This article takes a look at global macro implications that are arising from the Russian invasion of Ukraine and the associated response of global sanctions.
Global Supply Chains: Efficiency vs. Resiliency
Starting in the early 1980s, China began to open its economy to the rest of the world. And then starting in the early 1990s, the Soviet Union collapsed and its various former states also began to open their economies to the world.
This combination brought a massive amount of untapped labor into global markets within a rather short period of time, which allowed corporations to geographically arbitrage their operations (a.k.a. offshore a big chunk of their labor force and various facilities) to take advantage of this.
This was disadvantageous to laborers and tradespeople in developed markets, and advantageous to executives and shareholders, particularly in the US where we shifted towards massive trade balances in the 1990s. But it did also help hundreds of millions of people rise out of abject poverty in these developing countries, and created hundreds of millions of new global consumers for those global brands as their wealth grew. China experienced a massive increase in the average standing of living, and so did many former Soviet states.
Overall, the global price of labor got cheaper. And all else being equal, this was disinflationary for global markets. The supply of labor became quite abundant, which suppressed wages in developed markets. In addition, robotics began to take off, and this was able to displace some types of labor as well.
All sorts of management approaches regarding “lean manufacturing” and “just in time delivery” became popular among corporations and MBA programs during this era. Some of these had their roots in the early 20th century manufacturing revolution (via Ford, Toyota, and others), but they were basically rediscovered, expounded upon, and brought to a new level in the 1980s, 1990s, and 2000s across the entire manufacturing sector.
Of course, this was somewhat of an illusion. Companies basically traded away resilience in favor of efficiency, while pretending that there was minimal downside, and yet this type of approach only works under a benign global environment. Outside of the Middle East and a few localized regions around the world, the 1980s through the 2010s was generally a period of limited war as far as supply chains were concerned, with significant global openness and cooperation. Extremely efficient and highly complex supply chains, with limited redundancy or inventory, could thrive in this stars-aligned macro environment. Any company not playing that game would be less efficient in this environment, and thus would be out-competed.
In recent years, many people spoke about how inflation was dead, and how commodity scarcity was a thing of the past.
The problem with an efficient-but-not-resilient global supply chain, is that it stops working once the smallest of exceptions occur. It could be a natural disaster of some sort, such as a virus. It could be a human disaster of some sort, such as a war. Or both, in the case of the 2020s decade thus far. A highly-levered and fragile system is not designed for such shocks.
And the problem with calling commodity scarcity a thing of the past, is that cheap commodity prices deter new investment in new commodity projects, resulting in stagnant supply, and eventually scarcity and higher prices. The commodity industry is notoriously boom-and-bust in nature every couple of decades due to this dynamic.
The Russian Impact on Commodities
The global economy, in a blank-sheet-of-paper naïve design that disregards the complicating factors of geopolitics, basically says this: we’ll take Chinese labor and logistics infrastructure, Russian and Brazilian commodities, and developed market institutions and capital, and combine them (and resources from similar countries across the spectrum) into full products and services across the world.
Under this operating framework, we don’t need to build secondary manufacturing and shipping facilities, because we assume the ones we have in China will always be available. We don’t need to build secondary nickel mines for our EV batteries, because we assume the ones in Russia will be open and able to supply the world. Chile can supply our copper, Brazil can supply our soybeans, Russia and Ukraine can supply our wheat, Taiwan can supply our semiconductors, China can supply our labor, and there’s no issue here.
All good, right? For decades yes, until it’s not.
Russia is one of the biggest oil and gas exporters in the world. They’re also one of the biggest exporters of wheat, nickel, fertilizer, platinum group metals, enriched uranium, coal, aluminum, and more. It’s challenging for the global economy to function without those mines, in the event of sanctions. And in most cases, it takes several years to discover and build a new mine, in what is an otherwise tightly-balanced global supply/demand system.
Going forward, any back-tests about inflation or disinflation that only go back twenty or thirty years are practically useless. This whole 1980s-through-2010s disinflationary period (with one substantial cyclical inflationary burst in the 2000s) was during a backdrop of structurally falling interest rates and increasing globalization, with the sacrifice of resiliency for more efficiency.
The world is now looking at the need to duplicate many parts of the supply chain, find and develop potentially redundant sources of commodities, hold higher inventories of everything, and in general boost resilience at the cost of efficiency.
Macro Implications: 2020s vs. 1940s
I’ve been making a macroeconomic comparison between the 2020s and the 1940s for nearly two years now, and the similarities unfortunately continue to stack up.
For the most part, I was referring to monetary and fiscal policy and the long-term debt cycle for that comparison, with charts like this that my readers are quite familiar with by now:
I was also referring to social, generational, and institutional cycles, but less so to geopolitics or kinetic warfare. In other words, the 2020s were beginning to exhibit behavior normally associated with wartime finance, but without a war. Instead, it was a massive global fiscal response to a pandemic-related disruption of a highly-levered global economy.
