Rabo: This Is The Market’s Worst-Case Scenario

By Michael Every of Rabobank

The Wisdom of Solomon

The mainstream financial industry is finally grasping that the comfy tectonic plates they sit on are not just shifting but smashing into each other. Yesterday saw a Bloomberg op-ed titled ‘Putin and Xi Exposed the Great Illusion of Capitalism’, It read like a greatest hits of this Daily, referring to Norman Angell, imperialism, WW1, The Treaty of Versailles, imbalances and fascism, WW2, Bretton Woods 1, and communism and the Cold War. The conclusion: “Unless the US and its allies mobilize to save it, the second great age of globalization is coming to a catastrophic close…. Unless something is done quickly and decisively, the world will divide into hostile camps, regardless of what happens in Ukraine. And this divided world will not suit the West.” Likewise, Larry Fink of BlackRock states: “The Russian invasion of Ukraine has put an end to the globalization we have experienced over the last three decades.”

The Financial Times headline is NATO warning Russia not to use chemical, biological, or nuclear weapons – and Western preparations in case they do. The Russian case for potentially doing so to change the war’s momentum is laid out as The Institute for War notes: “The Ukrainian government and military directly stated for the first time on March 24 that the Kremlin believes its invasion of Ukraine has entered a second, “protracted” phase”. The assessment is that Russia no longer threatens Kyiv, needs far more troops, and is digging in. As @b_judah reports, while things can still shift on several fronts, “…the base case is this settling into a war of attrition. One view is the battle lines will like a sort of gigantic version of the Donbas frontlines post-2014.”

Short of no-longer-unthinkable WMD usage, it’s the market’s worst-case scenario. No quick end to the war. No quick political settlement. No quick back to normal. And the Balkans are smouldering; North Korea just test-fired an ICBM and stated it will prepare for long-term confrontation with the US; Armenia and Azerbaijan are close to conflict again; and Iran is primed for action in the Middle East, with Houthi proxies having targeted Red Sea oil tankers recently. At least a cease-fire has been agreed between Ethiopia and Tigray.

The G-7 is hence split over the issue of energy boycotts. That, as the US promises to send LNG to the EU –totaling 4% of its consumption(!)– and Russia leaves Europe unclear over when/if it will shift to rouble payments for gas, and is saying gold can be used instead, or perhaps Bitcoin. In which case, the latter two are arguably about to run up against Western sanctions.

As I dot-joined yesterday, eyes are now being turned to China. Former Trump National Security Advisor McMaster told the US press: “Of course they’re going to give arms to the Russians” – a claim with huge implications. But before that, yesterday saw news that ‘US sets red lines for China helping Russia dodge sanctions’, noting the White House has warned Beijing not to take advantage of business opportunities created by sanctions, help Moscow evade export controls, or process its banned financial transactions. There is now also a US red line over “systematic efforts, industrial-scale efforts to try to reorient the settlement of financial payments.” So, China tries to avoid the US dollar with Russia, and it faces US secondary sanctions.

Today, Politico notes ‘China’s Russia embrace triggers Congress blowback’ and: “The Biden administration’s efforts to enlist Chinese government support to isolate and punish Russia for its Ukraine invasion have hit a brick wall. China is maintaining its diplomatic, economic and rhetorical alignment with Russia and is disavowing any meaningful role in leveraging its influence with Russian President Putin to end hostilities that both the EU and the US State Department say have included war crimes against Ukrainian civilians. That positioning has provoked public dismay that is boosting the rollout of congressional initiatives to deter China from economic or material support for Russia’s war machine and to impose stiff penalties if Beijing provides such assistance.” Indeed:

Republican senators are proposing a Crippling Unhinged Russian Belligerence and Chinese Involvement in Putin’s Schemes (CURB CIPS) Act to block China from providing Russia financial system access to evade sanctions. This would target China’s Cross-Border Interbank Payment System (CIPS), China’s version of SWIFT as well as Russia’s System for Transfer of Financial Messages (STFS). Specifically, the proposed legislation would freeze or terminate any US-based accounts connected to Chinese financial institutions, or block their US-based property, that engage in transactions with a Russian financial institution using either CIPS or SPFS.
There is a renewed push for House Foreign Affairs Committee support for the Protecting Americans from Corporate Human Rights Abusers Act, which will curtail Chinese state firms’ access to US capital markets.
A member of the House Committee on Financial Services is also pushing a Special Drawing Rights Oversight Act to prevent Russia from accessing CNY.
House representatives have further introduced legislation to revoke China’s Permanent Normal Trade Relations status to punish it “for its heinous human rights atrocities — especially and including the regime’s ongoing genocide and forced labour of Uyghurs and other Central Asian minorities.”

