Jupiter Merlin Weekly: A world thrown into disequilibrium
The Jupiter Merlin team discuss the many factors throwing the economy into disequilibrium, particularly the war in Ukraine, and why simple economics isn’t the answer.
Not surprisingly, it is a preoccupation of markets currently to try and predict when inflation will peak, and then to take a stab at what rate it is likely to settle, particularly in the context of the principal central banks’ common targets of managing their economies to a 2% inflation target. This underpins investors’ analysis of central banks’ policy actions, the extent to which those measures will be benign or harsh, of long duration or short, and then by deduction, what the implied effect is on economic growth and longer-term prospects.
Given where we are, with inflation currently averaging 4-5 times those targets in most of the western world (Japan is a notable exception so far) and a recession looming as even Jay Powell at the US Federal Reserve was forced to concede this week, all defying virtually every optimistic expert’s forecasts and less than a year after the euphoria of the vaccine-led “reopening/reflation trade”, it seems a futile exercise to paint one’s self into a corner with a forecast which is most likely to be wrong. However, notwithstanding Galbraith’s waspish quip about the shortcomings of his own profession, there is significant point in understanding the underlying dynamics driving the inflationary forces and how they are changing in a febrile situation.
Inevitably, the reality of inflation is much more complex and nuanced, indeed sometimes contradictory: soft commodity prices related to foodstuffs and agriculture (wheat, soya, vegetable oils, rice, as well as agricultural fertilisers) are all substantially up on a year ago, mostly by around 50%, in the case of urea ammonium for fertiliser by 130%; but virtually all have come off the boil in the last month. In energy markets, Brent crude oil has retreated from recent highs but is considerably more expensive than a year ago; coal continues to test record high prices, as does heating oil. However, in the hard commodities concerned with industrial production and construction, prices are typically down, not only over the past month, but also year-on-year: copper and steel down 10% and 12% respectively against June last year; iron ore nearly halved over 12 months.
In normal economic cycles, momentum is typically determined by changes in consumer behaviour to which the supply reacts accordingly. Very seldom are we faced with the current complex circumstances: two overlapping but unrelated exogenous shocks, one a pandemic and the other a major conflict in Europe but whose effects are global, both significantly disrupting the supply-side of the economy and both leading to changing behaviour; and more than a decade of sky-high debt predicated on ultra-loose monetary policies which are suddenly being thrown into reverse while governments generally continue with Keynesian stimulatory measures geared to welfare, infrastructure spending and addressing climate change.
This subject is wide enough to fill a big book and, even then, not to do it justice. But in this (very) limited edition, we are going to focus on some of the changing behaviours and the geopolitical forces behind them which have forced the systems described above from equilibrium towards disequilibrium, in many cases leading to acute volatility, and why it makes forecasting difficult, even as growth slows perceptibly.
Remember, economic theory is not immutable law; it is simply the sum of all human activities denominated in pound notes, dollars, euros, yen, renminbi, roubles or whatever other currency. People are fickle, they have minds of their own and their own sense of what is rational behaviour, which will not necessarily conform to neat economic theorems.
We described two weeks ago, against the backdrop of poor growing conditions in many parts of the world, the extent to which his blockade of the Black Sea, including the port of Odessa, has significantly impeded the ability of Ukraine to export wheat, sunflower oil, agri-chemicals and fertilisers, as well as other minerals and ores in which Ukraine holds a significant global presence. Itself subject to sanctions, nevertheless Russia has significantly increased its export volumes of grain, and especially wheat, to allies or sympathetic countries who either refuse to join the sanctions regime or who are reluctant to apply it fully, principally Iran, Turkey and Egypt.
In energy, Russia accounts for 4% of total oil production, currently running at around 100m barrels per day globally. Again, subject to sanctions, but far from perfectly or uniformly applied (as an indication of the permeability of the sanctions membrane, which is more akin to a sieve, Russian oil exports in May were only down 15%), nevertheless it has already actively sought and found alternative markets including India; but the most important by far is China. In May, according to Chinese government trade data, China imported 8.45m tonnes of Russian crude, surpassing the tonnage bought from Saudi, its usual prime source. In context, although prone to volatility, Chinese oil imports from Russia had averaged between 6 and 7 million tonnes per month over the past three years; compared with May 2021 that 8.45m tonnage last month was 56% greater than a year ago. The Finnish-based Centre for Research on Energy and Clean Air estimates that Russia earned $97 billion from oil exports alone in the period from the third week in February to the end of the first week of June. Lower volumes were more than compensated by higher prices, even on a discounted basis when sold to hard-negotiating counterparties such as China.
