By Avi Deustch
March 19, 2022 – The events of this past month mark a unique confluence of geo-political and macro-economic events that seemed all but impossible just months ago. To summarize a few:
- The Russian invasion of Ukraine demonstrated once again the uncertain nature of war even in the tech-centric 21st century
- Western sanctions pummeled the Russian economy destroying the Ruble and causing oil prices to temporarily surge
- China was thrust into the spotlight with increasing pressure to choose a side in the conflict
- Covid reared its head again with outbreaks in China and Europe
- The Fed’s first interest rate hike since 2018 marked a new phase in this unusually short economic cycle
While the long-term effects of these events will take years to digest, its apparent that we are living in a fast-changing environment with much uncertainty looming ahead. What follows is an attempt to shed some light on the implications of the above.
Russian Invasion of Ukraine
Nearly a month after the Russian invasion of Ukraine, it’s clear that Putin is relearning a hard truth that’s felled many a Goliath, namely, that conventional armies struggle with asymmetrical warfare. TikTok may have changed how wars are seen by the general public, but it does little to change the reality of boots and steel on the ground.
Much will be written in the years ahead about the failures of the Russian army, but one thing is clear— Putin underestimated the effectiveness of a Ukrainian army fighting a guerrilla-style war to defend their own cities. Their resistance is strongly supported by the availability of highly mobile anti-tank missiles which can be devastating to advancing forces. With an estimated 17,000 Javelin missiles already sent to Ukraine, and more on the way, accompanied by Stinger anti-air missiles and drones, things are not going to get easier for the advancing Russian army.
It is no surprise then that negotiations between the two sides are heating up, with a draft agreement in place that would leave Ukraine independent but mostly de-militarized, and out of NATO. The alternative, which neither side wants, is to begin leveling large urban areas to protect the flanks of advancing armor columns. Putin is aware of the West’s biases and knows that what worked in Syria is best not tried in Ukraine. In all likelihood, the Russian’s slow advance is in part a play for time to reach an agreement before casualties reach a level that makes this impossible.
The chess game unfolding in the international arena is less hopeful. To be sure, the West has galvanized strongly behind Ukraine, offering multiple types of assistance and slamming Russia with devastating economic sanctions. Inadvertently, Putin may have revitalized NATO, the European Union, and Western democracies as a whole, with a common enemy to unite against.
At the same time, it appears the West is failing to peel China away from Russia, and reports that China is considering granting military and financial aid to Russia are deeply disturbing. It remains to be seen whether the meeting this week between U.S. and Chinese leaders will make any difference.
Perhaps the biggest disappointment is the global arena is the U.N., which again failed to play any meaningful role in the face of unchecked aggression and a humanitarian disaster. If ever there was a time to reimagine this organization that was long ago kidnapped by bad actors, it is now. The failure to do so at the highest rungs of Western leadership points to the continued vacuum of vision on matters of foreign policy and statesmanship.
The Economic Fallout
If the U.N. failed to act against Russia, the same cannot be said for the majority of the Western world. The sanctions imposed on Russia have crippled the local economy, devastated the Ruble, and brought Russia to the verge of sovereign default. In a show of creativity, the sanctions on banks and partial ban from the SWIFT system excludes the Russian banks used for energy trades with Europe.
Questions still remain about the stability of the global financial system in the face an inevitable Russian default on sovereign debt. It’s unclear if Russia succeeded in making the interest payment due to investors this past week, but regardless, Western sanctions on Russian foreign currency held abroad are expected to make future payments due in U.S. dollar near impossible. Despite this, the shedding of Russian bonds by Western banks following the 2014 invasion to Crimea makes a domino knock-on effect unlikely.
As expected, the main global economic fallout from this botched invasion is volatility in commodity prices. Grain and certain metal prices remain elevated, raising concerns of worsening price inflation. The shortages in grains is likely to hurt poorer countries and consumers the hardest, and there’s little to do but hope that the war ends with minimal destruction to crops.
Most noticeably, following U.S. sanctions on Russian oil imports the price of oil jumped to $130 a barrel, its highest level since 2008. This caused gasoline prices to skyrocket, adding much anxiety to the battered Biden Administration.
