Is Russia's Invasion of Ukraine the Preamble to a Second Cold War?
By Jim Reardon | March 9, 2022
The Ukraine crisis might be the preamble to the second Cold War and a restarting of a long history of geopolitical, economic, and military conflict between the East and West according to Craig Fuller, chief executive of the international trade publication FreightWaves.
The world of the first Cold War is being recreated. If the Russia-Ukraine conflict’s international ramifications keep spreading, we face a real possibility of a bifurcating global economy, in which geopolitical alliances, energy and food flows, currency systems, and trade lanes could split.
“State actors such as Russia and China are choosing regional hegemony over global integration — we could see this play out further in the Baltics and the South China Sea, not to mention the Middle East and the greater Pacific. As the result, entire supply chains may be rewritten, with new sources and partners — all in the interest of corporate and national security. This will create massive volatility and unpredictability.” Consumers will face higher prices says Fuller.
Liquidity is evaporating, leading to outsize pricing. “In short, the bid-offer spread is as far apart as [Vladimir] Putin and any Western leader he talks with to at his big table” according to Michael Every at Rabobank. “Expect those spreads to get wider and wider until something breaks. Which won’t be helped by the Fed…” said Every.
The United Kingdom introduced new sanctions against Russia, including banning Russian ships from UK ports and additional economic measures. The new measures prohibit UK individuals and entities from providing financial services to the Central Bank of the Russian Federation, as well as the Ministry of Finance and National Wealth Fund. Foreign Secretary Liz Truss announced the measures stating the UK, “stands with Ukraine, its people and its democracy, and will continue to support them diplomatically, economically, politically and defensively.”
In a previously unthinkable step for German Chancellor Olaf Scholz’s government, Germany announced plans to slowly move away from Russian gas dependence. "We will change course to overcome our import dependence," Scholz said from the parliament.
This decision represents a massive and expensive reversal for the government which has depended on Russia to secure its energy needs over the past two decades. Initially, Germany hopes to substitute Russian supplies with larger deliveries of liquefied natural gas (LNG), which can be imported by sea from producers such as the United States or Qatar.
But Germany lacks the infrastructure to receive overseas gas, with no LNG terminals along its coast where tankers can dock. Their absence means it will have to import supplies through one of the European Union's 21 other terminals, a costly solution at a time when energy prices are soaring.
On France Info radio French Finance Minister Bruno Le Maire declared France was waging an “all-out economic and financial war" against Russia to bring down its economy as punishment for invading Ukraine. Le Maire's initial remarks drew an angry rebuke from Russia's former president and prime minister, Dmitry Medvedev.
Medvedev is now the deputy Chair of the Security Council of the Russian Federation. He tweeted: "Watch your tongue, gentlemen! And don’t forget that in human history, economic wars quite often turned into real ones."
It is well known that Russia is one of the world’s largest producers of energy, both natural gas and oil. So as gas prices continue to hit new highs across the country, just how much of the world’s oil does Russia produce?
(Data: EIA, Chart: chartr.co)
Data from the U.S. Energy Information Administration (above) shows that Russia is currently third in the world in daily production of Brent crude oil, with 11% of the total. The U.S.A. leads with 20% and Saudi Arabia is second at 12%.
Interestingly, Russia’s “Urals grade” oil is now trading at an $18 per barrel discount to Brent as buyers are bypassing Russian oil in favor of other exporters. Shares of Gazprom the Russian state owned multi-national Oil Company have declined 90% from about $10 to $1 per share on the America exchanges
Standard & Poor’s lowered its credit rating on Russia from BB+ to CCC- with a negative outlook.
As Russia’s economy bears the brunt of western sanctions, China has emerged as the key player with the potential to lessen its partner’s economic pain.
Beijing and Moscow have forged close ties in recent years, often aligning to oppose what they view as interference by the US and its allies.
Earlier this month, Putin held talks with Chinese President Xi Jinping in Beijing, where the two leaders declared that friendship between their countries had “no limits” and no “forbidden” areas of cooperation. The meeting resulted in a raft of trade deals, including the signing of a 30-year contract for Russia to supply gas to China via a new pipeline.
Furthermore, this week Chinese customs authorities announced the lifting of import restrictions on Russian wheat. Gary Ng, an Asia economist at Natixis, said the current sanctions regime gives China considerable room to continue legitimate trade with Russia. “With China’s support, the pressure on Russia will definitely be less, especially for financial linkages,” Ng said.
