Global markets are jolted by an unprecedented combination of supply shocks and dealing with multiple blows to different parts of the asset allocation spectrum, Thomas Meichl writes in an essay for finews.first.
De-globalization started with the 2016/17 U.S.-China trade war, in 2020 the COVID-19 pandemic accelerated the trend, as onshoring of supply chains became popular.
Then, on 24 February 2022, we woke to the news we thought was impossible in the 21st century: Russia invaded Ukraine. This blatant move is a grave tragedy and humanitarian disaster, with more than 3.5 million people fleeing the country, and cities reduced to rubble.
The geopolitical risk barometer has risen to a level last seen during the Cuban missile crisis, with Russia stating readiness of their nuclear arsenal. Besides the humanitarian crisis and political tensions, the shocks to Asia’s financial system are real, and somehow seem a bit under-appreciated.
«The current combination of shocks has far exceeded the effects of the 1970s energy crisis»
Russia and Ukraine play pivotal roles in supplying commodities to Europe and Emerging Markets, in particular Oil and Gas, but also important agricultural commodities like wheat and sunflower oil. The current combination of shocks (Russia/Ukraine war and COVID lockdowns in China) has far exceeded the effects of the 1970s energy crisis.
In 1979, the Iranian revolution led to a total loss of production, and the global supply dropped by an estimated 5 percent. While Russia’s oil and gas production has not gone entirely offline, there are emerging challenges that are pushing prices upward.
The biggest impact is felt by Europe and China, which have been overly dependent on Russia’s energy exports. EU members have joined their American peers in imposing harsh sanctions, but countries like Germany and Austria are still voracious consumers of Russian oil and gas. China on the other hand, is possibly even more impacted by the current embargo.
The reason is mainly in logistics: There is only one pipeline from Vladivostok connected to a Chinese oil terminal, which was already operating at 100 percent capacity prior to the war. The big issue for China is that shipping routes for Russian oil are severely impacted. International insurance companies are waiving their coverage for tankers berthing and loading in Russian ports on the back of sanctions. So while Russian oil might be available at discounts of $25-30/barrel, there is currently no way to get the black gold into Chinese tanks.
Asian and European buyers will be competing for access to oil and gas from alternate sources in the Middle East and West Africa for months, if not years to come, thereby leaving energy prices at an elevated level.
«We have to brace ourselves for a turbulent period in the coming months and years ahead»
Russia and Ukraine have been major exporters of potash, urea and ammonia-based fertilizers. In fact, global fertilizer prices have been skyrocketing since 2021. This is a precarious situation for Asia, affecting food producers and net importers alike. Take Thailand, Southeast Asia’s biggest rice exporter. In 2020, fertilizer prices averaged around Thai Baht 10,000.
In 2021, that price climbed to around Thai Baht 16,000. As of March 2022, the price of one ton of Urea fertilizer in Thailand averages around 33,000 Thai Baht. This is more than double!
We have to brace ourselves for a turbulent period in the coming months and years ahead. Inflation is the biggest enemy of any political system and has often led to social instability and political tensions.
«For Asia in particular, I am cautious of countries with large current account deficits»
The current volatility makes it difficult to predict outright price targets or market moves. Irrationality often persists longer than solvency, so particular predictions are hard to determine. But it is puzzling that European stocks, for example, are trading within striking distances to levels before the Russian-Ukraine crisis, which has somehow changed the world as we know it.
For Asia in particular, I am cautious of countries with large current account deficits, where the future increase in imports will exaggerate the already strained government finances. Funding for USD denominated debt will also increase. As seen in many other risk-off scenarios, the dollar is likely to rise.
«The increase in core inflation is eating into private sector consumption and investments»
What keeps central bankers up at night is when inflation expectations become unhinged. The absolute level is often less critical than the rate of change itself. Here, the Federal Reserve (Fed) already committed a policy error in 2021, by not starting to hike rates when the U.S. Core PCE Index rose above 3 percent in May and remained there (transitory). Even the hawkish pivot in November has not helped to rein in inflation expectations for the months to come.
Therefore, it is a common expectation that the Fed will aggressively hike for fear of further inflationary increases, and they will hike into a rapidly slowing economy. The increase in core inflation is eating into private sector consumption and investments as purchasing power gets eroded. This puts us on track for a scenario that most of us only know from history books: stagflation.
The U.S. bond markets are already anticipating such a scenario, especially when the yield curve between the 5 and 30-year U.S. Treasuries inverted recently. This indicates that on a forward basis, the market is expecting exactly that: over-tightening in the near term and a resulting recession, which in turn will lead to rate cuts five years down the road.
«Equities that may do better than others during such rare periods are stocks from the commodity segment»
Despite all the imminent risks I see in the weeks and months ahead, big economic shifts like the current one also provide a great opportunity for investors with a longer-term horizon.
Equities that may do better than others during such rare periods are stocks from the commodity segment, in particular food and energy. In metals, precious metals may rank a bit above industrial metals in the event of a recession.
In Asia, we will have to deal with a very differentiated picture. Here the key will be to look for sectors and companies that benefit from high demand regardless of the economic climate and pricing power to pass on rising input and labor costs.
China is one of the few countries that has emerged from a policy of easing and is providing more stimulus and could become a potential outperformer. Another sector with potential long-term benefits is renewable energy and infrastructure, as the shift to alternative energy sources in times of high prices generally accelerates.
In a rapidly changing economic landscape, we can expect Asia’s financial markets to experience sudden shocks. Despite of geopolitical tensions, we are heartened to witness a silver lining in certain sectors and countries, and one thing we can look forward to is for the region to cultivate stronger resilience and flexibility, in dealing with unprecedented changes ahead.
Thomas Meichl is head of advisory at Singapore-based investment firm Kristal.AI. He manages two sophisticated strategies: the Future Vision Strategy is an equity portfolio investing in next-generation growth stocks and market sectors that are set to shape our future in the coming five to ten years; the USD Leveraged Bond strategy provides access to an actively managed and leveraged fixed income portfolio investing in global investment grade bonds.
