€35bn. For the avoidance of doubt, let’s spell that out: thirty-five billion euros. That is the amount the EU has admitted to having paid to Russia in hard currency since the first day of Putin’s Ukrainian invasion, in return for Moscow’s continuing supply of oil and gas. It is a run-rate of €1bn per day (or another way, in sterling terms, the equivalent of the total annual UK defence budget every 50 days).

The useless UN

As we enter week seven of the shooting war, amid headlines of ‘conflict gas’ paid for in ‘blood money’, nothing has changed. Divisions remain about how to deal with Russia both militarily and economically. President Zelensky continues his relentless virtual tour of global parliaments, praising the supportive, chivvying the reluctant, constantly looking for more practical military help. This week he trained his guns firmly on the United Nations.

 

If there is an institution which embodies paralysis, like a rabbit caught in the headlights, it is the ‘United’ Nations in the Ukrainian crisis. For ‘united’ is the one thing it most certainly is not. While on 2nd March it trumpeted the ‘overwhelming’ support endorsing condemnation of Russia’s aggression, with 141 member countries voting in favour of the motion and five against, no fewer than 35 abstained and 12 did not vote at all. But those 52 countries either rejecting the UN’s call or standing back, account for more than half the world’s population given they include both China and India and the majority of countries in sub-Saharan Africa. But while the UN Security Council has ten members, the real problem is the ‘P5’, the five permanent members, essentially the victorious allied powers in 1945: the UK, the US, France, Russia and China. They are the perpetual gatekeepers of the UN’s Articles, Protocols and Declarations, the others are on rotation on fixed-term tenures. Each has the right of veto. Zelensky made a simple and powerful accusation: if the purpose of the UN Security Council is to ensure security and protect the right of every country to self-determination, what is the point of it given that with well-flagged and accurate intelligence one permanent member was nevertheless allowed to invade his country, destroying that right to self-determination along the way, and a second has subsequently failed to call out the aggressor? The UN has demonstrably failed and worse, has not even had the decency to eject Russia from the organisation.

 

The reality is that ejecting a permanent member is less than straightforward. It requires Chapter XVIII of the UN Charter to be invoked, under which the Charter itself needs to be amended in a vote of the full general assembly with the hurdle being a two-thirds majority. In the world of realpolitik, a vote of condemnation is one thing; ejecting a P5 member quite another. One is registering a protest, the other making a very concrete point, actively taking sides with the possibility of real-world consequences. That is what Zelensky is up against with the UN: his country has already been run over by Putin, swathes of it flattened or laid waste and it remains likely to be partitioned; some UN members are Putin’s natural allies; others, particularly those who are former Soviet satellites and who share a border with Russia, have a vivid impression of the consequences of the vindictive side of Putin’s nature, reinforced by his familiarity with chemical weapons and his possessing the largest nuclear arsenal on the planet. His military might be tactically incompetent and is now much weakened through significant losses inflicted by vigorous Ukrainian defence, but that does not make Russia any less dangerous to deal with. If you’re going to poke a wounded bear, make sure it is with a very long stick.

NATO’s bind

NATO faces the same dilemma. It is what is limiting the response. Stretching the fibres of how much military aid, and of what type, to supply to Kiev (the distinction between defensive and aggressive weapons, the lightning rod a month ago having been the row about Poland supplying MiG29 jets), and how far one can go before Putin says “you’ve crossed the line”, this week the Czech Republic pushed the boundaries by sending a dozen Soviet-era T72 tanks to Ukraine; if the US flatly refused to endorse Polish jet aircraft, it is reportedly happy to endorse the gift of Czech armour, despite Boris having declared tanks to be a step too far. One reads it more often now in press editorials and commentary that without any legal obligation to provide direct help (the moral obligation is a very different matter) NATO is ‘happy to fight to the last Ukrainian.’

 

But there is a stark reality in NATO’s limited response: there is very little room for manoeuvre and certainly no element of surprise in a military response which would not give Russia ample time to prepare. Any conventional, full-scale NATO offensive in Europe would rely significantly on American military resources to guarantee success. With only nominal US forces currently in Europe (V Corps HQ is in Poznan, Poland), it would take a minimum of two months from Congressional approval to go to war (let’s forget about the niceties of the UN) to having two US Army Corps, at least 100,000 soldiers plus kit, convoyed across the Atlantic and ready to fight. Any such mobilisation would be construed in Moscow as an act of aggression, even if the reality is that forces would not be in action in under 8 weeks. That’s NATO’s military bind. Thirty years of the mis-named ‘peace dividend’ and reduced defence spending, combined with the US’ strategic repositioning towards the Indo-Pacific region has led to NATO being a virtual bystander to a conflict on its own borders in Europe.

Walk the walk? Or just talk the talk

But going back to our opening paragraph, the fundamental non-military problem in confronting Putin is the gaping breach in the sanctions wall against Russia. It is summed up in one word: energy.