But like Germany, China lacks the infrastructure to receive sufficient overseas gas and oil, and most LNG tanker operators are vowing to stay clear of Russian products.
The Markets
To say this has been an eventful past few weeks is an understatement. For the week ending March 4th, the 16% weekly surge in the S&P GSCI index tracking commodities is the highest in at least 50 years. The cause, of course, is the invasion of Ukraine by commodities supplier Russia, and the package of Western sanctions triggered in response.
Major commodities soared last week as the crisis in Ukraine and inflation continued to roil markets.
West Texas Intermediate crude oil surged 26.3% the week ending March 4, closing at $115.68 per barrel. Precious metals also gained with Gold rising 4.2% to $1966.60 per ounce, and Silver adding 7.4% to $25.79. The industrial metal copper rallied 10.1%. Oil and other commodities, as well as gold, continued to surge this week until Wednesday March 9th, when each saw sharp drawdowns. We were watching for this as the charts on these became parabolic, and a sharp, quick drawdown was expected.
The U.S. stock market of course has not been immune to all the turmoil in markets, as it has been in correction territory. At one point this week the S&P 500 was over 13.5% off it’s high from the first of the year. The Nasdaq was over 21% off of it’s high at one point, crossing the 20% bear threshold many investors follow.
The vast majority of international markets have seen a tough start to the year as well. Both developed and emerging markets are in correction territory, just like U.S. markets. Even with the recent rally the last couple of days, each are down more than 11% so far this year.
Geopolitical Fallout
At the beginning of this year, few Wall Street analysts expected substantially weaker economic growth in 2022. Of course, no one expected Russia to invade Ukraine at that time.
Source: Lance Roberts Real Investment Advice Newsletter
In the past, geopolitical events have tended to have a limited short-term impact on financial markets.
However, when the geopolitical event involves major sanctions, as with Russia, that could disrupt trade, cause credit-related issues, or create additional inflationary pressures, consumer confidence and economic growth may get impacted and the rate of growth will deteriorate. In fact, the US economy may have peaked last quarter.
The Atlanta Federal Reserve recently estimated that the GDPNow economic growth rate in the first quarter will be 0.00%, and economic data points are softening on several fronts as you will see on our Bull-Bear Indicator. Earnings estimates will likely decline as economic growth rates slow.
The Economy - February
Until recently, the economy has been in the process of regaining some good momentum after waning a bit at the end of 2021 and into January of 2022.
Coronavirus cases have declined, governments have lifted mask restrictions and businesses are trying to deliver more goods and services. The big holdups remain the lingering shortages of materials and labor.
The U.S. gained over half a million jobs in February as every major industry was hiring in the new year. The Bureau of Labor Statistics reported the U.S. added 678,000 jobs in February. The increase in hiring lowered the unemployment rate to 3.8% from 4%. Economists had expected just 400,000 new jobs to be created.
About a quarter of the new jobs created in February were in leisure and hospitality, the industries most affected when coronavirus cases were high. Restaurants added 124,000 new jobs last month and hotels hired 28,000 people. Hiring also rose strongly at white-collar professional jobs (95,000), health care (64,000), construction (60,000) and transportation and warehousing (48,000). No industry reported a decline in employment, although the “Information” sector registered zero new jobs.
The percentage of people in the labor force rose a tick to 62.3%, though it’s still well below the peak before the pandemic. The economy would have roughly 3 million additional workers if the participation rate in the labor market was the same now as it was prior to the pandemic.
The number of Americans filing first-time unemployment claims fell to a two-month low last week as labor shortages continued. The Labor Department reported initial claims for unemployment benefits fell by 18,000 to 215,000 last week. Economists had expected new claims to total 225,000.
Meanwhile, continuing claims, which counts the number of people already collecting benefits, edged up by 2,000 to 1.48 million. That number has returned to pre-coronavirus levels.
Across the entire country, ISM’s Manufacturing Index rose one point to 58.6 in February. The increase in the manufacturing index was the first in four months.
In the report, the index of new orders rose 3.8 points to 61.7 after falling at the start of 2022 to the lowest level in a year and a half. Production also edged up. Yet a gauge of employment dipped to 52.9 to mark a five-month low.
