March Market Thinking

1 min
March 10, 2022
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Regime Change

Vladimir Putin’s adoption of established ‘Western’ tactics of Regime Change does not mean two wrongs make a right, not at all, but it does suggest that many other regimes will change as a result, regardless of how quickly things are resolved. More accurately, a number of pendulums that were already swinging will accelerate. Energy and Food Security issues will not only lead to more exploration and production, but also a wider push back against the extremes of Net Zero and especially encourage more Nuclear. Financial Sanctions will drive a non Dollar bloc as well as a greater integration of China and Russia. Reshoring will continue as the latest variant of Globalisation falls apart. Already we see how in the near term sanctions are disrupting not only the physical supply chain and the energy pipelines, but also the monetary supply chain and the money pipelines too. Meanwhile, possibly the biggest regime change of all may be that the Fed stops caring about the wealth effect and flips the yield curve…

There are a surprising number of similarities between Ukraine and Covid. Obviously the sudden shock spiked risk premiums and subsequent moves are about trying to digest not only the event but also the second order issues of the reactions to the policies that arose in the light of the event (Lockdowns v sanctions). In true City fashion, we are scrambling to expand our knowledge about Geo-politics in the same way that we did about epidemiology, but in a lesson learned from 2020 we need to be careful not to fall for the traps of logical fallacies, especially the Appeal to Authority. Sorry to say, but many of the experts (on both sides) need to be recognised as having a singular agenda, just as they did with lockdowns, masks and vaccines. In this context, aggressive moves by western governments to shut down debate and frame everything as ‘Putin going full Tonto’ (to quote British Defense Minister Ben Wallace) are simply going to blind us in the Fog of War. It is not supporting Putin to point out that this is in the context of long term Cold War ‘Chess games’ between the US and Russia, but it may help us understand how we get out of this.

Meanwhile, from a markets point of view, we would argue that as and when we do emerge from this conflict, that just as with Covid (which has almost entirely disappeared as a narrative – except sadly in Hong Kong) we will find that a number of existing trends have been accelerated. In particular, we would suggest the move to a multi-polar world, including large scale de-dollarisation, de-globalisation, and greater energy and food security. We also suspect that the more aggressive elements of neo-liberalism will be in retreat and that nowhere will that be more important for financial markets than if and when US politicians and the Federal Reserve start to embrace Common Prosperity and focus on the 40% who own nothing and see no benefit from the so called wealth effect of the Fed Put and those who own everything. Now that would be a regime change!

Short Term Uncertainties

Obviously the biggest short term uncertainties are about the extent and duration of the war now going on in Ukraine. As we saw in the immediate aftermath of the declaration on 22/02/2022 traders are trying to push markets first in one direction and then another (see previous post Ukraine and markets). The real short term trading volatility however appears to be in the Commodities space. The dramatic spikes in commodity prices this week (Nickel up 70% in particular) are largely a function of margin calls from producers who have gone short (sold forward) actual production and have been caught in a short squeeze due to the west’s sanctions on Russia. There will also have been other speculators caught out by the sharp moves Of course, all leveraged markets suffer from a ‘cascade effect’ where they scramble to cover futures or options positions – and it’s amazing to think, as Oil spikes to over $130 that less than two years ago similar but opposite moves led it to briefly go below zero (as we discussed at the time in Sell Mortimer Sell).

It’s hard to remember that, as it passes $130, less than 2 years ago Brent briefly went below zero

While the short term gyrations of the commodities markets getting ‘short and caught’ may dominate the headlines, we should not lose sight of the implications of disruptions to the flows of raw materials due to western sanctions on Russia. As this table (sourced by us from the excellent Moon of Alabama blog, but originally sourced as noted) illustrates, while most commodities are ultimately fungible, replacing Russia sourced inputs will be highly disruptive across a wide range of industries in the medium term.


In terms of disruption we also have to add in Ukraine of course (as previously linked). Russia also supplies 50% of enriched uranium for Nuclear fuel, which makes its dominance of energy markets even more crucial and in the light of the links it has with Iran and the Joint Comprehensive Plan of Action (JCPOA) it could stymie US plans to restart the JCPOA and reduce pressure on Oil markets (although we suspect that most Iranian Oil is already going to China!)

Medium Term Risks

If short term uncertainties are concentrated in the commodities markets and other positioning and liquidity factors, which will only appear over the next few weeks, we suspect that, as with Covid, many of the second, third and even fourth round impacts of the invasion of Ukraine will be a function of the policy reactions to the initial event rather than the event itself. Thus while the short term gyrations in equity markets reflected the fact that medium term asset allocators were already largely hedged (Vix barely moved) and long term investors remain on the sidelines, we believe the next few months will start to reveal some longer term strategic shifts.

