Much has happened in the space of a week. In the wake of Russia’s Ukrainian invasion, the West has responded with a series of tough sanctions designed to tank the Russian economy. Energy and other commodity prices have soared and this is shaping up to be another energy and geopolitical crisis. The last three episodes resolved in recessions, which are equity bull market killers. Fourth time lucky?
- The 1973 Arab Oil Embargo
- The 1979 Iranian Revolution
- The 1990 Gulf War
- The 2022 Russia-Ukraine Energy Shock (?)
The backdrop sounds dire. Nouriel Roubini recently warned of stagflation in a Project Syndicate essay. An analysis from Oxford Economics shows that the shocks will hit the Russian economy, but Europe will not be spared. The US is expected to see the least negative impact from the Russia-Ukraine energy shock.
As the Fed embarks on its tightening cycle, it faces a nightmare stagflation scenario of higher energy and commodity prices pressuring inflation and falling economic growth.
How sanctions hurt Russia
In response to the Russian invasion, the West collectively agreed to exclude major Russian banks from SWIFT. More importantly, the Russian central bank, Bank of Russia (BoR), will be blocked from its assets held in the West.
Zoltan Pozsar, a money market analyst at Credit Suisse, warned that “supply chains are payment chains in reverse” and explained these sanctions matter to the global financial system in a recent research note.
Today we’ll say that all global payments go through SWIFT (including payments for commodities) and so exclusions from SWIFT will lead to missed payments everywhere again: the virus froze the flow of goods and services that led to missed payments, and war has led to exclusions from SWIFT that will lead to missed payments again. But by design, and not without a risk of retaliation: if a freeze in activity can lead to missed payments, an inability to receive payments through SWIFT can freeze the flow of goods, services, and commodities like gas or neon in kind.
In the double-entry accounting world, someone’s asset is someone else’s liability. Freezing or blocking access to Russian assets can create a problem on the other ledger on the balance sheet. Let’s unpack the effects.
The BoR reported that it has $630 billion in FX reserves as of February 18, 2022. The report is no longer available on the BoR website but a screenshot was saved by Matthew Klein at Barron’s.
The asset mix breakdowns show 23.3% in gold and 12.8% in RMB, which totals 36.1% that’s out of the reach of sanctions. In practice, Treasury Secretary Janet Yellen recently announced that roughly half of BoR assets were immobilized. Regardless of implementation details, Western sanctions have turned Russia’s vaunted FX reserves into a financial Maginot Line.
How sanctions hurt the West
While blocking BoR assets and cutting Russian bank access to SWIFT may sound good in theory for policy makers to tanks the Ruble and sparks hyperinflation in Russia, the West will nevertheless have to deal with a number of unintended consequences.
The most important consideration is the possible loan losses and losses from the possible Russian nationalization of banking subsidiaries. According to the latest BIS figures dated September 2021, the four largest countries most exposed to Russia are France ($23.6 billion), Italy ($23.2 billion), Austria ($17.1 billion), and the US ($14.5 billion). Austria’s exposure is mostly accounted for by Sberbank Europe, which leaves the French and Italian banks with high exposures to Russian assets. CNBC reported that Citi flagged $5.4 billion of exposure to Russia, which represents 0.3% of its assets, though it’s unclear how much of that was in its subsidiary Citibank Russia. Is it any wonder why financial stocks are skidding?
As for Russian energy exports, the US Treasury has issued guidance to exempt this category from sanctions. That said, sanctions on the export of oil field service equipment to Russia will hobble production capacity in the long run.
Treasury remains committed to permitting energy-related payments — ranging from production to consumption for a wide array of energy sources — involving specified sanctioned Russian banks. To help protect Americans, partners, and allies from higher energy prices that would drive more resources to Russia, Treasury swiftly issued and updated Russia-related guidance to allow U.S. financial institutions to continue processing these transactions and underscore that such activity is not prohibited by sanctions.
The Fed’s dilemma
For investors, the Fed cycle is still the center of all attention. In the face of the conflict, the Fed faces a dilemma. Fed Chair Jerome Powell made the following points in his Congressional testimony last week:
- The labor market is extremely tight.
- Inflation increased sharply last year and is now running well above the Fed’s longer-run objective of 2%.
- The Fed continues to expect inflation to decline over the course of the year as supply constraints ease and demand moderates.
- The near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain.
- The process of removing policy accommodation in current circumstances will involve both increases in the target range of the federal funds rate and reduction in the size of the Federal Reserve’s balance sheet.
Here is the Fed’s dilemma. Economic growth is skidding. The Atlanta Fed’s GDPNow nowcast of Q1 growth is 0.0%.
The yield curve is flattening, indicating expectations of slowing economic growth.