Prices have since settled down, owing in part to a rerouting of oil to places like India who are purchasing Russian oil at a discount. Ultimately, oil is at least somewhat fungible, and with the incentive to increase production in different locations as prices rise, the stress on oil supplies appears comparable to pre-invasion levels.
Chart 1 – Crude Oil Futures (per barrel) as of 03/17/2022. Red arrow marks the first day of Russian invasion of Ukraine. Source: Bloomberg Finance.
Spotlight on China
The other factor contributing to lower oil prices is a recent outbreak of Covid (remember Covid?) and the resulting lockdowns in several major Chinese cities. China’s zero-Covid policy, coupled with the low effectiveness of its homegrown vaccine, may prove economically unsustainable as China’s economic woes mount. Early indications from Hong Kong may signal a shift in these restrictive policies.
Similar Omicron (and its BA.2 sub-variant) waves are emerging in England, Germany, and other European countries, just weeks after governments started easing restriction, suggesting difficult decisions ahead. This wave has yet to hit the U.S., but if history is a guide that’s only a matter of time.
Since the was in Ukraine started China has been walking a fine line, refusing to condemn Russia and parroting much of Russia’s propaganda, but not offering explicit support either. Their reliance on dollar-denominated trade and on the SWIFT system has limited its room to maneuver in this crisis. China’s central bank could theoretically act as an intermediary accepting Russian Rubles in exchange for goods and services, and even currency. Doing so however would risk incurring secondary Western sanctions, not to mention international condemnation and further association with the increasingly isolated dictator. Given China’s latest economic weakness, even before the latest Covid outbreak, outright support for Russia seems unlikely.
But if China is currently limited by the global financial system, they are working hard to ease its reliance the dollar and the SWIFT system. According to the WSJ, China is in active talks with Saudi Arabia about pricing oil sales in Yuan instead of the U.S. dollar. Coupled with the Chinese SWIFT competitor, the CIPS system designed to settle Yuan denominated trades, these trends could some day pose a meaningful alternative to the dollar.
Ultimately, China seeks to become a global leader and is weary of creating a parallel financial system that is associated with failed aggressor states. Thus it is in no hurry to stick its neck out to support Russia, though it will surely take advantage of opportunities to edge out dollar as they come along.
U.S. Economy and Markets
Despite everything happening on the global stage, U.S. investors remained focused on the Fed’s attempt to orchestrate a soft-landing that would tamp down inflation without sending the economy into a recession.
Prior to the war, the equity markets appeared overvalued and bonds sagged from rising interest rates. This weeks’ stock market rally returned the S&P 500 to pre-invasion levels with a corresponding decrease in the VIX volatility index. The main driver of this comeback, along with the Ukraine peace talks, is the Fed’s apparent commitment to more aggressive rate hikes in 2022. Equity investors appear encouraged by the Fed’s stance, betting that lower inflation will offset the impact of higher rates on equity valuations.
Chart 2 – S&P 500 Index (top panel) and Chicago Board Options Exchange Volatility Index (bottom panel) as of 03/17/2022. Red arrow marks the first day of Russian invasion of Ukraine. Source: Bloomberg Finance.
Bonds investors meanwhile appear less convinced of the Fed’s ability to balance inflation and growth. The flattening yield curve suggests limited prospect of economic growth, and while we have not yet seen an inversion of the rates on the 10- and 2-year bonds, a reliable recession indicator, other minor inversions in the curve are a cause for some concern (see here for a deep dive into yield curve inversions). We continue to monitor the yield curve closely and its impact on our portfolio holdings.
Chart 3 – US Treasury Yield Curve as of 03/17/2022 (green) vs Yield Curve on 12/31/2021. There are slight inversions between the seven and ten year rates as well as the 20 and 30 year rates. Source: Bloomberg Finance.
These recent market highs are likely but a temporary respite before the news cycle brings additional volatility to the markets. We are only slowly starting to understand the combined effect of these geo-political and macro-economic events on the U.S. economy and are continuously adjusting our portfolios to adapt to this new environment. In the meantime we end with hope that a cease fire agreement will put a stop to this most unnecessary bloodshed and destruction in Ukraine.
– AD