 

How quickly is the west (and here it is almost entirely a European problem) able and willing to wean itself off Russian oil, and more explicitly Russian gas. Despite the deal brokered a fortnight ago between Joe Biden and Ursula von der Leyen at the EU Commission under which the US will gradually replace Russian-piped gas with American-shipped Liquid Natural Gas (LNG), political pressure is fast mounting for a more immediate and fulsome response particularly from Germany, Italy, Holland and Austria.

 

Amid discussions in Germany’s Bundestag, the nub of the debate is “should we be rationing the use of conflict gas and how much economic pain and inconvenience are we prepared to endure as a result?”. If Olav Scholz made a good impression in his speech a month ago when he abandoned Nord Stream 2, upturned the German constitution and made commitments to future defence spending, the nugatory response since and the polite but distinctly cool reception to Zelensky’s Zoom appeal to the German parliament (the speaker’s thanks immediately followed by “and now, any other business?” was particularly tactless), his government has left itself open to accusations of deliberate foot-dragging. It is not alone.

Brainard’s economic Exocet

And what of the economic effect more broadly? That lack of unity in energy sanctions has allowed the oil price to stabilise, now at around $101 for Brent crude. But with German and eurozone inflation data for March coming in at 7.3% and 7.5% respectively, stoked up by the war, they join the UK and the US with inflation rates approaching four times the central banks’ targets. This week it was Lael Brainard, the US Federal Reserve (Fed) board member and nominee to be vice chair to Jay Powell, who royally threw the cat among the pigeons. A left-wing social reformer and a recognised ‘dove’, she made an eye-catching and powerful (not to say political) speech about the pernicious effect of inflation on poorer families and their ability to afford even the basics to survive. She indicated that in addition to the already established programme of interest rate rises, the Fed would seek to make ‘rapid’ and ‘aggressive’ cuts to its balance sheet.

We have discussed on many occasions the path to raising interest rates when central banks have been using quantitative easing (i.e. buying bonds): taper-stop-hike, in that order, very linear, very logical. But if loosening monetary policy is easy to define, the opposite, tightening, is more vague, particularly when it comes to managing the central bank balance sheet.

Most economists and market strategists had been assuming that with the Fed buying no new bonds, a reduced balance sheet would be achieved by allowing it naturally to run off as existing bonds which reach maturity are not refinanced. Brainard is suggesting a much more aggressive stance: that the Fed should actively sell bonds back to the market. The question then is whether the market (principally the big financial institutions and foreign central banks) have the capacity to soak up new bonds which the US Treasury is issuing in the normal course of raising finance with the certainty that with quantitative easing having ended there is no Fed on which to off-load surplus stock, but not only that, now with the suggestion that the Fed itself will be an aggressive tap on the market as an active seller. Whether Brainard was speaking in a personal capacity, or flying kites to gauge the reaction, or had the authority to speak on the Fed’s behalf, remains to be seen. However, being the vice-president-in-waiting, markets took her comments at face value and reacted immediately, dumping stock and forcing up yields.

A rapidly flattening yield curve

What has been profound has been the extent to which the US yield curve (the way the yield changes for bonds with differing periods until maturity) has both risen and flattened very rapidly. If yields across the range have been rising, the acceleration at the short end (the bonds with less time until maturity) has been impressive. As recently as October, the 2-Year US Treasury (the one most frequently used by central banks as the indicator for interest rates and the commercial banks as the basis for mortgage rates) had a yield of 0.2%; today it stands at 2.51%. The yield on the central part of the curve, the 5-Year, at 2.74% now exceeds that of the 10-Year long bond at 2.67%. An ‘inverted’ curve, where shorter dated bonds have a higher yield than longer dated ones, was once regarded as a predictor of recession; it is no guarantee of one but it sends out strong warning signals that the economy may suffer under the near-term escalating cost of servicing the debt in issue.

A hostage to two global exogenous shocks in the form of a pandemic and a major war, combined with falling into policy elephant traps of their own making, the major central banks (the Fed, the Bank of England and the European Central Bank) face an unenviable position: complex, contradictory and with significant factors outside their direct control.

Post-pandemic economic recovery is being threatened by the dislocation caused by the war; rapidly rising prices needing reining in and markets unnerved that in being aggressive, the central banks will themselves run the risk of killing off the economy in the process (conventional economic theory suggests it is unusual to be raising interest rates into a slowing economy); markets having to reprice risk to reflect the increasing instability as the geopolitical tectonic plates shift perceptibly but not entirely predictably; and finally and certainly not least, having had well over a decade of quantitative easing and central bank support, the central banks are not only no longer the markets’ friends but in the case of the Fed, may now possibly even be a subversive influence. For the first time in a very long time, markets are having to assess risk free-standing of central bank support. In the case of bonds, they seem to be suffering a distinct bout of vertigo.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

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