On the other hand, commodity prices are surging, which puts upward pressure on inflation. Fitch warned that higher prices can have a self-reinforcing effect on inflation. While the Fed expects inflation pressures to fall as supply chain bottlenecks ease this year, higher commodity prices will make the projection of a core PCE rate of 2.6% by year-end difficult to achieve.
Inflation is a dynamic process and can be self-reinforcing. Energy price shocks related to geopolitical events exacerbate risks. Various scenarios could see inflation stay high through 2022. If core inflation were to remain high or increase further and inflation expectations started to become de-anchored from targets, this could prompt swift moves from central banks.
These conditions are laying the foundation for a stagflationary environment. Growth is slowing, but inflation pressures are still strong. Conventional thinking dictates that the Fed continues to tighten and drive the economy into recession in order to meet its price stability mandate.
That seems to be the path the Fed is on. In his Congressional testimony, Powell set a course for raising rates. While the Fed projects inflation to cool off this year, persistent higher commodity prices poses a problem for monetary policy. Powell concluded, “We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and a strong labor market.”
Powell also voiced concerns about how commodity price increases would feed an inflation spiral during his Senate testimony: “Commodity prices have moved up, energy prices in particular. That’s going to work its way through the U.S. economy. We’re going to see upward pressure on inflation, at least for awhile. We don’t know how long that will be sustained for.”
To reinforce his inflation concerns, Powell underlined the point that he is willing to drive the economy into recession to control inflation (see link to video).
Keep an eye on inflationary expectations. The 5×5 inflationary expectations are well anchored for now. Should they become unanchored, Cleveland Fed President Loretta Mester stated in an interview that the Fed may have to raise rates to above the neutral rate, which she defined as between 2.0% and 2.5%.
Rising stagflation fears
The financial markets are already beginning to discount stagflation risk. When the stock market weakened in late January, insider buying briefly ticked up, which was a constructive sign for equities. But when the market weakened again to test the January lows as geopolitical risk rose, insiders did not step up to buy. In effect, insiders are discounting a significant growth slowdown.
Bloomberg Economics sketched out three scenarios of how this crisis could resolve itself. Much depends on how energy and commodity supply disruptions play out. In all cases, the impact of the sanctions is the worst in Russia, moderate in Europe, and the least for the US. The best-case scenario, in which oil and gas keep flowing and markets calm down, sees a tanking Russian economy, a European slowdown, and a steady Fed tightening cycle. The worst-case resolves in 1970’s style stagflation and a synchronized global recession. There are no bullish outcomes.
Although the outlook appears dire, keep in mind that not all oil price spikes have led to recessions. The accompanying chart shows the two-year rate of change in oil prices (bottom panel), which was chosen to smooth out pandemic related disruptions. Since 1983, there were six price spikes when the rate of change rose above 100% and only three of them resolved with recessions.
Ed Clissold at Ned Davis Research pointed out that past geopolitical-related oil spikes have tended to be transitory in nature. If history is any guide, commodity price inflation anxiety will peak and begin to fade in about two months.
In conclusion, the Russia-Ukraine war is unsettling for the risk appetite and asset price outlook. It only accelerates the scenario I outlined several weeks ago (see A 2022 inflation tantrum investing roadmap). The market phases are defined as:
- Equity downtrend;
- Rising expectations of slowing growth or recession;
- Fed easing and recovery.
The market is somewhere in a transition period from phase 1 to 2. Tactically, the market is oversold and it could rally at any time. All it takes is the whisper of a negotiation breakthrough. Investors need to keep in mind that the Fed cycle remains the dominant driving force in stock prices. In the current environment, use rallies to reduce equity weights and overweight defensive sectors in their equity portfolios and slowly increase their weights in high-quality large-cap growth as duration plays in anticipation of falling bond yields and a flattening yield curve.
As an indication of the quality growth characteristic of large-cap growth stocks, forward estimates of the technology sector’s are still rising. This makes them a refuge for investors as economic growth slows.
Disclosure: Long TQQQ
There is a positive scenario that a newsletter I follow outlined. Half of their six Ukraine war scenarios ended with Putin being assassinated.
I am preparing a list of things to sell and buy when that is announced. Germany ETF EWG is top on the list to buy. It’s getting crushed now. Here is the chart.
https://tmsnrt.rs/3nBh7s7
Does your Winter scenario still hold if that happens?
No we get a mid-Winter thaw until Central Bankers continue the war on inflation. Spring comes when the Central Bankers are victorious or they surrender to inflation.
