Investability Bulletin 07/03/22: The S Word

Stagflation is making a terrifying comeback

Photo by olieman.eth

Stagflation is back. Crude oil soaring, stocks down, gold at $2k – welcome to the new world order of low growth, rising prices and bear markets…suppose this kind of inflation will wipe out the debt; the debt and the middle class. 

Brent surged to a peak of $139.13 overnight as the US said it’s in active discussions with European partners about banning Russian energy exports. That’s about $8 below the all-time high of $147.50 set in July 2008. GS: A sustained $20 per barrel increase in oil will hit GDP in the euro area by 0.6%, and by 0.3% in the US. What about a sustained $40 increase? France’s finance minister Le Maire said the government is working on risk evaluation of cutting off Russian gas. 

Self-sanctioning only removed so much from the market – 3-4m bpd; many were still active in Russian crude and the gas is flowing as before, including Shell which filled its boots with Urals crude at a record $28.50 on Friday…nice trade, but optics? However, as previously argued, it was only a matter of time before we got to the point of banning Russian oil and gas because of the escalation in the conflict and targeting of civilians. Or at least got to the point of talking about it – which is enough for the front month to rip.

If there is a ban, how do you turn it back on? That would mean longer-term repercussions and elevated pricing. If anything the back months need to catch up with the barrels-at-any-price action in the front month. We are already seeing a major oil shock that will reverberate for years. What happens next? Probably more strategic reserve releases – not that it will make much of a dent. Does the White House get US companies to increase production? Has Biden picked up the phone to the Saudis? There is some spare capacity but not much.

Meanwhile Russia is delaying the final agreement of a new Iran nuclear deal that would bring perhaps 500k-1m bpd to the market.  JPMorgan: “We believe [Brent] price needs to increase to $120/bbl and stay there for months to incentivize demand destruction … Crucially, were disruption to Russian volumes to last throughout the year, Brent oil price could exit the year at $185/bbl.” Key question is whether US shale producers can or are willing to step up: for now they are focused on returning money to shareholders – a more favourable stance in Washington would surely help. 

Commodities across the board are receiving panic type bid – wheat (+7%), palladium (+11%) and, in particular, nickel (+26%) surging again. Expect prices to remain high and the action volatile. Russian and Ukrainian negotiators sit down again today but at the moment the limit seems to be setting up humanitarian corridors within the conflict zone. European gas prices surged to a new all-time high, trades about $470 a barrel of oil equivalent.  

For now, this is all about supply disruptions…not sure demand can keep up with these prices. Who imports the most food/energy? We are going to see some mega disruptions and possible unrest in EMs…unintended consequences of sanctions could be more trouble. It was high food prices that sparked the Arab Spring a decade ago…We’re already hearing of Hungary, Argentina, Russia, Bulgaria and Turkey wither limiting, or completely blocking, grain exports. Ireland is encouraging farmers to plant grains – key planting season ahead, Ukraine almost certainly will miss it unless there is a ceasefire. Russian and Ukrainian grain exports make up a quarter of the global total. Going back further in history, soaring bread prices were a major cause of the French revolution. One hears the echo of Marie Antoinette in some of the smugness today.

Stocks slumped – no other thing they can do in this environment as investors hit peak defensive. The FTSE 100 slid under 6,800…horizontal support from the lows of May, July and September last year. The DAX and Stoxx 50 entered a bear market, both down about 3%. Travel and leisure again are the hardest hit, along with construction and household goods – very much a cost input inflation reaction. Wizz Air and TUI –12%. Banks all down by 4-5%, Stoxx Banks at lowest in 13 months…slower EZ growth now more than any Russia exposure. Basic resources and oil and gas sectors both +3% in early trade for obvious reasons…Shell +5%, hence why London is outperforming European peers. Asian shares were all lower – the Nikkei 225 down 3%, China shares similar. US futures are seen lower…expect test of 4,200 for the S&P 500.  

Defence stocks are doing well – BAE Systems +7% – Chancellor Rishi Sunak reported to have bigger defence budget at the top of his list for the upcoming spring statement. As stated last week, this is only the beginning of a significant period of rearming in Europe. Meanwhile, Russia plans to disconnect from the external internet on March 11th…major cybersecurity risk…Darktrace up another 2%, +35% over the last month.

In FX, a fairly predictable response with the dollar and Swiss franc bid. Sterling trades around the Dec lows at 1.3160 vs USD, key 38.2% Fib level support here. Break calls for 1.30 round number and possibly 1.28. Zloty and other east European currencies continue to be offered, PLN hitting a record low versus the euro. On the Swissy finding bid, EURCHF went below 1 this morning due to haven bid and general EUR weakness. The Swiss National Bank reiterated its pledge to intervene to stem the rally if required to do so. “The Swiss franc is currently sought after as a refuge currency, along with the US dollar and the yen,” the central bank said in a statement. “The Swiss franc continues to be highly valued,” it added. “The SNB remains prepared to intervene in the foreign exchange market if necessary.” 

As for Russia, last week I noted that “never has such a large foreign currency reserve been wiped out. [The] question is to what extent this sparks contagion in the global banking system that leads to CBs needing to act to supply the market with the USD it requires? I would expect dollarisation and a shortage of dollars to be the main effect and for a sharp move higher for USD as a result with the natural carry over this would have for peers.” The dollar rip that I’d flagged in the note last Sunday, as the likely result of the sanctions, was a slow grind before it really exploded on Friday as the FRA-OIS spreads blew out….as we’d flagged all week the likely main loser from this will be the euro. ECB this week – see below. DXY surged towards 99 and then gave a tiny bit back but not a lot. Expect more dollar strength. Chicago Fed president Charles Evans said the US central bank should raise rates close to neutral, which implies seven hikes this year.  

Another question I kept posing last week was whether markets were even close to pricing in total collapse of world’s 12th largest economy? Are they close to pricing for gigantic food and energy inflation? Thursday and Friday started to show investors were getting more concerned as European stock markets rolled over. We await to see what the net effect of the weekend’s events are tonight on the open.

The shift this weekend has not been as dramatic as last, but the situation only gets worse. Visa and MasterCard are among the latest companies to withdraw from Russia, and unless Russian troops turnaround, the Russian economy is going to go through a long, protracted, messy contraction. And it’s not good for anyone. This war will weigh on global growth, and poses potential systemic risks

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