Speculators face reckoning
With no swift end to the Ukraine conflict in sight, markets must wake up to the reality of massive energy and food supply shocks
Markets continue to underestimate the effects of the Ukraine war and will be shocked again in the coming weeks. The odds of financial collapse and a global recession are rising rapidly.
The world didn’t believe that Russia would invade Ukraine; that, in the event of an invasion, there would be huge consequences, because the West would calibrate sanctions to minimise domestic impact; and that an invasion would result in anything but a swift Russian victory.
These expectations have either been proven wrong or soon will be. The war may last for years with far-reaching impacts, even if it is contained between Russia and Ukraine. More worrying is that it could spread to other parties, unleashing a version of World War III.
The United States has announced a ban on Russian oil imports and Britain has committed to phasing them out by the end of the year. A European Union ban on Russian gas and oil may be the next big shock.
The EU’s response has been much stronger than expected – it has unveiled a plan to cut Russian gas imports by two-thirds within a year – because its people have shown more willingness to bear hardship at home. But it has so far stopped short of an energy import ban. This position may become untenable as public pressure mounts. Oil and gas prices could then surge past historical highs.
The resulting rise in inflation would force the US Federal Reserve and the European Central Bank to increase interest rates. The sharp drop in trade for oil importers such as India and the EU will push their economies into recession. Such a supersized energy shock has not been priced into the market at all.
Meanwhile, a shock to global food supply is unfolding. Russia and Ukraine together account for about 30 per cent of the global grain supply. The price of wheat has risen by around 30 per cent since the war began.
Many poor countries in Africa and the Middle East depend on imported food. If food prices double or triple, much of the world will face the spectre of social instability.
The long-term security impacts could be even more serious. North Korea is safe, while Ukraine is on fire – many countries may conclude that nuclear weapons are the difference. Japan, South Korea, Iran and Saudi Arabia could all go nuclear. If they choose to pursue their own security agendas, these countries would be likely to cut links with the US. The world would look more like it did before the Westphalian Treaty.
The financial bubbles of the past three decades have ballooned thanks to declining global interest rates and risk premiums. The opening up of China and postCold War peace helped drive those trends. Clearly, the world is becoming less safe and more volatile than at any time since World War II. The risk premium embedded in financial assets may return to wartime levels, at about 5 per cent. If that happens, global financial bubbles will surely pop.
Inflation, which has already been rising rapidly due to widespread labour shortages, will be exacerbated by the impending energy shock. Supply chain fragmentation is weighing on productivity. The world is staring at a decade like the 1970s or worse.
It is hard to imagine financial bubbles could survive such stagflation. Public anger may force governments to bring back central bankers in the mould of Paul Volcker. That would end three decades of speculation that have spawned the global ruling elite who gathers in Davos every year.
Even greater uncertainty could arise from the changing relationship between China and the West. The world expects the Russian economy to collapse under the imposed sanctions. It won’t. It has sufficient food and can replace Western consumer goods with Chinese ones.
Freezing Russia’s foreign exchange reserves has done the most damage so far. The country has raised its interest rate to offset the confidence loss. But it doesn’t have a deep financial system. A higher rate won’t have the same impact as in more developed economies.
The Western faith in the effectiveness of cutting Russian banks out of the Swift system is misplaced. In the age of WhatsApp and WeChat, setting up an alternative communication system is easy. Of course, a ban on trade with Russian banks has real impact. Russia must look to thirdcountry banks to settle bills.
Still, buyers of Russian goods can always wire money to a country that still has financial links with Russia. Buyers and sellers can ask their banks to settle with a third-country central bank. These central banks don’t even need to settle in real time; they can keep tabs for one another. The difference to be settled in the end can be assumed by the relevant government as credit or debt.
Thus, as war rages on and the Russian economy stabilises, Western anger may turn to China. Sanctions could make their way there. The resulting disruption to supply chains would trigger a global collapse.
A further complication is how Western aggression towards China would change its calculus on Taiwan. If Beijing sees sanctions already in place, it will have few incentives to hold back on the island. Another major conflict may ensue. This one may lead to direct missile exchanges between China and the US, covering the whole Pacific.
Currently, financial asset prices are still at the bubble end of the historical spectrum. But growth, inflation, interest rates and risk premiums all signal a fall to the lower end. It looks like a deep dive awaits the world’s speculator class.
The risk premium embedded in financial assets may return to wartime levels, at about 5 per cent. If that happens, global financial bubbles will surely pop