Well, now we can unfortunately throw kinetic war into the mix as well, and then a secondary financial/geopolitical war happening in the background, with frozen sovereign reserves, global sanctions, shifting geopolitical alliances, and so forth. The world, in many ways, is becoming bifurcated or multi-polar. Thousands of Ukrainians are estimated to have been killed or injured in this conflict so far; even if the war ends soon, it will likely have shifted geopolitics for a very long time to come, and in some ways that we may not foresee yet.
At one end, the US and Europe appear more aligned than they have been in a while. At the other end, China and Russia have been pushed closed together, and a number of countries have had to take a neutral stance on Russia’s war with Ukraine due to their economic reliance on Russia.
India, for example, has avoided outright condemning Russia, in part because it is a huge trade partner with Russia (albeit not for oil) and has had a multi-year plan to increase trade with them. India is a big importer of arms and commodities, which are the two export industries that Russia happens to focus on.
Similarly, China gets a considerable amount of energy and commodities from Russia.
South American countries in general have taken a harsher stance on Russia than China or India have, but many of them are reliant on Russia for fertilizer, and have taken steps to avoid fertilizers from being included in sanctioned products.
Egypt has likewise taken a middling stance. Saudi Arabia and the United Arab Emirates have also drifted away from the US in terms of relations in recent years, with that trend continuing during this current conflict.
The Wall Street Journal ran a piece called, “If Russian Currency Reserves Aren’t Really Money, the World Is in For a Shock.” The gist of the piece is that if sovereign reserves are easily freezable, this may spur central banks to re-evaluate their reserve practices, and shift more towards gold as a reserve asset once again, while also focusing on maintaining larger raw industrial/agricultural commodity inventories. Scarce commodities, physically held within the country’s jurisdiction, can’t be sanctioned or frozen.
Similarly, Credit Suisse published a piece by former Federal Reserve analyst Zoltan Pozsar, called “Bretton Woods III” with this rather strong introduction:
We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.
A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money, and this crisis is about the rising allure of outside money over inside money. Bretton Woods II was built on inside money, and its foundations crumbled a week ago when the G7 seized Russia’s FX reserves…
Back in late 2020, I wrote about the eventual diversification of global reserves and payment channels into a more multi-polar reserve currency world, with a renewed emphasis on neutral reserve assets. Much like how COVID-19 accelerated the practice of remote work, I think Russia’s war with Ukraine and the associated sanction response by the West will accelerate that diversification of global reserves and payment channels.
A few days ago as a notable example, the WSJ reported that Saudi Arabia is considering accepting yuan for some of China’s oil purchases. Since 1974, Saudi Arabia has officially only priced its oil in dollars, regardless of which country was buying. However, as US oil purchases from Saudi Arabia have diminished and China’s oil purchases have grown over the years, China has far surpassed the US as the biggest buyer of Saudi oil. And when your biggest customer wants something, such as an update to the payment terms, the idea of “the customer is always right” may start to apply.
In a world where official reserves can be frozen, some degree of reserve diversification would be rational for most countries to consider, and as investors we should probably expect this to occur over time. This is especially true for countries that are not strongly aligned with the United States and western Europe.
I’d be inclined to fade some of the biggest spikes in commodity prices, but then expect the longer-run prices to remain elevated for longer than people think. Many commodities have tight supply dynamics, wars are inflationary, and duplicating parts of the supply chain is inflationary.
This also should be decent for gold over the medium term as the major option that countries can turn to now as a protectionist reserve asset. Bitcoin may benefit as well in the long run, since it is a way for people to store value outside of the traditional financial system and move that value with them if they need to relocate, albeit at the cost of rather high volatility.
The structure global monetary system tends to change every several decades either due to new technology or sovereign defaults (often both), and yet participants tend to assume it will be permanent this time, which is a classic “end of history” perspective.
The system changed significantly in the 1920s through the 1940s after the World Wars and Great Depression depleted many countries’ ability to maintain their currency gold pegs, including on the winning side of the wars. It changed significantly again in the 1970s, when the US defaulted on its currency gold peg and established the petrodollar system with Saudi Arabia in its aftermath.
The 2020s could very well mark the next change, with a shift towards sovereign reserve diversification and an emphasis on neutral reserve assets once again, in light of a less-cooperative global environment and the ability and willingness to freeze each others’ sovereign reserves if those reserves are held in fiat liabilities.
Meanwhile, The Fed’s No-Win Scenario
With official inflation levels at nearly 7.9% year-over-year, the US Federal Reserve is basically forced to try to tighten monetary policy. Their short-term interest rate is the furthest below CPI since 1951:
Just yesterday, the Fed increased their rate by 0.25%, which marks the first rate increase since 2018.
