9 Mar 2022
Global Macro-economic and Geo-political Update
Given the recent invasion of Ukraine and the unfolding geo-political events we thought it important to provide an update.
Geo-Political – Russian Ukraine War
In our most recent newsletter, we considered “the democratic countries” reaction to an invasion of Ukraine by Russia. The sanctions will have downstream consequences for all Organisation for Economic Co-operation and Development (OECD) countries, as Russia and Ukraine are major suppliers of grain, minerals and energy products.
Russia is about the 12th largest economy in the world but probably has the largest asset base in the world of natural resources, e.g., gas, copper, oil and nickel. So, its exit will have a huge impact on the global economy, including shortages leading to price hikes (inflation) as impacted countries seek alternative suppliers. Does this represent an opportunity for Australia? Yes, as it has been well reported that China is actively seeking alternative iron ore suppliers to Australia. Perhaps fortuitously, Australia is positioned to replace the Chinese market with markets that Russia previously operated in which they will now be excluded.
Russia has been reducing its holdings of US treasuries for several years now and replacing them with Chinese, Euro and Yen bonds and gold, as part of their response to earlier US sanctions. Russia as at 31 December 2021 held just USD3.9 billion in US treasuries, so this aspect will have little, if any impact on financial markets. Russian investors will not receive their coupons or principal when their US, Japanese and Euro bonds mature as they are frozen. For investors in Russian bonds the news is equally not good, as Putin has signed a decree saying the bond holders can be paid in rubles (not USD, Yen, etc.), although it is unlikely any payment will be made, and if in rubles, the bondholders will have massive realised losses given the significant devaluation of the ruble against the USD. A game of “tit for tat”!
It would be a very different situation if China invades Taiwan, as China holds USD1 trillion in US treasuries. They are the second largest holder of US treasuries after Japan. If a scenario arose where sanctions froze Chinese holdings of US, Japanese and European bonds occurred this would lead to a major conflict. At a minimum China would immediately cease funding the US budget (estimated to be USD3.3 trillion and increasing) and current account deficits leading to massive hikes in interest rates and a deep recession in the US, as America would have to live within its means. China, US and the world have too much at stake for this to occur, and our comment is to highlight that the situation with Russia is serious, but very different to a conflict involving China.
The world is splitting into “Democracies” v “Autocrats” with Russia and China being the leaders in the dictatorship world. Each hemisphere has its supporters. Iran historically and culturally falls into the democracy campaign even though it has a supreme leader; however, its relationship with America is so fractured that it could easily fall further into the dictatorship camp. The US is keen for the Iran Nuclear Deal (JCOPA) to be re-instated and has now made overtures to Venezuela to return to the fold, as both countries have major oil reserves.
The de-dollarisation as the world’s reserve currency has been a goal of Russia and China for many years, and the invasion of Ukraine and the resulting sanctions is accelerating this move. In future, countries will likely limit their foreign reserves as a sanction risk management strategy. We previously reported that central banks generally had been increasing their gold reserves.
Markets – Equity and Property
Equity and debt markets are responding to the above with increased volatility, and we may possibly be at the start of a bear market. On 5 January 2022, the S&P/ASX 200 and S&P 500 index were 7,596 and 4,796 respectively. At the time of writing this newsletter (8 March 2022) they were 7,042 and 4,201, which are falls of 554 and 595 points respectively. Equally, our market intelligence is that residential property prices in some areas have fallen by 10-20% since Christmas, despite media hype that prices will continue to rise this year.
Increasing Interest Rates, More Fiscal Stimulus and QE
It is likely the US Federal Reserve (Fed) will increase interest rates by 0.25% later in March; however, this is next to meaningless in the fight against inflation which is running between 7% and 12% in the US, where interest rates are close to zero. It is the psychological aspect of a small increase that is important as the Fed wants to slowly deflate the asset price boom in property, equities, commodities and bonds.
Globally governments have withdrawn their Covid stimulus programs meaning free money has come to an end, or so we think. Similarly, central banks have flagged their intention to end accommodative monetary policy, e.g., increase interest rates having engaged in it for 20 plus years. This desire by governments and central banks to return to responsible fiscal and monetary policy will now be put on hold, as they will need to act to combat the disruption caused by the Ukraine/Russian war and associated sanctions. There will likely be more QE and possibly further fiscal stimulus packages. Australia is also faced with a huge clean up bill from the terrible floods which are requiring Federal and State Government action.
We expect there will be a very slight rise in US interest rates, and this will have flow on impacts to Australia, there will be more QE because of a USD liquidity shortage in global debt and equity markets and further fiscal stimulus, as much of the OECD population income is government subsidised. People need to be able to live! These along with shortages in agriculture and energy products and supply chain issues mean difficult times ahead.
Hold the Course
In mid-2019 we re-structured portfolios because of negative yielding international bonds. In 2021, we sold out of Australian bonds because of concerns of stagflation and moved into Inflation Linked Bonds and increased allocations to hard assets, e.g., energy, mining, agriculture, gold and infrastructure. In particular, we identified lithium, copper and nickel as minerals that will be in great demand in the future. These have been correct calls as these sectors have been increasing in value while others have fallen. We still believe that in the medium term that holding investments in technology, industrials and financial institutions are necessary part of your portfolio.
It’s time to be patient and watch while holding the course with some portfolio tweaking as required. Now is not the time to panic. We observe that well known investor Jeremy Grantham recently said, “If your do not lose money in the next period of time then you are doing well”.
If you wish to discuss the above or any other matter, please feel free to contact us.