Markets gyrated heavily last week, commodities spiked, then stalled, while equities sold off and then bounced. Vix was little changed suggesting that asset allocators were already hedged and there was little follow on selling after CTAs went short. Bonds (as ever) liked the idea that the Fed might hold off on rates, while EM debt markets got hit by the reality that a large part of the market is effectively untradeable for the foreseeable future. As the situation develops, we consider some of the possible longer term implications, most specifically that sanctions, by blocking trade, access to raw materials and money flows, while ultimately fungible, will lead to meaningful disruptions.
The markets had a wild ride last week as the uncertainty about Russia and Ukraine was resolved with Russia’s demonstration of clear intent on ‘Regime Change’ in Ukraine. Equities, Credits and Currencies (especially the Ruble) sold off heavily and bonds rallied along with Commodities like Oil and Gas and Grains. Only to all reverse shortly after. Likely that the commodities were already heavily discounting disruption, while the equity and credit markets remembered that, perversely, war tends to be good for assets (so long as you are not in the war zone obviously).
EM Credit has a tougher time as, regardless of how quickly events are resolved, parts of what is never a particularly liquid market are now effectively locked down for the foreseeable future. This has caused some of the more liquid credits to be sold to meet margin requirements and other liquidity events.
Oil and Gas spiked initially then fell back, suggesting that the run up in previous month had effectively discounted disruption and also due to traders considering the possible supply responses. One possible response may be to allow Iran to export Oil and Gas to the west at full price rather than at a discount to China – which would be ironic – but ultimately commodities are fungible.
Problems with Pipelines
The Nordstream 2 pipeline has long been an obsession of the US, representing as it does a closer economic bind between Russia and Germany – something that has been a central objective of US Foreign Policy to prevent happening since WW2. As such the US has been trying to prevent its completion for several year already, but in fact it is something of a red herring here in terms of German access to gas, it is simply another method of Germany buying Russian gas rather than using existing pipelines through Poland and Ukraine. (Around 2/3rds of Russian gas to the EU currently goes through Ukraine.) From Russia’s point of view, it makes sense geo-politically not to have access to one of your biggest customers going through ‘pro-western’ countries along the way and thus vulnerable to sanction, while from the US’s point of view, the loss of the transit fees from Russian gas could seriously destabilise the incumbent regimes with a risk that they could turn ‘pro-Russian’. Incidentally it is interesting to note that despite promises to the contrary given at the end of the Cold War, NATO has expanded from 16 countries to 30 including most of the former eastern block that carry piped gas to western Europe and are in turn also dependent on that gas.
As previously noted, the dependency on gas is, to no small extent, a function of Green Energy policies. Despite repeated claims as to potential generational capacity, the reality is that windfarms and solar panels can not ensure baseload stability and have to be backed up by conventional generating capacity, which effectively means gas turbines that can be ‘spun up’ quickly when the wind doesn’t blow (or blows too much) or the sun doesn’t shine. Nuclear power can provide base load, but can not be rapidly switched on and off, so the decision to ‘rely on unreliables’ has forced practical dependency on gas. Meanwhile the decision not to do fracking or further develop North Sea gas has left Russia as the main option. One, likely, consequence of the sanctions on Russia may be to bypass the green lobbyists and accelerate Energy Security measures via Nuclear power – a movement that was already underway as the reality of Zero Carbon policies started to hit home with politicians.
The second pipeline we need to consider is a money-liquidity pipeline. Over the weekend the Russians were kicked out of the European SWIFT settlement system and the should now be some serious concerns about the impact the financial sanctions could have on the wider markets. In particular, Russia has an estimated $600bn in foreign currency reserves that are not sat in US Treasuries, but mainly in the FX swap markets (and Gold). Taking that much liquidity out of the system is bound to produce dislocations – hopefully not in the manner of a Lehman – but just as the dependency of Gas is going to force western countries to adopt more nuclear, so dependency on $ markets is going to force Russia (and likely China) to adopt more ‘$ bypass’ structures. Given the importance of Russia to the Oil and Gas markets on the supply side, along with Iran and the importance of China on the demand side, the future of the Petro-Dollar, which is ultimately a fundamental source of current US economic power now looks even more challenged. Perhaps Crypto in the form of Central Bank Digital stablecoins transacted on the blockchain for major commodities will be the immediate result and disrupt FX markets as a result? After all, the daily size of the FX markets, at around $6trn, is bigger that the annual total for Global Trade. The markets seized on stocks linked to China’s alternative to SWIFT, which may not ultimately be the answer, but highlights some of the possible workarounds.