And this is the current Congress: the incoming one is likely to be even more hostile. Let’s not forget even the White House wants to kick Russia out of the G-20, while China wants it to stay in: what happened to the G-8, one might ask? Even Stephen Orlins, president of the New York-based National Committee on U.S.-China Relations, as pro US-China relations as one can get, says: “We are at a potential inflection point. If China uses its unique relationship with Russia to mediate an end to this Russian invasion, sentiment on Capitol Hill toward China could improve. At the other extreme, if China should supply Russia with military equipment, U.S.-China relations will drop to levels not seen since the establishment of diplomatic relations.” Against that backdrop, what is the smartest Chinese geopolitical move?

Arguably not ‘China Confirms ‘Policing’ Deal with Solomons’. In short, the Solomon Islands may allow Chinese police, and military, to be stationed there, giving China its second foreign military base after Djibouti, and its first in the Pacific. Australia and New Zealand are shocked, as are the US and ASEAN. Indeed, it’s hard to see any wisdom of Solomon in that decision unless Beijing has already decided that the warnings of Bloomberg and Fink are coming to pass. Notably, China has seen large capital outflows since Russia invaded Ukraine, unlike other EM: it is being treated differently. The headline above, combined with the mood in the White House and Congress, suggests there could be a lot more ahead. China may or may not be trying to build something with Russia, and the Solomons, but its economy is still dollar-based at heart: it may have to find that out the *very* hard way.

Meanwhile, other big policy shifts loom. The West is trying to show it can fight Putin and emerging-market hunger, as ‘G-7 leaders pledge action to address food shortages caused by war’. They state: “We will make coherent use of all instruments and funding mechanisms to address food security and build resilience in the agriculture sector in line with climate and environment goals.” Yet there are enormous implications: let’s see the details of how one boosts agri planting within four weeks, as fertiliser costs soar, and deals with food-as-fuel biodiesel. Likewise, White House advisor, and environmentalist, Deese is now saying there should be greater oil production in the US – presumably as opposed to in Venezuela or Iran. But what policies will shift to see it happen, and when?

Against this, US durable goods orders dropped more than expected yesterday (-2.2%), suggesting that even though the Fed keeps talking about 50bp moves, and bond yields are surging (albeit US 2s and 10s slightly lower at 2.14% and 2.36%, respectively, at time of writing), the actual economy is already slowing. And that’s before we get $150 oil and food-flation.

The Fed may be about to make a terrible policy error, but if this current phase of globalization is ending, it won’t be the only one to have done so. So will everyone who didn’t see the ‘Great Illusion of Capitalism’ ending.

There will be real consequences for the way the Fed works –and the way we all do– if either of those come to pass, and far more so if they both do at once. Perhaps indicatively, over the border in Mexico, yesterday saw the President announce the central bank rate decision to hike 50bp well in advance of the actual news(!) Less central bank independence? Impossible!

Unless we are in a war economy in a collapsing global system in which supply chains are the front line, barter and counter-trade return, industrial policy is needed, so is MMT, where possible, and even rationing, price controls, and perhaps capital controls are required in places. So, yes, that means real consequences for all of us in business and markets. You can take traditional market rules of thumb and try to use them as fuel or food, and instead embrace older wisdom, such as that wars are highly inflationary before they are then deflationary.

None of this is new –or unexpected– if one wanted to look for it.  I turn to the Wisdom of Solomon to make that key point:

“What has been will be again, what has been done will be done again; there is nothing new under the sun. Is there anything of which one can say, “Look! This is something new”? It was here already, long ago; it was here before our time. No one remembers the former generations, and even those yet to come will not be remembered by those who follow them.

Happy Friday.