Chart 1: Vix suggests Asset Allocators were already hedged

Source Bloomberg, Market Thinking

In the meantime, we should be looking at the March options expiry coming up on March 19th for more clues on positioning. We have always regarded March as probably the most important of the quarterly expiries and rather like in 2020 a decision not to roll over medium to long term put protection can provide an upside impulse to markets – especially if, as previously discussed, the market is in a ‘short gamma’ position that means options market makers are acting as amplifiers of market moves rather than counter-weights.

The obvious medium term implications are associated with physical supply chains, which will alter even if the crisis is resolved quickly; energy security is now more important than concerns over nuclear power for example and dependence on imported gas will lead to increased attempts at finding other sources, such as fracking. Then there is the money and liquidity supply chain; the weaponisation of finance by the US will, in our view, accelerate the move to alternative systems, by Russia out of necessity, but also by Asia in general.

Long Term Trends – many regimes changing

We suspect that in the future 22/02/2022 will be looked back as a day of more widespread Regime Change than simply that attempted by President Putin. Regardless of how quickly the crisis is resolved, energy security is an obvious fall out from this, as governments long in denial of well documented energy policy failures are galvanized to resolve them. Blaming the dramatic escalation in energy prices on Russia (as they are already trying to do) is not going to work. The current dependency on Russian gas will lead to alternative sources of gas including Fracking but also more E&P generally and a ‘patriotic push back against the puritans‘ promoting all things Green (ignoring their cries for even more of their expensive unreliables). This will also enhance the existing swing towards small nuclear that was already underway, which means more focus on Uranium.

Similarly on interest rate policy, we might suggest that the Fed Put is more important to markets than Putin. Another straw already in the wind prior to Ukraine was the idea that the political aspect to the Fed might itself have a ‘regime change’ and start to focus a bit more on the 40% in the US who own nothing and a bit less on the 1% who own almost all the financial assets. Instead of focusing solely on the wealth effect of rising stock markets and house prices, they may instead try and ‘do something’ about inflation, specifically by inverting the yield curve. Not quite “Common Prosperity”, but going in that direction. Equally, an inverted yield curve would effectively reduce the influence of a lot of the so called ‘alternatives’ like Private Equity, Private Credit and leveraged loans as well as the carry trade in general.

Third, we have the likely impact of the world splitting into a Dollar and a Non Dollar bloc. Whatever happens next, China is not going to continue to trade (and maintain balances) in $ now that the US has revealed its likely actions if you conduct policy it ‘does not approve of’. (This is nothing to do with Taiwan incidentally). As the infographic shows, China is the largest trade partner for 2/3rds of the world and with it likely to be buying most of its hydrocarbons from Iran and Russia (albeit the markets are fungible) and not using $s, the latest weaponisation of the $ trading system is going to hasten the end of the Petro-Dollar. It is also going to undermine the ‘Exorbitant Privilege (as De Gaulle put it) of the $ as a reserve currency, something we have discussed before. We still suspect that China has a plan to peg the Yuan to some sort of currency basket – the most obvious being (as we noted back in 2019) the Strategic Drawing Right (SDR) of the IMF, not least because it would also allow SDR borrowing to replace $ borrowing for emerging markets and thus reduce their sensitivity to US Monetary policy – as well as its influence generally.

China is the largest Trading Partner for 2/3rds of the world. What happens when (not if) it stops using $s?

Source Visual Capitalist

This would of course have knock on effects for emerging markets, especially if the current ‘flight to quality’ in $s switches to a $ depreciation trade. Second, and in a way far more structurally important, what happens to FX markets in general? The $6trn of global trade illustrated on the map generates that much activity every single day in FX trading volumes. Put simply, enormous amounts of $ leverage are employed not so much to provide liquidity for Global Trade but in order to facilitate front running and speculation of those flows by the major banks. (Try and find a successful FX trader not seeing ‘the flow’). We know from the recent $1bn fine from the EU for major banks running a cartel that the problem is significant and that the fact that the top 10 western banks controlled almost 75% of the market in 2016 (something that will only have got bigger since then). According to some sources, the first quarter of 2020 saw FX profits for the top 10 banks jump 25% as this and and other trading revenues hit record levels of over $30bn.

Finally, and linked to the above, there is Crypto. Blockchain and smart contracts will undoubtedly remove a lot of the big banks from the flow on which they rely for their trading profits, but as a bigger issue being accelerated by Ukraine All governments have been worrying about losing control over ‘money’ and it may be that they see this ‘crisis’ as their chance to control crypto currencies, using the excuse that Russia is able to bypass sanctions. President Biden has just issued an executive order and while Bitcoin jumped on the news, we suspect that this is another regime change underway.

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