This unusually wide gap between inflation and interest rates is one of the key reasons I regularly compare the 2020s to the 1940s (rather than primarily the 1970s, despite some other similarities there), and I have been making that comparison for nearly two years before the gap became as wide as it is now.
My May 2021 newsletter went into detail on this dynamic, but basically, since debt was so high in the 1940s (unlike the 1970s where it was low), and the inflation was driven by fiscal spending and commodity shortages in the 1940s (rather than a demographics boom and commodity shortages as in the 1970s), the Fed held interest rates low even as inflation ran hot in the 1940s (unlike the 1970s where they raised rates to double-digit levels).
Unfortunately for the Fed, the US economic growth rate is already decelerating, and basically the only way to reduce supply-driven inflation with monetary policy is to reduce demand for goods, which is recessionary. The ISM purchasing manager’s index, for example, has been pointing downward, and so have the weekly leading indicators:
Credit markets are already weakening, the Treasury market is becoming rather volatile and illiquid, and the Fed has ended quantitative easing. The Fed is likely to continue monetary tightening until financial markets get truly messy, at which point they may reverse course to the dovish side yet again.
Stagflationary economic conditions are inherently hard for central banks to deal with; stagflation is somewhat outside of their expected models.
In fact, the Fed might end up being forced to tighten liquidity with one hand and loosen liquidity with the other hand, using various standing repo facilities, SLR exemptions, purchasing off-the-run securities, and similar options available to them to maintain sufficient liquidity, while officially doing no more broad quantitative easing for a while.
This is another reason why countries may shift towards gold and other commodities for a portion of their official reserves. Not only can fiat reserves (bonds and deposits) be frozen by foreign countries that issue those liabilities, they also keep getting devalued with interest rates that are far below the prevailing inflation rate because debt levels are too high to raise rates above the inflation level. Official sovereign reserves represent decades of accumulated trade surpluses for a nation; the last thing they should want to do is hold the entirety of those reserves in melting ice cubes that diminish the purchasing power of their national savings.
This continues to be a very uncertain time for most risk assets, and I continue to have a rather defensive stance while still seeking out attractive equities where possible, including many in the healthcare sector, consumer staples sector, and energy pipeline industry. I also like to be overweight commodity producers in this environment, even though they will have periods of cyclical downside moves. For alternative assets, I view gold and bitcoin as attractive monies to own as part of a portfolio, in a world where fiat money supply is expanding at a double-digit rate and interest rates are well below the prevailing rate of broad price inflation.
This is a good time to build a “watch list” of equities that you like. The correction in equity markets across the world has taken some of the valuation heat off of stocks, even as the major indices like the S&P 500 remain rather expensive. I’m starting to find interesting opportunities out there to add to positions.
However, there remains considerable macro pressure that points towards the prospect of a choppy global equity market, so I’m not increasing my overall equity allocation percentage at the moment. Supply chain disruptions can hurt companies in any number of ways, resulting in lower profit margins or outright losses in some cases. I already have plenty of equity exposure as it is.
An example of a stock that gets more attractive over time as it gets cheaper is HDFC Bank (HDB), a large Indian bank. The past five years have been rough for them; they faced a cyclical global slowdown, then COVID-19, and then some company-specific IT problems that resulted in regulatory action against them. However, I continue to have a favorable view of India’s structural growth story, and the country remains relatively underbanked and with low household leverage.
Another example would be Bristol Myers Squibb (BMY), the large pharmaceutical business. The company has a strong pipeline of new drugs, but also a lot of patent expirations for its big existing drugs coming up, which means the company has to effectively rotate its portfolio of revenue-producing drugs in the coming years. To offset that risk, it is priced very cheaply, with a single-digit price/earnings ratio and a solid dividend yield. I think the current price offers a good accumulation zone.
Lastly, in a world of sanctioned and separated energy markets, Canadian oil and gas producers look appealing. In part due to operational issues, Suncor (SU) hasn’t run up price as much as you might think in this macro environment. Oil stocks in general are priced for rather medium long-term oil prices (investors are basically fading the near-term spike in oil prices and assuming a return to normalcy), and Suncor is among the cheaper ones at the moment. I expect it to probably grind higher over the next several years while paying out a hefty dividend along the way.
I don’t position any one stock to be a large portion of my portfolio, since any of them can run into company-specific problems, but I certainly prefer a diverse basket of these types of stocks rather than cash over the long run, for the bulk of my portfolio. Many of them have higher dividend yields than the interest rate that investors can get on cash and Treasuries, while also having some capability to grow over time.
However, we should be mindful of and prepared for considerable volatility even in good stocks. That’s why I’m also diversified into cash-equivalents, gold, bitcoin, real estate, and other assets as part of a diversified portfolio.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.