The Good, The Bad & The Ugly

While the corona pandemic worsens on the European continent and infection rates rise in countries with high vaccination rates (like Portugal), geopolitical problems also intensify. The conflict between Ukraine and Russia is getting more severe as many news corporations speculate about Russia's possible invasion of Ukraine.

After Europa and Russia have gone back and forth about natural gas delivery, Vladimir Putin is finally back on the world stage, after former US President Barack Obama has stated that Russia is not more than a regional power in 2014. 

For more than 20 years now, Putin has been the most powerful man in Russia. While I sometimes feel that within the Biden-Administration sometimes the one hand does not know what the other hand is doing, Putin makes the exact opposite impression. Obama's statement probably encouraged him to improve Russia's position on the grand chessboard. 

However, it seems that there are 3 parties involved: The Good (Biden), The Bad (Putin), and the Ugly (Europe). In a call between Putin and Biden this Tuesday, the US president voiced the deep concerns of the United States and our European Allies about Russia’s escalation of forces surrounding Ukraine and made clear that the U.S. and our Allies would respond with strong economic and other measures in the event of military escalation. 

It seems that Europe is getting caught in the crossfire again because it would be tough for Europe to support the US in this question indefinitely. A person familiar with the subject told Bloomberg that the US expects Germany to stop Nordstream 2 in case of an invasion.

This could mean trouble for Germany's new chancellor, Olaf Scholz. In the old coalition with Angela Merkel's CSU, Scholz's social democrats backed the plan of Nordstream 2, one of the social democrats' new coalition partners, the Green Party, has opposed the project since the beginning. 

More tension between Russia and the US could hurt Eurozone GDP growth, although Q3 numbers came in better than expected. However, the trend is already showing slowing growth, and a rise in geopolitical turmoil could be even more harmful.

Europe has a problem because it is highly dependent on Russian natural gas, especially during the cold winter season. After the news about a stop of Nordstream 2 made it to the public, European gas prices have started to rise again. Nevertheless, I may add that European energy policy has shown some improvement these days because the EU-Commission finally acknowledged nuclear power as green. While this is good for future energy supply within Europe in the long run, there is still a high dependency on nat gas. 

The Russian ruble profited from rising gas prices and hence appreciated significantly against the Euro this year. If one expects higher gas prices to come, this could lead to an even stronger ruble.

Higher energy prices are favorable for Russia's economy since the country is rich in resources, and therefore the effect shown in Chart 2 should not be surprising. Interestingly. Further, in my opinion, the monetary policy response from the Bank of Russia against the corona pandemic was very interesting because there hardly was any response. While M2 in the United States rose by 38,5 % since January 2020, Russia's M2 has only increased by 20 %. And if you look at central banks' balance sheets, one sees that Russia has expanded its balance sheet by just 18 %.

Putin indeed is not a democrat and does not hesitate to silence political opponents. Still, it seems he is interpreting the current situation much differently than his Western pendants. If some analysts are right and we really are at the beginning of a new commodity supercycle, Russia would definitely benefit. 

If Europe wants to transform its economy into a greener version, this may be impossible without russian natural gas. Moreover, Putin has placed his figures on the grand chessboard (Zbigniew Brzezinski) extraordinary smart. Due to a cooperation with Iran, Russian controls gas flow to Europe via Nordstream, and it also controls the gas flow from Chalous Europe. (Grant Williams newsletter 'Putin on the Ritz' is a recommended read here)

But rising gas prices are not Europe's only problem. Ambitious goals concerning the green transition also have consequences for CO2 emission prices, which have nearly tripled since the beginning of the year. To me, this is a sign that Christine Lagarde and Isabel Schnabel are wrong in their beliefs, that inflation looks like a hump and will fall to the ECB's target of 2 % next year. Higher energy prices because of higher CO2 emission costs will be inflationary. 

However, the rise in the price of CO2 is politically welcomed, as it should support the transition away from CO2-intensive production of businesses to renewables. Nevertheless, natural gas is one of the main factors to achieve this goal, and hence the demand for natural gas will increase. To prevent prices from rising, supply would need to expand, which is definitely not the case now: European gas storage is clearly below its 5y median. 

Higher energy prices will be a burden for low-income households. Governments are responding to rising prices just as usual: France tried to subsidize energy expenses and thought it would cost about 4 trillion Euros, but as it recently turned out, costs would be around 12 trillion, just as much as annual costs for the whole justice department. Just governments at work, I might say...

About a month ago, I wrote about how rising gas prices will lead to rising ammonia prices (the primary input for fertilizer production) and thus to higher agricultural prices. As a result, I fear that the recent rise in wheat prices is far from over.

In my opinion, the ECB tries to calm down market participants who - by far - are still trusting the ECB when it comes to monetary policy. Although, a recent statement by Isabel Schnabel may hint that future tapering maybe is not so far away as some may expect. Surprisingly, after being in denial for at least a decade, the ECB now agrees that QE fuels asset bubbles.

If the ECB really tapers soon (and it is definitely ok to be skeptical about this), the signals of how it should be done are not so clear. OeNB governer Holzmann recently said that a possibility could be that ECB raises rates first and slows bond-buying later (Yield curve control?), although it seems that this is solely his personal opinion which does not reflect the opinion of the governing council.

This brings me to the Fed. A tightening of monetary policy in an environment where economic growth slows while inflation is not coming down may not be the best idea. Recently even politicians have noted that supply-chain problem will stay around for longer:

Treasury Secretary Janet Yellen said that U.S. reliance on foreign supply chains has proved a vulnerability and that the country needs to produce more critical goods domestically in order to protect both its economic and national security.

 

“It’s possible that policies that people will describe as protectionist are going to be necessa-ry in order to create the appropriate incentives to produce things at home,” Yellen said in an interview recorded on Monday for an online conference hosted by the Financial Times. She didn’t offer further specifics on the potential measures she envisioned. - [Bloomberg]

But bringing critical goods production back to the US is, in my view, highly inflationary. Domestic production means higher costs and hence higher prices. I am sure the way how the Biden administration would achieve this would be another stimulus program to boost production (their words, not mine). 

In the end, let me shortly write about today's US CPI numbers. Estimates for November inflation are 6.8% YoY (.7% MoM). I would not be surprised if today's numbers beat expectations, especially because the prices for used cars are on the rise again, too, despite deflationistas cheered about them a few months ago when they pushed back from previous highs. 

The economic and geopolitical environment is very inflationary at the moment. The Chinese yuan is also appreciating, and this means higher inflation to come for the west as lots of goods are imported from China.

Rising or persistently higher inflation while economic growth is decelerating would be the beginning of Stagflation in Europe and the United States. Protectionist policies do not help very much, I would say, and we should know that since the end of the Sun-King Louis XIV. To make the economy more vibrant, I would suggest more trade and cooperation and bury the Good/Bad(/Ugly) narrative...

Have a great weekend all!

Fabian Wintersberger

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions, or organizations that the owner may or may not be associated with within a professional or personal capacity.