The backlog of orders also soared to the second highest level on record, a sign that companies can’t produce enough to meet high demand.
A lack of labor and ongoing shortages of key supplies are holding back production and contributing to the highest U.S. inflation in 40 years. Timothy Fiore, chairman of the survey, said businesses can cope with labor and supply shortages so long as they have plenty of patient customers with orders.
The Fed Problem
The Federal Reserve will meet in mid-March to discuss its first-rate hike since 2018, when the Fed stopped raising rates amid a sharp market decline. However, as opposed to 2018, when there was little inflation, the Fed will be meeting with the Consumer Price Index (CPI) running above 7% and oil prices above $100/bbl.
The whole point of the Fed hiking rates is to slow economic growth, thereby reducing inflation. Unfortunately, with the economy already slowing, additional tightening could elevate the risk of an economic contraction, given that low rates have largely supported economic growth. Since earnings are highly correlated to economic growth, corporate earnings will likely suffer from Fed rate hikes.
There will be many parties interested in the actions of the Fed this month.
Reversal Of Liquidity
The most significant risk to earnings is the reversal of liquidity flows. In March 2020, the Federal Government and the Treasury, and Federal Reserve began dumping trillions of dollars into the economy to combat the effects of the Covid shutdown.
Unlike previous crisis events, the Government started sending checks directly to households to boost consumption. Remarkably, the government handed out so much money that, despite the worst unemployment this country has ever seen outside the Great Depression, personal income increased at a 12% rate.
Thus, while GDP (what we produce) plummeted, personal consumption spending rose! The end result was a stock market that quickly recovered its losses. Furthermore, the GDP surged from the increase in economic activity. 2020-21 has witnessed, by far, the biggest government cash giveaway of all time. However, that liquidity is now reversing, and without it, the GDP is expected to slow markedly.
The world socio-economic outlook has changed dramatically as the result of the Ukraine crisis and the increasing inflationary spiral. Prudent risk management led us to begin reducing stock and bond market exposure in tactical market sectors since the beginning of 2022 as this picture has darkened.
Our Cyclical Bull-Bear Indicator
Our goal is to be defensive in Cyclical Bear Markets, and to be more aggressively invested during Cyclical Bull Markets. The job of the Bull-Bear Indicator is to determine when a new Cyclical Bull Market or a new Cyclical Bear Market may be emerging. This is purely a measurement of market data, with no academic theories involved.
Our Cyclical Bull-Bear Indictor is like a barometer. It uses 90 different market data points to measure market “pressure.” A high number of positive data points (above 55) are indicative of a strong market. A move below 45 indicates that a cyclical bear market may be at hand and a reduction in market exposure or an exit from the stock market may be advisable.
Note that this indicator has been superimposed above a chart of the S&P 500. The chart illustrates how this indicator effectively identified appropriate exit and entry points in the S&P in 2000 and in 2008-09 thereby avoiding much of the ultimate -50% declines.
On the other hand, false signals (“whipsaws”) occurred in 2011 and 2016 resulting in quick reversals and small losses. A small price to pay to prevent major losses. Of course, past performance is not an indicator of future performance.
As you can see, on March 4th, this primary long-term indicator (above) dropped into bear market territory with a reading of 43.76. This is the first time in six years and only the fourth time since 2000 that the bear market indicator has been triggered. Most of our short-term indicators have turned negative as well.
It’s clear that certain market sectors have become overheated, and their companies are being repriced. Defensive measures in our Schwab accounts have included taking profits and selling vulnerable positions as well as adding defensive positions in commodities, energy, gold, and funds that have run counter to the stock markets. Currently, the Schwab accounts are holding up relatively well during the recent sell off.
At the present time, we have no stock market exposure in our TIAA IRA accounts thereby helping to preserve the record returns registered in 2021.
This market has been far more resilient than many investors ever thought possible. That suggests whatever craziness we have experienced can continue for some time. Fundamentals sometimes don’t seem to matter much in this environment. The viruses will likely recede; our government and economy are still running; companies will continue to earn profits under most conditions; and as the owners of those businesses, long term investors will continue to benefit.
Our team will be focusing on our charts and on the hard data and economic indicators that will most likely impact your investments and determine your outcomes over the long term.
Stay tuned...