12 Mar Fallout!
“The West has responded to Russia’s invasion of Ukraine by detonating its nuclear currencies. Fallout will include inflation, geopolitical instability and more.” – The Lonely Realist
Vladimir Putin has set his sights on attaining immortality by following in the footsteps of Peter the Great and creating a 21st Century Russian Empire. It was this ambition that led to Russia’s invasion of Ukraine. The West’s response was to weaponize its currencies, the Dollar, Euro, Yen and Swiss Franc. The fallout from the West’s economic detonations of those nuclear currencies most certainly will adversely impact Russia, but also will affect, and irradiate, everyone on Earth. Consequences will include not only economic upheaval and, for Russia, economic devastation, but also geopolitical stresses, political disruption, and the threat of expanding warfare. The domino effect of measure followed by countermeasure echoes the potential for spiraling conflict that presaged World War I – some might call this early stage of combat The Guns of February.
The fallout from Russia’s invasion of Ukraine and the West’s response, including expansive sanctions that blacklist Russia’s largest banks, cut-off Russia and Russian businesses from the SWIFT payments system, and effectively isolate Russia’s economy (the 11th largest in the world), affect a broad range of economic activities. The recent surges in the prices of oil, natural gas, coal, electricity, wheat, copper, aluminum, palladium, nickel, potash (a component of fertilizers), and other strategic commodities will not be transitory. Moreover, the longer the conflict lasts, the greater will be the adverse impact on the economies and businesses of Europe (which will be affected the most), America and the world (especially third-world countries). There were no such 20th Century Cold War economic disruptions between the Soviet Union and the West, both sides being sensitive to the risks of weaponizing their mutually-beneficial trade in energy and commodities. That sensitivity now has ended with the West’s adoption of crushing anti-Russia sanctions. Add to these the risk that Russia’s military operations may damage energy infrastructure (pipelines, production, exploration, etc.) and 2022 begins to resemble the early-1960s when the Berlin and Cuban Missile Crises set war-nerves on edge.
Global recession beckons. The increasing squeeze on natural resource trade and production with accelerating deglobalization and manufacturing and production nationalism will exacerbate the existing COVID-created damage to international supply chains. Existing high inflation levels and negative real yields necessarily will result in rising interest rates. “Not every recession has been caused by an oil price spike, but every oil spike has caused a recession,” an historical truism repeated recently by Brian O’Reilly, head of market strategy at Mediolanum International Funds. Russia now is experiencing merely the initial onset of economic decimation. There is more to come, far more. EU economies were already feeling the pressure of energy and commodity shortages and rising prices, and America has been experiencing accelerating inflation. Add to these that Central Banks are behind the tightening curve and that the COVID-19 pandemic continues as a major health threat. The world quite clearly is facing unprecedented difficulties. “Perhaps the scary part is that in 1990 [during Operation Desert Storm], the Fed funds rate was 8% and eventually embarked on an easing cycle. Today, the Fed is at the beginning of a hiking cycle. It seems more and more likely a recession is unavoidable,” the forecast offered by Ryan Grabinski, a strategist at Strategas Securities. Even a cursory knowledge of history confirms that all the ingredients now exist for stock market shocks and for bonds to suffer greater pain than equities.
Investors accordingly have been reducing their price expectations for equities and fixed income instruments in the belief that the world is entering a period of stagflation – high inflation paired with a foreseeable recession.
The Biden Administration has chosen to address oil and gas inflation by prioritizing a move to alternative energy sources. Counterintuitively in light of the Ukraine invasion (at least in TLR‘s view), the Administration has banned new oil and gas leases on Federal lands (and adhered to its decision to cancel the Keystone XL pipeline), choosing to reject policies that would foster increased North American oil and gas production. (A satirical take on the Biden policy can be found here.) America’s oil and gas producers, having been burned by pre-COVID over-drilling (and pressured by shareholders’ ESG concerns), naturally are reluctant to repeat past mistakes without receiving government inducements – it is not sufficient that the Biden Administration has told shale producers to “do whatever it takes” to increase production. Inducements are necessary. The result is an approach that seems to mis-prioritize the twin threats of Russia and climate change – both are real, but the rising risks of inflation, recession and World War III appear to be the more immediate. Resource nationalism today appropriately should take precedence over addressing longer-term climate risks. The facts have changed and America’s policies should change as a result. The adherence to pre-existing climate change priorities stands in sharp contrast to the Biden Administration’s turnabout in its efforts at rapprochement with Iran and Venezuela, each of which remains an ally of Russia and both of which are charter members of the Axis of the Sanctioned (previously discussed here). The Biden Administration reportedly has entered into negotiations with Venezuela to offer reduced sanctions in return for increased oil production. More surprisingly, America is continuing to rely on Russia to revive the 2015 Iran nuclear deal that would eliminate a range of sanctions and return Iranian oil to the global market (a much-criticized approach). Additional efforts by the Administration to induce America’s former allies Saudi Arabia and the UAE to increase oil and gas production to help offset Russian sanctions also have been unsuccessful. Saudi Arabia prefers to stick with its OPEC+ production agreements (the “+” being Russia) and continue to rely on oil sales to its largest client, China.
The harsh reality is that America no longer can rely on its former allies. America’s international credibility has been eroded by its withdrawal from Iraq, serial mistakes in Syria, failures in Afghanistan, and inconsistent policies with respect to Iran, North Korea, Russia, China, NATO, Libya and others, all of which sacrificed the security of America’s allies to facilitate America’s domestic political agendas. For Saudi Arabia, the UAE, Israel, Egypt, India, Turkey and other nations, good relations with Russia and China are necessary complements to their fading attachments to America.
“With the invasion of Ukraine, we’ve had our century’s version of Sept. 1, 1939 – after another ‘low dishonest decade.’ Now it’s up to Biden to save us from another Dec. 7, 1941.” – Bret Stephens (NYT 3/7/22)
Today’s times resonate with uncertainties. The Global Financial Crisis spanned 2007-09, the COVID-19 pandemic has been ongoing for more than two years, and now the world is facing its third global paroxysm in little more than a decade. As the Bret Stephens quote highlights, the Russian invasion of Ukraine echoes with elements of Germany’s 1939 invasion of Poland (a stark reality TLR has referenced in numerous commentaries). However, significant differences include that the world today has not been suffering through a Great Depression. To the contrary, 2022 should be another year of post-COVID economic growth and accelerating inflation coupled with unprecedented technological and biotechnological innovation. The differences make it impossible to draw predictive analogues. What is clear is that there will be ongoing economic, geopolitical and social upheavals with attendant unanticipated consequences – in short, fallout.
As an economic footnote, with the two exceptions of the interest-rate hiking campaign by the Fed after the Crash of October 1987 and Powell’s unsuccessful attempts to raise rates after the Christmas Eve selloff in 2018, the Fed hasn’t raised rates when equities have been 10% or more below their peak …, as they are today. The Fed’s expected rate increase next week therefore may create economic instability, the opposite of what markets are anticipating.
As a geopolitical footnote, BCA Research, a premier provider of global investment research and investment advice, has stated its belief that there is a 10% chance of nuclear apocalypse within the next year from the fallout over the Ukrainian invasion. These times, indeed, are different.
An index of TLR titles can be found here.
Finally (from good friends)