It is also worth noting that EM Bond and equity funds are facing liquidity issues that are affecting non-Russian or Ukrainian assets; with those two markets effectively frozen right now, liquidity issues (including margin calls) are forcing sales of more liquid assets, triggering a round of further distressed selling. As with the China ADR situation in 2021, the major losses will be borne by overseas investors and other EM companies/countries looking to raise external finance. As far as the Russian situation is concerned, we would fully expect Western politicians to now ‘play their ESG Card’ and demand that all western financial institutions that have signed up to the (deliberately vague) ESG commitments must now divest from Russia. In effect this means that they have signed up to follow what are essentially US Foreign Policy directives (see Trojan Horses and Slippery Slopes). Here the message of freezing Russia’s $ assets will not have been lost on the Chinese and we are likely to see liquidity being moved beyond US reach – not a fire sale of US Treasuries to be sure, but the Chinese may revisist the notion of a more international system for FX reserves – possibly based around the IMF Special Drawing Rights (SDR).
The third pipeline is (of course) the world trade and commodities pipeline. Russia and Ukraine are major exporters of a wide range of commodities, and blocking or sanctioning these will undoubtedly cause meaningful disruptions, even if, like gas, they are ultimately fungible. The Baltic Dry Shipping index is up 45% on the month – although for context it is still 60% below the Covid induced highs of last October and is better thought of as back to 2019 levels. (Somewhat intriguingly, it peaked on the day of the invasion). Thus just as we were seeing the Covid induced supply shortages start to ease, their is a risk they could spike up again, compromising the ability to control inflation. Meanwhile, as BA found out when the UK government sanctioned Aeroflot, most of the air routes from Europe to Asia go via Russia – another unforeseen consequence and a slow realisation that sanctions can work both ways.
An obvious winner from all this is, of course, China. It is a keen buyer of Russian gas in any event as well as many of its other commodities, as illustrated by the following info Graphic from Al Jazeerah. While not actively supporting Russia, not least because of its own concerns about separatists, it is certainly not going to damage its own economy to suit the demands of the US. Indeed, it will look to do the opposite.
As the world’s third largest Oil producer, Russia accounts for 27% of Europe’s Oil imports and a full 40% of its gas imports. Indeed one of the biggest customers of Russian oil is the US, which, despite being the world’s largest producer of oil and gas, is also easily its biggest consumer, such that Russian oil is 7% of US total consumption. Presumably the US and UK (at least) will have to sanction Russian exports, but it is doubtful that Europe will agree/ be able to afford to do so. The Oil and Gas lobby in the US will undoubtedly be lobbying hard to overturn ‘green’ production bans – doubtless to produce ‘Freedom Fuels”. In the meantime, higher commodity prices generally have already contributed to Russia’s ‘siege economy’ and with China and other ‘non-aligned’ states happy to buy its commodities, perhaps even in Rubles, it looks like sanctions will hit ‘The West’ harder than they hit Russia.
The Middle East also. Russia and Ukraine between them account for 25% of the world’s wheat exports and at the very least a blockade of the Black Sea ports is going to put them all effectively in Russian hands. While this will clearly be a big issue for the US Big Ag traders like Cargill and Archer Daniels who currently control the Ukraine export market, it is also interesting to look at the customers, the largest of which are in the Middle East and North Africa, as shown by this highly useful infographic from Al Jazeera. Wheat is mainly imported for human consumption and it is worth remembering that a spike in wheat prices was given as one of the reasons for the discontent and the ‘Arab Spring’ uprisings of 2013.
An obvious alternative supplier could be the US, but they produce a lot more Corn than wheat at the moment (what is third after Corn and Soyabeans) and the majority of that goes into animal feed and ethnol production. Indeed, an astonishing 30% of US corn production goes into bio-fuel production. Perhaps this too, could be reviewed in the light of the New World Order and represent another blow to ‘Big Green?’ Also, a meaningful amount of US corn is exported to China, which again might instead chose Russian supplies.
To conclude.
The traders’ initial response to the Russian invasion of Ukraine was to buy commodities and sell financial assets, but, with a few exceptions, that produced little in the way of follow through activity from asset allocators or longer term investors and so, largely, reversed quite quickly. The next stage is to think of the medium and long term consequences, not only of Russia’s actions, but of the west’s response. Near term, sanctions on commodities will hurt consumers more than producers as the biggest buyer of all – China – is not going to participate and ultimately all commodities are fungible. This could cause further economic hardship in Europe due to gas prices and possible instability in MENA as Russian and Ukrainian wheat exports are affected.
Elsewhere, longer term, the recognition of Energy (and other) Security needs is likely to encourage more traditional oil and gas development and particular more nuclear energy. It will also challenge many of the Green lobbyist’s notions such as turning corn into fuel and building solar panels over agricultural land.
Similarly with the financial sanctions such as removing Russia from SWIFT, Europe would have problems paying for oil and gas (although these can be bypassd) and EM markets generally face being hit by liquidity issues. In the near term they represent probably the greatest risk of disruption to markets as changes to the daisy chain of liquidity and leverage can have a big destabilising effect. Ultimately though, this will speed up the development of alternative systems and partnerships, essentially driving Russia and China closer together and thus represent a potential existential threat to the Petro-Dollar and by extension US soft power.
Financial markets as we know them are essentially Western based, but in the last 20 years or so have been increasingly reliant on liquidity and capital from creditor nations and central bank money printing. Shutting out the former risks total reliance on the latter, implying a whole different sort of regime change coming.
