Toxicity
Last week, demand for safe havens was pretty strong due to the invasion of Ukraine. However, everything changed this week. There is no more heavy demand for bonds and gold but equities and risky assets instead.
Bond markets corrected sharply after Bloomberg reported that, according to sources within the EU administration, the EU is planning another round of joint bond selling for investments (similar to NextGenEU) into energy and defense.
On Wednesday, the Ukrainian side signaled its willingness for talks with Russia to end the war as fast as possible. The result was a brutal rally in European indices, and the German DAX closed about 1,000 points higher than the day before.
Is the euphoria is justified? We do not know yet, I would say because the statements are the same as before the war started: Russia wants Crimea to be Russian territory, and independence of the Donetsk and Luhansk regions and a neutral Ukraine. Contrawhise, Ukraine strongly opposes giving away territory, and only neutrality of Ukraine is on the table, according to the media.
If nothing changed, why did markets rally? Honestly, I do not know, but the reports obviously spread optimism among market participants that the war may eventually end in the near future.
I am not so sure about that because western politicians still do not seem interested in de-escalating the situation. Instead, they are discussing more severe sanctions on Russia. On Tuesday, the Biden Administration stated that the US would stop importing oil from Russia.
While this sounds like a big deal, it is pretty much the same as if Justin Trudeau says that Canada will not import more oil from Russia. Canada has not imported any barrel from them since 2019, and US import volume is also shallow (8 % of all imports)
On the other hand, if Europe would take such an action, it would be something entirely different. Nevertheless, European politicians again dismissed the idea this week.
The oil price is already close to its 2014 highs, WTI notes at 110 USD/barrel. After the news on Wednesday, it only slightly fell, but the situation looks pretty complicated to make a serious estimation of how the problem would develop further.
The west has to fight several combats on the economic front. Firstly, the economic slowdown is already happening because government stimulus from 2020 and 2021 did end abruptly. The sugar-high of the economy in 2021 will not be repeated, and growth will slump again.
But there was another side-effect of those stimulus programs: a rise in inflation. Because of the recent war and the new economic turbulence, it is hard to say if the inflation peak is already in. In my opinion, we should bury the expectation that inflation in the Eurozone will come down back to 3 %.
Sanctions against Russia have lowered the supply of commodities significantly already, and big companies have to act on the spot. This week, Shell has stated that it will restrict wholesale with fuel oil, diesel, and other refined products.
Oil and gas are Russia’s most important export goods, and thus problems are most apparent there. Recently, the country has struggled to sell its oil on the international market because no one wants to buy it.
But Russia exports much more things. Wheat, fertilizer, nickel, palladium, aluminum, and steel.
Not only will wheat rise in price, but all food prices will also rise. Fertilizer is essential for industrial agriculture and producing enough food to feed the world. The production of fertilizer uses a lot of gas. Yara, a big fertilizer producer, has already announced that it will reduce output at two facilities in Europe due to high gas prices.
Russia is also exporting a significant amount of fertilizer to European countries. If the sanctions are kept in place for longer (and this may very well be the case), the question is, who will start to replace Russian production?
Western sanctions also mean more trouble for already bad functioning supply chains. Russia is responsible for 40 % of global palladium production, which is needed for various industrial goods like auto and semi-conductors.
Experts already say that the output of produced cars and trucks might shrink by billions of Units. From CNBC:
Russia’s invasion of Ukraine could reduce global production of new cars and trucks by millions of units this year, according to experts.
Local Russian production is expected to feel the greatest near-term impact as companies suspend operations. But, officials say, the longer the war continues, the higher the risk of ripple effects across the automotive industry.
“There’s no question. It’s going to ripple. It’s just going to be really dependent on obviously how long this goes on,” said Jeff Schuster, president of global forecasting and the Americas at LMC Automotive. “The sanctions and trade impact play a big role in that.”
As I wrote above, global supply chains are already in bad shape because of the political measures to fight the global pandemic. Let us hope that the peace talks will go fine and produce good results soon.
