There are years when nothing happens and years in which centuries happen.
Carlos Fuentes
We’ve seen a whirlwind of events in the past week. Here are some thoughts on the most important themes.
Ukraine and the Fed
Unfolding events in Ukraine of course represent a humanitarian catastrophe — and we note that Ukraine is a nation well-versed in the suffering that attends war, revolution, and conquest. While our thoughts and prayers go to all those who are in danger and displaced, our primary role is to analyze the effects that these events will have on global economies, financial markets, and geopolitics. Those effects will be profound. We believe that they have the potential to tip the global economy into recession.
The Federal Reserve has already made a decisive policy mistake — failing to identify the persistent nature of post-pandemic inflation (in spite of market consensus sounding an ear-splitting klaxon for months). It had a very narrow window, perhaps one that had already closed, to avoid a second policy mistake and engineer a soft landing from pandemic policy. It needed to avoid going too slow (and allowing inflation to become psychologically embedded) or going too fast (and driving the U.S. economy into recession by “slamming on the brakes.”)
Russia just squeezed the Fed even harder between that rock and that hard place.
Energy and Minerals
Russia’s outsized role in global energy markets — and particularly in European energy markets — have led to wild gyrations in oil and natural gas prices as sanctions and reactions to sanctions unfolded. However, energy is far from the only important resource commodity affected by the conflict and by the sanctions. Russia currently produces 17% of the world’s high-purity nickel, a mineral which is a critical component in lithium-ion batteries — and supply was already tight before current events began to unfold. As a consequence of an unprecedented 250% price spike, London nickel trading was suspended and remains suspended as of this writing. Woe to any shorts stuck and unable to cover (such as Chinese nickel giant Tsingshan Holding Group, which assembled a bailout package — from JPMorgan among others — to avoid default).
Nickel’s Historic Price Spike
Source: Bloomberg, LLP
Of course, there are other suppliers eager to take up the slack — Indonesia immediately volunteered its services — but as we have learned from two years of supply chain disruptions, and as commodity investors have long known, the process of expanding mining supply and refining capacity is lengthy and expensive.
We note that nickel prices make it particularly puzzling that the U.S. administration is calling for a redoubling of decarbonization efforts. Soon, it will become apparent to those who haven’t yet been paying attention that green energy and transport are also highly dependent on materials — with all the economic and geopolitical ramifications that involves. Investors should also note this reality well — as we have been saying for many months in our bullish view of uranium, copper, and tech-adjacent materials.
The sudden realization of its energy fragility is leading Europe to make a whipsaw shift away from its total and uncritical embrace of decarbonization — with Germany as an unexpected leader. Both this energy shift and the EU’s newfound concern for adequate military expenditures are likely to be prolonged processes needing significant long-term inputs: bullish for materials and for defense, where US companies are undisputed global leaders.
The U.S. response has again been puzzling. The administration has seemed eager to go afield to autocratic regimes in the Middle East, where it has largely received a cold shoulder aside from the UAE, and even put out feelers to the dictatorship of Nicolas Maduro in Venezuela, or pursued a détente with the Iranian regime. If it so happened that the leadership in Washington D.C. decided that their first public appeals should be to despotic regimes before making public appeals to energy producers like Texas or Canada, then American citizens should question the quality, ability, and motivations of said leadership.
Wheat
Further, Russia and Ukraine together account for 30% of global wheat exports and 20% of global corn exports. Grain prices are spiking with the prices of many energy and hard commodities. (We note that China’s agriculture minister recently accounced that the country’s winter wheat harvest was “the worst in history.”)
Of course, food grains also depend on fertilizer – much of which is also a hydrocarbon product, produced from natural gas via the Haber-Bosch process.
Before we address the quandaries this produces for the developed world, let’s remember that the Arab Spring (the series of armed antigovernment uprisings in many Arab countries about 12 years ago) was sparked when a Tunisian man set himself on fire in despair over the price of wheat. Grain prices have existential importance for the political stability of many developing countries. If food inflation now has a similar effect, one can only imagine the geopoilitical ramifications of another refugee crisis layered on top of a European land war which still has a remote but real chance of bringing NATO and Russia into direct conflict.
