarm because it gets attention. But many others in our hyper safe modern society have been conditioned to ignore fire alarms because “it’s usually nothing.” Alarms go off all the time, but fires are rare. Why not finish your coffee and wait to see if others start to move for the exits.
The same behavior is observable in markets, especially in relation to non-standard tail risks like those from politics or geopolitics. For most of the last few decades, excess returns – so-called “Geopolitical Alpha” – accrued to those who bought the dip when others panicked, reinforcing “it’s usually nothing” complacency. False negatives greatly outnumbered non-standard events that had a permanent effect. This is one of the reasons that Donald Trump’s second term has been so shocking for markets: it’s not nothing and it is happening with alarming frequency.
That said, geopolitical risks remain the dog that hasn’t barked. Israel and Iran had a “12-Day War” in which the US participated but you wouldn’t know it from market prices. Perhaps that’s why markets appear to be sanguine regarding two seemingly unrelated but potentially worrisome developments in Eastern Ukraine and East Asia. Hat tips to @bigserge and @HFIR, respectively, for bringing them to my attention. With volatility markets showing signs of Trump fatigue but still warry of Trumpian shocks, hedging non-standard risks is far more challenging than when I wrote Geopolitical vega or recommended long volatility of volatility strategies following President Trump’s election. But there are still opportunities to hedge recent ill omens if you look carefully.
Key insights
Russia is on the verge of a major breakthrough in the Ukraine war that could dramatically shift the battlefield and bring about a rapid peace in Russia’s favor.
China’s accelerated commodity binge is a worrying sign they may be readying for war this year.
Though seemingly unrelated, these are positively correlated risks: each disperses both Western attention and military deployments, increasing the likelihood of the other.
Trump-era volatility of volatility has made hedging through deeply out-of-the-money options prohibitively expensive, but positive-carry direct hedges exist, particularly for those willing to accept US dollar exposure. I suggest ten potential hedges, dollar and non-dollar exposed, that span currency, rates and commodity markets.
This week, unrelated developments in two different regions raised my level of concern over consequential geopolitical risks. The first is increasing reportage that Russian troops are overtaking Ukrainian positions in the critical logistical node of Pokrovsk in the Donetsk Oblast of Eastern Ukraine. The second development is the sharp build-up in commodity stocks by China. The first could portent a rapid collapse of Eastern Ukraine and a de facto end to the war on Russian terms, inflicting a major strategic defeat on Ukraine’s Western backers. The second might reflect Chinese preparations for an embargo or invasion of Taiwan this year. Though the developments are unrelated, the risks are not, as one likely increases the risk of the other.
So goes Pokrovsk, so goes Eastern Ukraine
Last Fall, I explained – 10 months too soon – why Pokrovsk is critical to the defense of Ukraine east of the Dnieper River. Roads and rail links make it a key logistical hub for Ukrainian defenders who are further aided by its relatively higher elevation in an otherwise featureless plain. The city anchors the Ukrainian lines in Donetsk Oblast, one of five Russian-claimed provinces in Eastern Ukraine. The loss of Pokrovsk might allow Russia to break the stalemate of trench warfare, reopening maneuver for a sweep through Ukrainian positions to the Dneiper River that bisects Ukraine, forming a formidable defensive barrier between the East and West of the country. For this reason, the city has been a primary focus of both Russian offensive efforts and Ukrainian defense for much of the last two years.
Reports emerged this week that Russian forces have nearly encircled Pokrovsk, are operating in the city itself, and that Ukrainian forces are beginning to withdraw.1 I first brought up the risk of Pokrovsk’s fall in my research last summer but Ukrainian defense of the city was far fiercer than expected. Now even the Ukrainian government is acknowledging that the situation is dire.2 Polymarket now puts the chances of the city falling by yearend at over 80%, with nearly 1-in-3 odds that it falls before the end of August.