It’s somewhat surprising that Putin hasn’t already been taken out. How much of that hesitation is due to the current ‘politically correct’ global culture of our time? We have a demoralized/understaffed police force in San Francisco restrained in carrying out their responsibilities by a DA who is disinclined to prosecute much crime (and who is in turn supported by liberal councilmembers more interested in the rights of transients/ addicts than in curtailing the thefts/ robberies/ assaults perpetrated by these transients/ addicts on the tax-paying residents of the city).
Now we appear to be standing aside while a dictator flouts human rights and commits war crimes. Self-defense is a basic right. Biden + allies have every reason to engage the Russian air force/ infantry.
World war 3 would be bad for investments, pretty sure. Putin is unhinged and a direct confrontation with a nuclear state is in no one’s best interest. A measured response is frustrating, perhaps better to consider the array of financial war that has been waged in less than a week, and the strengthening of the cross Atlantic partnership. This will put pressure on Putin internally.
Putin will not succeed IMO. Ukraine is not going to roll over. It will be bloody and horrible and take longer than any of us would want, but in the end Putin will be a defeated.
Understood. But we need to put ourselves into the shoes of those already in the line of fire. The threat of nuclear war has existed since I was a child.
(Personally, I’m sure there are multiple stakeholders in the background already in the process of preparing to terminate the war one way or another.)
Read Ross Douthat in The NY Times today.
Right. A cold war is based entirely on subterfuge and deterrence. What we have right now is an unprovoked direct assault on a country that is currently not part of NATO. Left unhindered, Russia will likely destroy millions of lives and overtake Ukraine.
If Putin then decides to invade Poland, the US is obligated to engage Russia.
Does it all come down to a twist of fate – could the EU have preemptively offered EU membership to Ukraine and prevented an assault, for instance – or would Putin have used that as a pretext for war? I don’t have the answers – I have an opinion, one undoubtedly shared by several advisers to Biden. A good case can be made either way.
China is good at playing the long game. Perhaps Xi will come up with an exit plan that offers Putin an ‘honorable’ way out – as honorable as possible under the circumstances.
‘The only thing necessary for the triumph of evil is for good men to do nothing.’
We can certainly argue that imposing global sanctions is doing much more than nothing. But is it sufficient?
In the Feb. 12 blog I posted “There is one stock in the top list of MOO that I consider the best investment in the world today.” I hope readers were able to find it. Someone said at the time, it was likely the Canadian potash stock Nutrien. They were right and I hoped it would be an easy choice for anyone who realized I never recommend stocks and were curious.
The Monday close on Feb. 14 for Nutrien was $73.39 and yesterday’s was $94.99 for a 29% gain in fourteen trading days. Likely, has been the “best investment in the world.”
I never comment on an individual stocks but this one stood out so plainly. Sorry for my regulatory need to be not forthright with the name.
I’m still holding it for my clients. The easy money may be gone but it is just 9 times rising forward earnings with a valuable, needed product to grow more food. The prices of agricultural products are so high that farmers will be making huge profits and afford fertilizers that add more production and income.
Even in investment ‘Winter’ season, the occasional opportunity pops up.
If you’re interested in the sector and longer term, £EML could be worth studying.
A pre revenue potash producer in Morocco, if they execute they will be producing, and crucially transporting potash far more cheaply than most competitors.
Sometimes positive developments arise out of left field. Here’s one possibility. A three-hour meeting face to face? Better than anything I’ve heard yet.
‘Israel’s Prime Minister Naftali Bennett met for about three hours Saturday with Russia’s President Vladimir Putin in Moscow, according to an Israeli official.
The unannounced meeting took place with the blessing of the US administration, the Israeli Prime Minister’s Office said in a statement.
The Israeli official said that Bennett’s diplomatic push was also coordinated with Germany and France and added that the Israeli leader “is in ongoing dialogue with Ukraine.”
Following the conclusion of the Moscow meeting, Bennett is now en route to Berlin for a meeting with German Chancellor Olaf Scholz, the Israeli official said.
Three days ago, Bennett held separate phone conversations with both Putin and Ukraine’s President Volodymyr Zelensky.
Zelensky has appealed to Israel to mediate efforts to bring about a ceasefire.
While Israel has condemned Russia’s invasion in comments by Foreign Minister Yair Lapid, Bennett himself has avoided direct criticism of Russia or Putin.
Israel has sought to maintain good relations with Russia in recent years so it can continue air strikes against Iranian targets in Syria – which Israel regards as critical to prevent the transfer of precision-guided missile technology to Hezbollah.’
Well, if the eurozone is weaker, and there is scrambling for the $ then a hedge shorting the European stocks and going long the US stocks with a potential bonus from a stronger dollar could happen.
Just because something makes no sense does not mean it won’t happen.