Gas sales are more directional than crude oil deliveries. The majority is delivered by pipeline. Back in March, we suggested that Putin would be more than likely to play the gas joker, pulling on the significant geopolitical lever available to him to inflict economic pain on the West simply by turning off the gas taps (he controlled 30% of western European gas supplies, and more than 40% of Germany’s). Through the Russian gas supplier Gazprom, this is precisely what he has done. Beginning a month ago with Poland and Bulgaria, he has since ratcheted up the pressure by withdrawing supplies to customers in Denmark, Finland, Italy and Germany who refuse to settle in roubles. This week he has turned the screw again, reducing by 60% the volume of gas supplied direct to Germany through the principal Nord Stream 1 pipeline under the Baltic. Having abandoned its commitment to Nord Stream 2 when Putin invaded Ukraine, Germany had already had to find means of securing replacement energy sources simply to keep the lights on and the economic wheels turning. Backtracking rapidly on its brand-new greener energy policy only published last December, the equally new government announced relaxation in the target dates for decommissioning of both nuclear (originally to be completed by the end of this year) and coal-fired power stations (to be completed by 2030). Now, with this latest attack, Olav Scholz’s government has been forced into a further U-turn: it has had to announce that already mothballed coal-fired plants will be brought back online, and it has told both industry and the public to be prepared for gas rationing this winter, even though the majority of German houses and apartments rely wholly on gas for heating, hot water and cooking. With demand for coal rising, particularly in China and India, in response to escalating gas prices but global coal supply declining thanks climate change politics, in dollar terms coal prices have increased by 210% in 12 months. Germany’s latest reaction can only exacerbate the pressure.
- Flashpoint Kaliningrad: surrounded by Lithuania and Poland, home to the Russian Baltic Fleet and intermediate Iskander nuclear-capable missiles with a range of 300 miles (from Kaliningrad, Poland, the Baltic States, eastern Germany, the Czech Republic and eastern Denmark would all be within range). Lithuania’s suspension of the movement of EU sanctioned goods to the Russian enclave has prompted Putin to declare retaliatory measures which will be not only diplomatic but ‘practical’. What ‘practical’ means remains to be seen, but Lithuania is a NATO member, so even if by asymmetric rather than conventional means, this retaliation increases the tension between Russia and NATO with the risk of open military conflict.
- NATO expansion: linked to above, Sweden and Finland’s intended accession to NATO (so far blocked by Turkey) would not only create a new 830-mile direct frontier between NATO and Russia along the Finnish border in the immensely sensitive area of the White Sea and the Kola Inlet, it would also mean apart from Russia’s own short coast centred on St Petersburg (and also Kaliningrad) every single other country with a coastline on the Baltic would be a NATO member. How does Putin counter that threat?
- EU expansion: this week the EU has agreed to both Ukraine and Moldova becoming candidates for membership (clearly neither has had a chat with either Poland or Hungary about the wisdom of that dubious aspiration). Ukraine’s mutual mood-music with the EU over 30 years, and the internal strife it generated along the way leading to several revolutions, was the genesis of the war we find ourselves in today (see our essay, ‘Anatomy of a Crisis’ from 17 February). Obviously, the situation has changed significantly in Ukraine, but surely a pre-condition of membership, alongside getting rid of endemic corruption and creating political and economic stability to the EU playbook, is the end to the war. One imagines Putin, to the extent he is able, will redouble his efforts to ensure that Ukraine remains under Russian influence and not Brussels.
- Russo-Chinese love-in: Putin is still working hard internationally to maintain existing friendships and nurture new allies. His recent call to General Secretary Xi Jinping on the latter’s birthday confirmed that however publicly neutral China might be on the subject of Ukraine, the two countries’ mutual bonds are strong and, if anything, are getting stronger. Having allies on side, including India, Iran, Egypt but particularly China, gives Putin two helping hands: first, to generate sufficient income to continue to wage war, even if the cost to the Russian economy overall is significant; second, it gives him political clout to prevent a consensus coalescing against him in the UN and even in NATO.
The reason for labouring this is that, just like before the war started, investors were looking at the situation through their own lens: if it was irrational to them for it to start in the first place, it would not happen. How wrong! Now, there is a tendency to view inflation as some disembodied, nebulous concept working independently with a life of its own. It is not; inflation is always caused by stimulatory factors. There is also the natural inclination to make comparisons with periods such as the 1970s and 80s, the last time we had proper inflation, and indeed, for some while, stagflation; as investors clutch at straws to find anchor points, there is a greater risk of a lazy assumption that it will conform to historic norms. Today’s situation with its the confluence of many complex factors is very different. It may display similar symptoms and prompt familiar responses (i.e. how to contain costs, government pressure to help struggling families, industrial action for higher pay etc), but this time it is geopolitics, exacerbated by two years of dealing with a pandemic, which is shaping events rather than straight forward ‘O’ Level economics.
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