The risks that Russia could overrun Ukrainian positions and rapidly take much of Eastern Ukraine once Pokrovsk falls also have risen. For over a year there have been increasing reports of widespread desertion by Ukrainian troops, difficulties conscripting and fielding enough troops, of fighter exhaustion, and the risks of Ukrainian lines collapsing across the 750-mile long front line.3 It also comes as the Zelenskyy government faces its first widespread public protests since the war began (albeit on unrelated issues).4
Lost Western credibility and a political crisis for Europe
The loss of Pokrovsk to Russian forces would be a major blow to Western efforts to secure a peaceful resolution to the war on less favorable terms to Russia. Russia would have little incentive to restart negotiations that broke apart this week with no progress or to offer any concessions.5 Indeed, Russian actions appear to suggest that it is preparing for a sustained push to the Dnieper. The Russian Duma passed legislation this week increasing the state’s ability to raise conscription, and consistent with Pokrovsk pivotal role in reopening maneuver warfare, there are unconfirmed reports of a buildup of Russian forces East of Pokrovsk and to the South in Zaporizhia Oblast.6
If the fall of Pokrovsk did lead to a collapse of Ukrainian lines to the Dnieper it would be more than just a setback for Ukraine’s Western backers, particularly those in Europe. It would be a strategic disaster. Ejecting Russia from Eastern Ukraine would be impossible without a level of Western military commitment that has proven politically infeasible and could raise the risks of crossing the nuclear threshold. Russia likely would declare victory in its “special operation,” having retaken all the Ukrainian oblasts it currently claims and ending the war on its own terms. Western credibility would be in shreds and Europe, in particular, likely would suffer a political earthquake of recriminations and insecurity given rising populist pressure that has generally been antiwar.
Why is China in such a hurry to stockpile?
The other development that caught my eye this week was China’s accelerating stockpiling of critical resources. While this has been going on all year, the startling pace – and nearing completion – of its strategic petroleum reserve build was only made clear to me by a chart from @HFIR. According to their calculations, China is only 90 million barrels – or three months at its current pace of stocking – from filling its newly expanded reserve facilities. That raises two uncomfortable questions: (1) What’s driving the recent urgency to fill it? (2) And, what happens when they finish?
China has been stockpiling more than just crude oil, and all in a seeming hurry: coal, cobalt, copper, gold, grains, iron, and nickel.7 Because China’s actual inventories are state secrets and it provides no transparency on either its targets or motives, analysts have made various conjectures from a sign of economic weakness to taking advantage of low prices to precaution against potential US sanctions to preparing for an invasion of Taiwan.8 It is hard to reconcile accelerating imports with the economic weakness thesis, and while the prices of some stockpiled commodities (cobalt and nickel) are near cyclical lows, the prices of others are relatively high and rising sharply (copper, crude and gold), calling into question bargain hunting as a motive.
Preparing for trade war? Or hot war?
That leaves preparing for conflict with the United States – either strategic restrictions under Global bifurcation, or war over Taiwan – as the likely motive for stockpiling. The former cannot be discounted. US controls on technologies have been increasing steadily since the first Trump Administration and both China and the US reached into the embargo playbook during the rapid escalation of trade tensions following “Liberation Day.” Further, the US and its European allies have made threatening noises about enacting a broader set of sanctions on China for its tacit support of Russia in Ukraine.
But one also can’t discount that China is preparing for a hot war. Its military buildup and preparations, which I have documented extensively (here and here), as well as its direct threats to achieve reunification by force need to be taken seriously. Furthermore, as my partner David Kilcullen notes in his book The Dragons and the Snakes, China’s much broader definition of warfare that includes actions like lawfare or economic sanctions raises the risks that it misinterprets US actions as a declaration of war and China responds kinetically.9 China may also see the US turn towards reindustrialization and rearming as narrowing the window in which it has a clear strategic advantage in the Western Pacific, encouraging it to move forward any planned action against Taiwan.
If preparation for a hot war is the motive the acceleration in stockpiling and the nearness of its estimated completion (at least for crude) worryingly suggests the timeline may be this year. If so, as I described in May you live in interesting times: The Wheel of Fortune, a full Chinese blockade and embargo of Taiwan is the most likely course of action, backed with a threat of invasion to force submission. Because October is typically monsoon free, making an amphibious invasion less risky, that suggests that the embargo could start as early as August.
Correlated risks
If Chinese stockpiling is related to war preparations, the coincidence of its planning window with Russian advances in Ukraine makes the two risks self-reinforcing. A collapse of Ukrainian lines would both distract the West and draw American resources away from the Pacific, lowering the risk that China would face an American response to an embargo of Taiwan. Similarly, a Chinese move on Taiwan would draw American resources out of Ukraine, easing the Russian path to victory.