I was struck by a similarity to 2000. Remember the Y2k bug and everyone was worried. The Y2k could have impacted tech the most. What happened was this nasty whipsawing rise and as 2000 approached and things seemed to get fixed, the nasdaq blew out. Makes me wonder if there was some kind of short squeeze going on, aside from the mania.
So now we have rates to rise, QE to be ended…both of these telegraphed just like Y2k. The tensions between Russia and Ukraine are not new, just the actual war.
So keep an eye out for a whipsawing rise in the markets, a catalyst like the war ending, covid over, Fed pause, we could get a repeat of 2000 nasdaq.
Powell did not answer the question about Volcker, he just said he hoped history would record that he was “prepared” to do what it takes. Not that he would do it, and if the war ends, commodities soften, inflation abates because of demographics, yoy stuff and they bump rates to 0.5 by June then stop…history will say he was prepared. Remember, these guys dissemble, he’s not going to say that rates WILL BE 10% by dec 2023, and he’s not saying they will do nothing. The takeaway is we’ll know when it happens.
If we get a meltup and of course the inevitable crash rates will go down to zero or lower. There will have been more excesses in that scenario and more consequent damage.
Of course the market may be starting a bear.
OMG! Don’t know how he’s positioned now, or what he is smoking? Can’t be good.
https://twitter.com/BillAckman/status/1500267394329108482
Two questions for all:
1. Despite a war in Europe, rising inflation, a hawkish Fed, slowing economic growth, how come the US markets are still standing tall?
2. Assuming there is a ceasefire in the coming week(s), what happens to the SWIFT sanctions and the freezing of Bank of Russia reserves? How long does it take before at least the economic relations normalize somewhat?
Thank you.
From JPMORGAN, a more sanguine perspective:
Investment takeaways: Look at the trendlines, not just the headlines
There is really no way of knowing what the ultimate outcome of the Russian war will be. We need to rely on our read of market history, which suggests that the economic trajectory that existed before the shock tends to continue. The exceptions happen when things like energy price shocks precipitate a change in economic conditions. While that is clearly a risk this time, we think that the U.S. economy can continue to power through higher energy prices.
Ultimately, we believe that markets will be able to see the longer term and stabilize (see the experiences of COVID-19, or Brexit, or elections, or countless other geopolitical events through post World War II history). While the violence in Eastern Europe will likely continue, investors should not forget to focus on the basics: examining corporate earnings, inflation, central bank policy, and interest rates in order to make decisions. There will be volatility on the way, but fundamentals prevail.
I wonder if there is a distribution to retail investors going on before a pull rug operation.
That’s when the euphoria phase happens, if it does. It is a classic that retail buys at the top. Of course retail buying does not mean a top, but was retail euphoric at new year’s? No we were all spazzed out over Omicron since Thanksgiving. GME Reddit boys driving it up to 500 or so, that was euphoria, but narrow in focus. If we get a “nothing can stop this bull moment” as it smashes to new highs, get worried, well worried more than you are already.
The second half of 2020 felt like some kind of euphoria in terms of retail being convinced that central banks would always drive stock prices higher. Whatever is being thrown at the stock market, the Fed will always respond with moar QE – and even with inflation showing up in the data, they will ignore it because they are determined to throw liquidity at the markets. In hindsight it looks like this created indiscriminate buying, with a lot of weaker tech stocks being lifted to irrational highs and this doesn’t mean just ARKK, but also names like Meta/Facebook, Netflix and PayPal. NVDA also comes to mind as an example of euphoria and now the chart doesn’t look pretty. While the stronger tech stocks like Apple, Google and Tesla may continue to hold up well, will they be lifted back to the old highs?
For me, euphoria is an in spite of everything moment…when trillions of $ get stuffed into the system, acting crazy makes sense.
If the S&P breaks 5000 and you start seeing predictions of 6k, 7k etc and glorious pictures of a bull goring a bear…lol.
The Chinese will have their own issues over Evergrande I think.
This is the age old question of dumb money vs. smart money. JPMORGAN as an asset manager, among other things, is in a fiduciary role for its clients. So, I think they are giving their best thinking. No guarantees that they are right though. I don’t think anyone really knows the outcome. Heightened uncertainty and volatility. Some investors go for safety, some for higher risk/reward.
We are evaluating a position in Gold. Foreign governments are likely to hold more of their reserves in Gold in the future. One consequence of sanctions on the Russian Central Bank.
The Chinese now know the western playbook as a response to military aggression, no direct military involvement but economic sanctions. They have a strong incentive to prepare for similar economic sanctions in the case of a Taiwan invasion.
They CCP have been preparing for a long time. That is the main reason for the economic war against my country (Australia) that has been in progress for ages. No doubt they are taking further notes but there are many things they cannot produce of sufficient quality.