The Fed’s Path Forward
All of these events occurring together are of course not a coincidence. Vladimir Putin obviously chose his moment to reclaim Ukraine as a Russian vassal state carefully. Inflation was already persistent, and already becoming psychologically embedded. Recent attempts at distraction notwithstanding, it is not only the Russian invasion of Ukraine that is driving up prices at the pump. It is the inflation impulse we have been talking about for well over a year. However, that impulse has evolved. It is now driving expectations, which suggest it is becoming behavioral.
Pandemic QE was different from what went before. Post-Financial-Crisis QE served to rebuild bank balance sheets and remained largely within the financial system — leading also to a long rally in stocks. Pandemic QE, however, was more or less directly monetized via coordinated action between the Fed and the Treasury Department, and spent into the real economy via the panoply of pandemic relief programs. More liquidity, more inflation. Russia is simply fuel on the fire — not the instigator, but an accomplice.
The Fed’s Response In Question
In simple terms, the Fed has two choices: stick to its guns — its stated plan of rapid interest-rate hikes and QE wind-down — or ease off those plans to a greater or lesser degree.
If it does the former, sailing into the wind of even more intense global materials inflation, it runs the risk of rapidly precipitating a recession.
If it does the latter, it runs the risk of even more deeply entrenching an inflationary mindset, and perhaps precipitating an inflationary recession — a legendary beast not seen since the 1970s, recounted in the sage lore of “ancient” traders, but scoffed at by the foolhardy young.
The foolhardy young may also not remember what the oldsters know about what to hold during an inflationary recession. We’ll give you a hint: it lives on the periodic table of the elements between platinum and mercury. (OK, cheat sheet: we’re referring to gold, which would benefit mightily from such an environment.)
Threading the needle has become more fraught, and recession risk is rising.
Systemic Concerns
When the pandemic hit and supply chains seized, few in the public (or policymakers) understood the fragile nature of just-in-time delivery systems. The inflationary spikes and currency gyrations currently unfolding (thanks to ill-conceived monetary and fiscal policy, war, and sanctions) threaten to reveal greater than appreciated global systemic financial stability risks. While we believe that these will be contained, anxiety about them, combined with unfolding current events, also heightens the chances of a negative impact on the real economy.
We learned during the Financial Crisis that systems meant to mitigate counterparty risk can crack under extreme circumstances, and we cannot yet evaluate the cascade of effects that may result from the excision of Russian exports and the Russian financial system from their connections with the western economies.
Accelerating Geopolitical Shifts
Two countries were notable abstainers from the UN vote condemning Russia’s invasion of Ukraine: India and China, jointly representing 40% of the world’s population. The financial sanctions being imposed on Russia are hastening a number of developments and possibly cementing a parallel suite of international financial solutions available to illiberal regimes, including China’s alternative to the SWIFT system which coordinates international transactions between banks.
Crypto — Slowly Gaining Acceptance as Integral to the Future of Money
Of course, crypto has been front and center in the news surrounding the invasion, with crypto enthusiasts using decentralized platforms to send donations to the Ukrainian government, and much speculation about Russian oligarchs and officials using crypto to evade sanctions. (In truth, the utility of most crypto for crime is limited, as recently underlined by Chainalysis, a blockchain analytics firm employed by many governments, which found that only 3.7% of crypto is in the hands of criminals.)
More significant to us was the release of the Biden administration’s crypto executive order on Wednesday. This order makes it clear that the administration understands the importance of U.S. dollar stablecoins in maintaining global dollar hegemony — and is willing to allow significant space to the private sector in crypto innovation as long as there are adequate regulations to counter fraud and tax evasion.
It reads in part: “The United States must maintain technological leadership in this rapidly growing space, supporting innovation while mitigating the risks for consumers, businesses, the broader financial system, and the climate. And it must play a leading role in international engagement and global governance of digital assets consistent with democratic values and U.S. global competitiveness.”
To us, this is bullish for crypto in the long term, though many risks still remain.