All these things are putting pressure on inflation. Inflation is already higher than it should be, primarily because of the ignorance of central banks in 2021. For months they were telling everyone that it is only transitory until the sharply reversed course at year-end (Madame Lagarde, on the other hand, not so much).
Now central banks are telling markets to get ready for tightening, and it might have been an excellent choice to signal this during times when inflation was expected to come down anyway.
This hope was not unfounded. A weakening credit impulse, the end of stimulus, and a potential improvement of supply chain problems supported that theory.
But the current situation changes everything. Today (Thursday), Italy published its PPI numbers for January. It does not bode well: YoY PPI came in at 41.8 %, and MoM change was 12.4 %. Is inflation already getting out of hand?
I do not really have an answer to how central banks should react to higher inflation rates. The correct answer might have been to raise rates substantially back in 2001 or 2008 to support a restructuring of the economy instead of trying to grow out of debt via loose monetary policy.
QE did not lead to the aspired goals for the real economy, and it only helped governments continue to load up on debt for little interest.
QE and low-interest rates within the financial economy have led market participants to keep money within financial markets instead of investing it into the real economy. As a result, asset prices got propped up by the policies. If no more money is infused into the real economy, the real economy stagnates, and thus I would argue that central bank policies are the main driver of weak economic growth.
Why do we have inflation now? Because of extensive additional stimulus programs during the pandemic. To be fair, I am slightly surprised that governments ended with handing out credit guarantees more or less. But those guarantees led to real investments into the real economy and thus fueled inflation.
Businesses faced a rise in demand and thus tried to keep up with it. They expanded production, hired workers, and so on. However, when times are uncertain, and governments mess around with credit guarantees, it becomes harder to anticipate the future accurately. And this is the primary job for an entrepreneur: To foresee the future situation as best as possible.
Probably businesses are building up inventories because they miscalculate future demand? Supply and demand imbalances were already significant before the pandemic began, and the extensive interference of central planners into the economy did not change it for the better.
Today (Thursday), the ECB has signaled that it will end its PEPP program in Q3 of 2022, sooner than expected. This pushed interest rates above this year’s pre-war levels. Let us see if the ECB is keeping its word and moving in the right direction. It disappointed on too many occasions to expect this to be 100 % certain.
The biggest problem for the economy is rising energy prices, though. Sanctions and self-sanctions of businesses have driven up global energy prices, and especially Europe, which is heavily dependent on Russian oil and gas, suffers.
Therefore it is no surprise (and actually a good thing) that the EU is looking for alternatives. But I am slightly surprised that nuclear power (again) hardly plays any role. Von der Leyen talked about two main measures the EU is going to take in a statement from March 7:
Our second topic will be energy. We have to get rid of the dependency on Russian gas, oil and coal. I know that the two of us agree on this. The Commission will be coming forward with proposals tomorrow. There are three main pillars: One is the diversification of supply away from Russia and towards reliable suppliers. This is mainly LNG and pipeline gas. Both have the advantage that the infrastructure is over time hydrogen-compatible.
The second main element is to repower the European Union. Repower means massive investment in renewables, like solar, wind and hydrogen. We are looking for a focused acceleration of the European Green Deal. This is not only important and good for our strategic investment in our independence, it is also good for our industry and it is good for our planet. This has to be complemented by a third pillar and that is improved energy efficiency: from renovation of buildings to smart industrial processes, to artificial intelligence, for example, to effectively manage smart energy grids – you name it.
The EU Commission is so stuck in its green transition that it does not note repeating the German mistake. Germany also stated this week that it would not go back to nuclear energy. Astonishing because Germany became so dependent on Russia because it abandoned coal plants and nuclear plants to go fully renewable.
To produce renewables, you need fossil fuels, which unmasks von der Leyens statements as pure marketing without any substance.
It is tough to make prognoses in this toxic economic environment. After its hawkish surprise, the market is expecting the ECB to raise rates in Q4 this year. At that time, the economy will likely be back in recession. Hard to tell if the ECB will withstand calls for loosening monetary policy again…
Have a great weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)
Thank you for reading! You can subscribe and get every post directly into your inbox if you like what I write. Also, it would be fantastic if you shared it on social media or liked the post!
(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)